Options vs. Options Spreads: How to minimize your risk

Investing in options is better than investing in stocks: On August 20th of this year, I wrote and article called "Options vs. Stocks: How to minimize your risk." In it one can clearly see that Options offer a safer and more efficient way of investing in today's markets. Today you will see how there is an even better way of trading options. This article is part two of three where the third part will follow in the coming days. Even though investing in options provides a better bang for buck, one can immediately look for ways of perfecting the craft.

The Problem: The enemy of long options positions is time! All else held equal, out of the money long options positions will decay to zero and cause buyers a complete loss. example: a trader buys a September 500 put in Apple AAPL for $8.8 per contract. If Apple is over 500 on expiration day (September 21) then the trader loses the entire $8.8 which is 880 per contract.

The solution: Recruit the enemy. Since time is the enemy, smart traders add a little of the enemy forces onto their positions. This is easily done by instead of simply buying that 500 September put in Apple AAPL, a trader can buy the 500/495 put spread. To do this, a trader not only buys the 500 put but also sells the 495 put in equal counts. This reduces the cost from $8.8 to $2 per contract. The trade order ticket looks like this:

* Buy to open AAPL Sep 500 put (cost is 8.8)

* Sell to open AAPL Sep 495 put (credit is 6.8)

* net cost of the put spread is 8.8 -6.8 = $2 per contract = $200. So you see how this is much less of a risk than the 880 when only buying the 500 put alone. Selling the 495 put makes it so that time is not only fighting against the 500 long put BUT now also fighting FOR the short 495 put. If the 500 put loses premium with time decay, now the 495 put will also lose premium thereby reducing the overall position loss. Too confusing? here is the visual aid that will clarify:

The chart below (Chart 1) shows Apple's September options chain. On it you can see the aforementioned put examples. Today Apple rallied ahead of its event and this caused anyone holding Apple puts to lose money. Consider the two traders below: On 9/6/13 Carla bought the 500/495 put spread whereas John decided to risk going long the 500 put without selling the 495 put like Carla did. Today Apple popped over 1.6% and caused both traders to lose money. However the loss magnitudes are drastically different. The table below illustrates that Carla only lost $.50 whereas John lost almost $4.7 (refer to the Apple option chain below to see how).

The disadvantage: There is a catch in taking spreads vs. single legged options? By limiting her risk with the put spread, Carla also limited her potential profits to the width of the spread and in this case is $5 (less the premium she paid) even if Apple falls to zero. Regardless of whether they admit it or not, most traders are not good market timers.

Conclusion: There is no one style fits all when it comes to trading options. It may all come down to the traders' profiles: those who enjoy the thrill of higher risk prefer the all in approach with long only options; those who enjoy the luxury of time-assist are likely to opt for the options spreads approach.

"But wait... that's not all." There is a better way to trade options: For this you have to tune in to the next article. Meanwhile you can go here for hints.

http://www.marketfy.com/store/item/create-income-with-options-spreads/

You can also join me on Sep 12th for a free webinar. Reach out to me on twitter or stocktwits for details.

For more of the author's trading ideas, follow him on Twitter and StockTwits (@racernic).