Options Trading News

May 28, 2012  Mon 5:12 AM CT

Recently I took a few days off to show my kids around Boston and Cambridge, and we even got to pet some stingrays and sharks at the aquarium. And while I admit that I thought about my trading positions a couple of times, I didn't spend a minute worrying about them.

The reason: good hedging and risk management.

I consider myself a relatively short-term trader. Although I don't usually scalp, I generally hold positions from one day to one month. But in the last couple of days I didn't even bother paying for Internet access at the hotel and didn't sweat it when I did eventually get online back home and had a massive computer crash.

Although I enjoy the "thrill" of intraday trading, I've found that I am better suited--emotionally--to a longer holding period. (It also allows me to take much-needed vacations, something I am slowly learning to do.)

RayHaving a properly allocated and protected portfolio allows me to sleep at night. And there is no better time to revisit this theme as we ponder whether this year will reinforce the adage of "sell in May and go away."

The first key is limiting leverage. Most pros recommend that you have no more than 1 percent to 3 percent of your trading capital at risk in any one position, though some are willing to go up to about 5 percent. This can be difficult for stock traders, but option traders have more, well, options.

Protective puts are one way to limit risk. I have also recommended collar trades of late to hedge positions--selling calls to offset the cost of owning puts, giving up some upside while limiting downside.

Of course, for those who don't have to own stock, call spreads can provide essentially the same exposure for a much smaller margin requirement. That would also allow you to trade more positions.

This takes us to the next step. Option traders can be bullish or bearish with equal simplicity, without needing to take the risk of shorting stock. So having a mix of call and put positions allows you to further hedge your portfolio.

Retail traders and investors have been turning to the volatility funds in increasing numbers to protect themselves. But as I have noted repeatedly, these VIX-based products can raise serious issues, as Bloomberg noted this morning in a story about some potential pitfalls.

One of the most basic tenets of risk management, in any area, is don't buy what you don't understand. You don't buy a used car without a CarFax or similar background information, and you don't buy a house without an inspection. Likewise, you shouldn't buy a VIX-based product unless you're well versed in this type of trading vehicle.

So while there is no absolute need to sell in May, hedging in May allows you to withstand the current market gyrations and enjoy the summer--as well as all that money you've made in the first five months of the year.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of May 2.)
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