Option Investor

Trading Basics

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Put writing can be used to complement a conservative
stock portfolio because it offers two strategies for
generating profits: collecting premium through the
sale of out-of-the money options, and/or acquiring a
specific issue at a reduced price, which is eventually
sold for a profit.

In the OW model portfolio, we focus on the first method;
selling OTM options with average target returns of 5%
to 8% per month. Since risk management is so critical
to the success of this approach, we also strive to offer
a diverse range of candidates in a variety of market
sectors. Of course, this goal is not always possible
with a limited account balance, which reduces the
number of positions that can be held at one time.

Despite the apparent fundamental value or technical
quality of the issues listed in the portfolio, it is crucial
that each individual investor perform the necessary due
diligence until it is determined that a position meets
their personal risk-versus-reward tolerance. A trader
should also research the underlying company and its
calendar of upcoming events, earnings dates and other
scheduled announcements. The axiom, "Knowledge is
Power" was never more appropriate than with investing
and with the vast amount of published material available
on the Internet, there is no excuse for being uninformed
about a stock or its industry group.

Once you have selected a favorable candidate, you must
decide how many shares of the stock you are willing to
(potentially) purchase through the sale of cash-secured
puts. We generally suggest writing a minimum of 5 - 10
contracts to prevent commission costs from significantly
affecting the (target) return on investment. We also
recommend that you place the opening order at a "limit"
price, rather than at "market," as the initial credit from
the (put) option sale can often be improved, especially
when a particular series is thinly traded.

After your order is filled, you should monitor the price
of the stock until the sold options expire, or need to
be closed (and/or adjusted) due to unexpected activity.
The OW staff tracks all of the positions on a daily basis
but we can not monitor each issue continuously, so it is
essential to employ some type of loss-limiting mechanism
(eg; a stop-loss or sell stock order) when the position is
established. The portfolio commentary is provided to
help traders understand when (and why) we believe
various positions should be opened, closed or adjusted.
However, it is not intended as a substitute for individual
trading techniques nor does it replace your duty to
manage the positions in your portfolio.

Risk Management

A "short" put position generally requires the underlying
issue to remain above a specific price in order to earn
a profit. Therefore, you should be relatively confident
that the stock will achieve this result before initiating
any play on our candidate list. In addition, you should
be aware of the share value that will achieve a "break
even" basis in the overall position, so you can determine
the price (exit point) the underlying issue would have to
reach in order to generate unacceptable losses.

Ideally, you would simply enter the suggested positions
and then wait for option expiration. Unfortunately, it
does not always work that way. To be successful on a
consistent basis, option positions should be closed (or
covered) when predetermined exit points are reached
and you must be prepared to make these trades when
they are needed, not after the play has moved beyond
a reasonable loss level. This kind of portfolio management
requires advanced planning and the discipline to execute
preset strategies in adverse conditions, regardless of
your emotions or instincts.

With this form of option trading, there is large downside
potential and in many cases, failure to adjust a position
in a timely manner can lead to a catastrophic loss. In
fact, it is not uncommon for investors who have enjoyed a
long string of winning positions to get "wiped out" by one
bad play simply because they failed to limit their losses
when the market moved against them. With this knowledge
in mind, we suggest that you consider using trading stops
on any sold (short) options to help limit losses when the
underlying declines. Some traders base these orders on
the value of the stock, exiting the position when it falls
below the sold (put) strike price. Other traders place a
"buy-to-close" order (on the option) at a price that is no
more than twice the original premium from the sold put.

Regardless of the method you choose, understand that the
best trading system is worthless if it is not implemented
in a timely manner. You simply can't afford to be making
decisions after the position is in place -- under duress,
and likely at the worst possible moment. The only way to
avoid this fate is to develop a plan with a target exit (or
adjustment) point, and stick to it. This requirement is
difficult for new traders to adhere to however the fact is,
professionals use proven money management techniques
to maximize profits and limit losses and that's why they
come out ahead in the long run.

Trade Wisely!

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