by Ken Trester | February 18, 2008 5:03 am
Diversification, important in all investments, is critical when it comes to trading options.
Especially for novice option traders, because some of your positions will be losers, the more positions you have means increased odds of hitting a home run. But with only a few positions, you could easily wipe out your portfolio very quickly.
Diversification means you should own both puts and calls, and a variety of each in myriad sectors and with different expiration dates. Further, take at least two or three different options positions, and buy at least four contracts per position to reduce commission costs.
The most important type of diversification is what I want to discuss with you today — diversifying over time!
Be sure you’re investing in options from different expiration months and keeping both short-term plays (like we do in my Fast Options Profits trading service) and some longer-term plays, any where from a couple of months to several years. Take advantage of Long-term Equity Anticipation Securities (LEAPS) to buy up to two-and-a-half years’ worth of time to take advantage of stocks going up or down over the long term.
A staggered strategy allows you to collect profits year-round and also insulates you from global crises and other events that may impact the U.S. markets significantly.
When you are diversifying your options portfolio over time, don’t confuse that premise with buying a lot of option positions all at once. You are betting on market volatility, and if the market goes to sleep, you are sunk if your options melt away and expire. (Although we’re in exciting times, sometimes the market hits the snooze button for a year or so.)
Enter option positions gradually over time, patiently waiting for the market or a stock to explode. Once you see the market waking up, you can increase your option buying activity.
A good game tactic is planning to spend a set amount of dollars each year and to gradually invest the allotted capital over that period, possibly using seasonal tendencies (i.e., being prepared to make extra trades around earnings announcements and major conferences, while scaling back on trades during slow or exceptionally volatile times) to maximize your opportunities and gains.
Time diversity is also important because it ensures you will have enough money in reserve to return and play another day if you happen to encounter a losing run — I want you to be trading options for a long time to come!
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