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Carley Garner of DeCarley Trading shares some of her insights into indicators, strategies, and trader psychology. The author of Currency Trading in the Forex and Futures Markets explains what she sees as some risky moves traders make, and shares some tips for potentially mitigating risk.

Kate Stalter: Today, I’m pleased to welcome back a return guest, Carley Garner of DeCarley Trading. Carley, I wanted to start out today with the big picture about options trading. A lot of equity traders and investors hear the horror stories about options, and it scares them off. But you’re actually a long-time proponent of this.

What’s a good options strategy that could be used at this juncture? There seem to be a number of ways the equity market could go at this point. Say we go into a confirmed rally on the equity markets. What would be the best way to use options in that situation?

Carley Garner: Well, the great thing about options is they can be extremely versatile. You can make an option trade or spread as aggressive or conservative as you want it to be.

Obviously, there are basically two things you can do with options: you can either buy them or you can sell them. But the beauty is, you can put together a trade that combines both buying and selling, maybe calls or puts, to accomplish one goal.

So it can get extremely complicated, obviously. But one idea of somebody that might be bullish to the S&P but they don’t want to take the risk of just buying the market outright, or buying a futures contract or whatever venue they’re trading in, they could do something that’s called basically a bull call spread with a naked leg, where you buy a call near the market.

But we all know options are really expensive and they’re priced to lose, so anytime you’re forking out a ton of money for a call option close to the money, your odds of success maybe aren’t that great. So what you want to do is, look for ways to finance that trade. You can do it somewhat conservatively, by maybe selling a call option up above and then maybe also selling a put below, to basically bring in enough premium to pay for the option you buy.

Depending on how you structure it, it might even be a free trade as far as cash outflow. But what you’re paying for is the liability, of the risk of the market really selling off sharply and causing you trouble on a short put. Because anytime you sell a put underneath the market, your risk is theoretically unlimited beneath the strike price of the put.

So basically you’re paying in risk instead of money, is really the difference, but you’re getting in-the-money call option. If you really did your homework and you feel good about the market going up, that might be a good way to play it.

One thing to point out also in a trade like that, even though you do have theoretically unlimited risk beneath the strike price of your put, you’re not necessary taking immediate risk. What I mean by that is, if you bought the market outright, whether it’s an ETF or futures contract or whatever it is, your risk is immediate. You’re immediately making or losing money as the market goes up or down.

With an options spread like this, it slows the trade down. The S&P might drop ten points. Your option spread might not lose much value, so you might be losing, but it’s not going to be nearly as much as you were losing if you just bought the market outright.

Obviously, it goes both ways. If you’re right, and the market rallies, you’re probably not going to make as much on an option spread as you would just buying the option outright, but the idea is, you’re slowing things down and you’re giving yourself a little better odds of success.

Kate Stalter: One thing that I seem to be hearing about a lot more lately: More individual investors are starting to use covered calls as part of their strategy. Are you seeing that more often, and is that something you suggest?

Carley Garner: We typically deal with the commodities side of things, and futures, and options on futures, so it’s a little bit different than in stocks. I do have a lot of traders that do covered calls in commodities or in futures. But the difference is: we’re trading on leverage, and so it doesn’t work out quite as well. It’s not nearly as conservative as a strategy as it is on the stock side of things.

Let’s say you go long the market, you sell a call, it provides you a hedge. But if the market drops sharply, you’re holding a leveraged instrument. That call is going to help you out a little bit, but it’s not nearly as exciting as it is in an unleveraged investment.

But what people do in the futures markets, instead of doing a one-for-one covered call—for example, if they buy an e-mini S&P future, they might sell two calls above or three calls above. The risk on that is obviously if the market rallies sharply, then the three calls aren’t going to keep up with your one long future, but the principle is the same.

Continued…

Tickers Mentioned: Tickers: VIX