Conservative Equity Option Trading Tips

Taking a conservative approach to trading equity options can be a successful way to generate profits, while mitigating risk. While trading options can involve high volatility, carefully crafted trades can avoid these issues. By observing the following basic tips, a trader can maintain a conservative approach.

Focus on Long Options

By taking only long option positions, and avoiding writing (selling short) options, the downside of trading is reduced. If an option becomes worthless at expiration, the most that the owner can lose is what was paid for the option.

For example, if you pay $2 for a call option and the stock falls, the loss is limited to $2. Conversely, if you write a call and the stock soars, the loss is unlimited. Short options have a much higher level of risk than long options.

Avoid Trading Naked Short Positions

A naked short position in options trading refers to selling an option when you do not already own the underlying stock. For example, writing a naked call, as in the example above, means that the writer sells a call, receives the premium ($2 above), and then hopes that the stock does not appreciate a great deal.

This naked position can be distinguished from what is known as a covered call. A covered call involves selling a call option after you own 100 shares of the underlying stock. In the case of a covered call, if the stock’s price increases significantly, the stock will likely be called – the writer of the option already owns the shares, so they can deliver the shares without having to buy them at the new higher price. This is the more conservative approach to writing options.

Heed the VIXX

The VIXX is a general measurement of the level of volatility in the broad market as measured by the S&P 500. When the VIXX is very high, this signals that there is a high level of volatility prevailing in the market and options will be more expensive.

If you want to remain conservative, buying options during unusually high VIXX readings should be avoided. Options purchased with high VIXX will be expensive and require a larger move to be profitable. While the VIXX is not directly linked to every equity option, it can serve as a proxy for the general market.

Large Cap Stocks are King

The prices of large cap stocks tend to be more stable than the price of smaller, more growth-oriented companies. Because options are priced based on the implied volatility in the price of the underlying security, the options on large cap stocks will tend to be less expensive and less volatile themselves.

When seeking a conservative approach to option trading, identifying instruments that tend to remain stable over the longer-term is a significant step towards achieving that goal. The more stable a given option’s price, the more conservative it can be considered.

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