Less Risk, More Control
by Don A. Singletary
If you're trading options, here's a management tool that can offer you less risk.
Ever sell out of a trade too early because it ran against you, only to have the market turn the instant you sold? Or maybe your stops get hit a little too often? To many traders, these scenarios are all too familiar. If this happens to you, it could be your trades are not matching your risk tolerance. At a certain point - and that point is different for everybody - an emotional buzzer goes off when you have reached your limit for risk tolerance. Very few investors can successfully manage a trade that is outside their comfort zone.
One way to avoid this problem is to select trades that will allow you a broader comfort range, at least until you have more experience with the markets. Vertical option spreads offer a wide selection of risks and margin requirements that can be tailored to fit almost any risk tolerance and account size.
There are two types of vertical option spreads, the credit spread and the debit spread. Both involve selling one option and buying another in the same expiration month at the same time but at a different strike price. They are referred to as vertical because one is above the other.
For a debit spread, the investor sells one option and buys another, resulting in a net debit or cost to his account. This strategy can reduce the cost of buying an in-the-money? option. Here's an example: Suppose it's the middle of November and the January orange juice futures contract is at 118.70. You might like to be long?, hoping for a freeze. Take a look at these option prices:
Don A. Singletary is a commercial risk management hedge consultant.
Excerpted from an article originally published in the July 2001 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2000, Technical Analysis, Inc.
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