Randy Frederick

Managing Risk Using Options

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This article originally appeared on The Options Insider Web site.

Risk management is key to a trader's survival.

It has often been said that those who survive are not the ones who make the most money, but the ones who lose the least. Even the best traders make bad trades, and minimizing losses is one of the most important things you can do to help ensure that you'll survive to trade another day.

In volatile markets, this is more important than ever. That's why I'd like to focus on a few ways you can use options to reduce or limit your risk.

The notion that options are only for speculators, and are either too risky or too complicated for average investors, is a common misunderstanding. Although it's true that options can be used for speculating, they are often used to hedge equity positions and help minimize the risks of trading.

And while there are a lot of complex option strategies, many are simple and can be effectively used by investors who have rarely or never traded options before.

Among these simpler strategies are covered calls and covered puts. Employed correctly, these strategies can potentially increase profits and limit losses simultaneously.

Covered Calls: Long Stock Position and Short Calls in Equal Quantity

This is one of the most common option strategies. Selling covered calls against an equity position generates premium income and creates an obligation to sell the stock at the strike price.

While covered calls can be a great way to generate income in a flat or mildly uptrending market, the limited risk protection that covered calls can create should not be overlooked. The protection is limited to the amount of premium received.

A covered call writer typically has a neutral to slightly bullish view of a stock. In many cases, the best time to sell covered calls is either at the time a long equity position is established (buy/write), or once the equity position has begun to move in your favor.

When creating a covered call position, it's generally best to sell options with a strike price equal to or greater than the price you paid for the equity. If the stock remains flat, declines in value or even increases a little, an at-the-money or out-of-the-money call will likely expire worthless and you'll get to keep the premium you received when you sold the covered calls, with no further obligation.

Once that happens, you can do it all over again for another month. If, by the expiration of the option, the stock has appreciated in value to slightly above the strike price, you'll probably have your stock called away at the strike price. This could occur prior to or at expiration.

This isn't necessarily a bad thing, though. If you sold at-the-money or out-of-the-money calls, this will generally result in a profit on the trade. That profit will usually exceed the profit you would have made had you simply bought the stock and then sold it at the appreciated price.