Popular Options Strategies: The Risks Involved – Part 1
Here’s an overview of a couple of the most popular option trading strategies. The risks involved with these strategies are pointed out and why they so often fail in volatile markets is also explained. Naked Puts and Credit Spreads are up first.
Most option traders have experienced some trading successes along with some unexpected, very often sudden and dramatic, losses. The good news? Well, two small points. One, you’re not alone. Two, the problem is in the basic structure of your trades and this you can change.
You’ve probably tried some of the more common trades like a short put where the put is sold, the premium is collected, and the investor hopes that the underlying price will stay somewhere near the initial price or go up slightly. This way the option expires worthlessly, the premium is capped, and the next trade is started.
But real life seldom matches precisely with our plans and the underlying price sometimes goes down significantly. You can try to ride the credit already collected by making some simple adjustments but if the price continues to be uncooperative you wind up locking in your losses.
Another trade you can configure to minimize the loss potential is taking that naked put and making it a put spread. The idea behind this is the same. Sell a position, buy a position, collect a premium, and once again hope that the underlying price is going to stay above the credit spread.
The problem remains that the underlying price doesn’t always do what you want it to do. As the price drops, you can make some adjustments but you’re already eroding the small premium you collected. You also maintain a significant risk so that if the underlying price continues to drop you’re just going to lock in more and more losses.
These types of difficulties are very common. In order to avoid these trading issues, then you really need to learn a completely different way to trade options.
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