Market News

April 13, 2012  Fri 11:25 AM CT

Many experienced options traders never actually own stock, at least not for long. And there's good reason for that.

The flash crash of May 2010 scared many out of the market, especially retail investors. And on March 20 we saw a sudden drop in shares of Apple, falling to $542.80 from nearly $600 in an instant. Now that may have been just a "fat-fingered" mistake or a computer glitch, but some recent research has looked at the significant number of mini-flash crashes in individual equities.

We know that the market can drop quickly and gap lower. Stop-loss orders or trailing stops make sense for stocks, but they may get filled at much lower prices on a quick move or low liquidity. 

Many traders use collars for protection, selling calls and buying puts to limit losses while keeping the hedge costs low. That is a good idea for those who must be long equities, as we noted in a recent column about the famed "Cuban collar."

But a bull call spread is essentially identical to collaring a long stock position and doesn't require owning any shares, so it has a much lower margin requirement. More important, this option position will not get crushed in a flash crash.

Another strategy that can make sense is a bullish butterfly. This trade has greater commission fees and is exposed to more bid/ask spreads, so limit orders are a must, but it can be hugely profitable on stocks that are grinding higher. (I discussed just such a strategy on Apple in this February column.)

Bull call spreads or bullish butterflies preclude the need for hedging because they are already hedged. The potential gains are limited, but these positions will provide much-needed protection if stocks drop dramatically in a matter of minutes or seconds.

The same long option strategies can be used in VIX-based exchange-traded funds and notes. Or better yet, in put spreads for those with a bearish inclination or wanting some balance in their portfolios.

While the issues surrounding the recent collapse of the TVIX can be argued til the cows come home, those who had long VIX calls or VXX call spreads did not see half of their positions disappear in two days, as those who owned TVIX did last week.

A good strategy is one that can make money if the underlying assets rise but has a small risk and an asymmetrical payout. That is exactly what call verticals and butterflies can do for you, without costing a huge premium for protection. (See our Education section)

So even though options are more complex than stocks and do require more education, they are well worth the effort both for returns and risk management.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of March 28.)
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