Long or Short Positions

The obvious problem with advanced strategies is the high-risk attributes of each. Positions involving long calls and puts require substantial point movement; even in a net debit position (in which the cost exceeds the receipt), you must fight against time erosion. Positions with any short calls or puts involve market risk. Uncovered calls are the highest risk position possible using options—clearly inappropriate in a conservative portfolio. Short puts may or may not be appropriate either, depending on your opinion of the underlying stock, its fundamental strength, and whether you are willing to buy shares at the put's strike price.

When the mix between long and short positions is used, the possible variations of spreads and straddles present conservative possibilities. Some have already been introduced. For example, to remove the risk factor from a ratio write, you can add a long call at the top of the strategy. If you own 300 shares, you might write 4 calls with a strike of 50. You also buy a call at 55,5 points above the strike price of the ratio, thus covering the otherwise uncovered short option in the ratio spread. The top-side long position is a form of market risk insurance; if the stock's price were to rise so that all 4 calls were exercised, you could cover 3 of them with your 300 shares; the remaining call is covered with your long 55 call. You would lose $500 on the difference between those strike prices (55 less 50 strike). However, there are two mitigating factors. First, you received premium for the overall ratio write. Second, the $500 loss is preferable to the possibility of being exercised and losing much more. This is a conservative use of options to manage a ratio write, transferring it from a potentially risky strategy to a safe one.

Mixing the Long and the Short

Another example using combinations of options is the opening of a long call and a short put in a down market. This provides multiple benefits. First, the cost of the long call should be offset by the income from writing the short put. Second, if the stock declines further in value and the short put is exercised, your basis in the stock is averaged down. The average basis consists of the average price between original purchase of shares and the strike price of newly acquired shares, minus put premium. Third, if the stock does rise, you can either close the call at a profit or exercise it and buy additional shares below market price, further reducing your average basis in the stock. This strategy—assuming you would be satisfied if and when the short put was exercised—is conservative. It involves low cost or zero cost (in some cases, even a small credit), and it is advantageous under any scenario of price movement. Even no movement would be satisfactory, considering that the combined strategy is a zero-cost one.

Using long puts to insure paper profits against the possibility of price decline is a sensible strategy by itself. But consider yet another variation combining long and short options: the long put and short call combination. In this instance, you achieve downside protection in two ways. First, the long put would match ITM intrinsic price movement dollar for dollar. That put can be exercised and shares sold above market value, or it can be closed to take paper profits without selling shares, a highly desirable attribute of the insurance strategy. Second, the covered call offsets all or part of the long put cost, so that you end up with free downside protection, and it may reduce your basis in the stock to the extent that the short premium of the call exceeds the long premium of the put. Remembering, too, that time works to the advantage of the short position, the covered call can be closed at a profit, allowed to expire worthless, or exercised. You can also roll forward and up to avoid exercise if the stock's price continues to rise.

These are only some examples of how you can continue to manage your portfolio on a conservative basis using options in combination, enabling you to take appropriate action in three market conditions:

1. In up markets, protecting or realizing paper profits without having to sell stock

2. In low-volatility markets, increasing current income with covered calls

3. In down markets, averaging down your basis and turning paper losses into paper profits or realized profits

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