Option Investor

The Readers Write: Option Trading Q&A

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With so little activity in the portfolio, we thought some of our new readers might be interested in this E-mail, which asks a number of common questions about the Option Writer Newsletter.

Attn OptionWriters:

I just signed up for the newsletter trial and I have some questions. I have traded a few options in the past but I never sold any naked because I heard this was a speculative strategy.

Is this really something the average person can do without giving away all their money?

2-How come I don't see any losers in the summary? And there is no recent advice other than the new trade on PCLN.

I'd like to know how you pick the stocks and what to expect as far as future recommendations.

Thanks Much!


Hello WR,

It's nice to have you aboard for a trial run with the OW Portfolio. Option trading isn't for everyone but the folks who work at the OIN pride themselves on offering some of the best option-related information available on the Internet at a reasonable price.

Despite what you may have heard, selling uncovered options is a viable technique, when utilized properly in the appropriate market conditions. The validation for this statement can be substantiated in many ways however a simple observation of the activity at a major exchange reflects the popularity of the strategy among professional and retail traders, fund managers, and institutions such as large corporations. Having made that assertion, a more important question exists: "Should it be part of a conservative trader's portfolio?" In our opinion, the most efficient way to evaluate an option-trading strategy is to examine its basic advantages and weaknesses. These would include: ease of use and management; risk versus reward potential; the affects of pricing components such as time decay, volatility and leverage (delta); and the capital required to effectively employ the technique on a regular basis. Writing uncovered options ranks fairly well in all of these areas except one - the ratio of risk to reward. Not surprisingly, that component is also the most misunderstood aspect of selling naked puts and it leads to the worst drawback of all; the possibility of a catastrophic loss where only minimal collateral is required.

Based on that observation, the sale of uncovered (put) options is definitely not appropriate for everyone. However, to suggest that "conservative" traders should not use the strategy is analogous to saying they are also incompetent or incapable of understanding the various attributes of a particular position or technique. Instead, we would venture that most market participants, regardless of their level of experience, can be educated about the shortcomings of the strategy and be taught to implement and manage it correctly in market conditions that are appropriate for its use. With that idea in mind, it is obvious that one must become knowledgeable, as well as proficient, to succeed in this unique (and often notorious) method of option trading. The best way to achieve those goals is to read all you can about the strategy and fortunately, there are number of excellent books on the subject, as well as online articles about position management and adjustment strategies.

Regarding the OW Portfolio, there have been losers, just not as many as you might have in the majority of trading strategies. That's because selling "out-of-the-money" options is a high probability/low profit technique that yields lots of winners but with much smaller gains. Another way we keep the portfolio "in the black" is through rigorous position management, including the use of trading stops and conservative exit (and adjustment) strategies. While there are a number of different techniques used by professional market players to manage a portfolio effectively, our primary stipulation is to have a closing order in place at all times to protect against unexpected moves in the underlying.

Since all of the plays in the OW Portfolio are monitored on a regular basis, you can expect commentary and technical observations when a particular issue warrants additional attention. This process generally includes identifying a stock as being on the "watch" list and, when necessary, labeling it as an "early-exit" candidate with a specific closing technique. However, this service does not replace your replace your duty to manage the positions in your portfolio, nor is it intended as a substitute for your personal trading strategies. In most cases, we will recommend closing a (losing) play long before the stock moves beyond the sold (put) strike price. While some people believe we are a bit too conservative, keep in mind we manage the OW Portfolio with the least experienced traders in mind, so our actions may occasionally be premature.

As far as the methodology for picking the published candidates, we begin the search using software-generated lists of stocks with overpriced (OTM) options. Then we review the technical outlook of each underlying issue, its industry group, and market sector, to determine if the position has a reasonable potential for success. Finally, we assess the risk-reward outlook and those positions that meet a minimum criteria move to the "supplemental" list of candidates. After we have all the possible plays for a specific day, we simply choose those which (in our opinion) appear most favorable. Our objective is a 4-8% monthly return (based on the minimum collateral requirements) with at least 10-15% downside margin for adverse price movement. Of course, that can be a very difficult task if the options market has relatively low premiums, thus the best course of action is to choose trades that offer a favorable balance between probability of profit and potential risk.

In all cases, remember that the determination to trade is solely yours. Although we try to identify only positions that will achieve the specified goals, not every play is a winner so it's crucial that every reader utilize strategies (ours or theirs) to limit losses before they become excessive - while there is still some portfolio capital for the next success. Regardless of your trading style, we believe you will eventually benefit from some of the positions offered in the newsletter. At the same time, you must remember they are all just candidates and should only be considered with respect to your personal risk/reward attitude and trading style.

OW Staff

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