Randy Frederick

Managing Risk Using Options

by Randy Frederick   11/02/09

Free Trading Guides

 

A Few Words of Caution

As you know, there are very few risk-free profit opportunities in trading -- and covered calls and covered puts are no exception -- so, I'll conclude with a few precautionary points:

1) These strategies will usually limit significant profit potential if a stock moves substantially in your favor.

2) While these strategies do limit risk somewhat, they cannot eliminate it entirely.

3) Losses are limited only by the amount of premium you receive on the initial sale of the option.

4) Any time you sell a covered option, you have established a minimum buying price (covered put) or maximum selling price (covered call) for your stock. Any movement in the stock beyond that established price creates no additional profit for you.

5) Selling a covered option when your stock position has already moved significantly against you could cause you to establish a closing price that ensures a loss to you.

6) To make sure that you don't lock in a losing trade, before you sell a covered call or put, ask yourself, "Would I be happy if I had to close out my stock position at the strike price on this option?" If the answer is yes, you'll probably be OK.

7) While our examples assume that you hold the covered position until expiration, you can usually close out a covered option at any time by buying it to close at the current market price.

8) Whether the equity portion of your strategy is profitable or not, waiting until expiration will maximize your return on an out-of-the-money option -- however, you are not required to do so. In addition, a significant change in the price of the underlying stock prior to expiration could result in an early assignment.

9) Keep in mind that if your short option is in-the-money, you could be assigned at any time.

10) Be very careful before you decide to sell a covered option that's been adjusted due to a company reorganization.

11) When companies merge, spin off, split, pay special dividends, etc., the options of that company can become very complicated.

12) If you see a deal that seems too good to be true, it probably is.

Remember, you win some and you lose some -- you can't be right all the time. The important thing is to survive the losers and make it to the next winner.

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