Recent Volatility Got You Spooked? Try Option Spreads

08/28/2009 12:01 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Although there are no magic trading bullets to deal with short-term volatility, there are some things you can do as an options trader to take additional control over your risk. Option spreads are one way to take more control. A spread combines more than one option contract or an option and a stock into a single trade. Some spreads are directional (bullish or bearish), while others are neutral towards market direction, but will profit if volatility falls (or rises).

Some option spreads like long straddles and strangles are designed to provide unlimited profits when you think the market is going to make some very big moves in the near term, but you have almost no idea as to the direction in which the breakout will be. A long straddle or strangle has a fixed amount of risk, but can be very expensive if the market moves very little.

Vertical spreads and covered calls can be used to limit risk, provide income, and still take advantage of a bullish or bearish trend. Traders have to be careful when trading these strategies, however, as they are a higher-cost trade, but they can offer the unique benefits of income (with short vertical spreads and covered calls) or a reduction in the negative effects of time value (with long vertical spreads).

By John Jagerson of LearningMarkets.com.

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