Define Your Risk

 2/27/2014

Unless one is a professional options trader, their options trading setups should include well-defined risk. I do not advise being naked options short, even net options short as in a ratio spread. Oh, and by the way, a covered write is exactly the same as being naked short puts, but that’s a lesson in itself. Part of my entire “simplify and demystify” working method of trading options is to always and at all times know exactly the most one can lose on any particular trade or strategy. In my instructions I always ask mystudents to tell me what is the maximum risk, what is/are the break even points and what is the maximum profit. If the maximum risk is undefinable then I teach that the trade is not worth doing.

Hey, on a quality of life basis if nothing else. Who needs a position that carries a risk, however unlikely, that could blow up your entire portfolio if it went wrong? Life’s way too short for that kind of worry, eh?

By way of this let me discuss a well-known strategy that aims to either capture dividend yield or generate short-term income. That being the cash covered short put.

I love dividends, by the way. I firmly believe that companies should pay out part of their profit to the people who take the risk of being shareholders. And, in this world of near zero interest rates there is that constant quest for yield.

Take a stock that pays a yield with which you are comfortable, but you would love to have that stock at a lower price giving an even higher dividend yield. Classic options trading theory says sell the out of the money put entirely secured by enough cash to buy the stock at the strike if assigned. That cash can be put in a (however low) interest-bearing asset such as T Bills and used to buy the stock if assigned. If not assigned then the short put expires worthless, short-term cash is generated and on to the next options trading cycle.

By: Randall Liss, The Report Liss