Don’t Get Caught Naked When The Tide Goes Out

by themeatballeffect on February 9, 2010

Would you like to spice up your portfolio and get better returns? Sure you would. Who wouldn’t! But be careful. Just like your mother told you, too much of a good thing can be bad.

In this article we look at the most common mistake investors make when trying to increase their portfolio returns by option trading. That mistake involves increasing portfolio returns at the expense of a greater increase in risk. Good trading, in my opinion, is all about enjoying better returns with less risk. Less risk being the key point here.

So what is this mistake, and how does it happen?

It starts innocently enough when you learn about selling cash secured puts. You sell out of the money puts on stocks you would like to own, but at a better price. If the stock goes up, you get to keep the premium and earn extra money on cash you have sitting idle in your account. If the stock goes down, you end up buying it at a better price than you usually would. An all round winner, so you think.

Then one day it hits you like a tsunami. You realize those cash secured puts you’re selling don’t actually require all the cash that you’re setting aside. In fact your broker probably only requires about one-eighth of what you’ve reserved.

Being a person of sound mind and body, you suddenly realize you’ve found the Holy Grail of Trading. You just need to trade eight times bigger. Sure you’re making good money now, but you could make eight times the good money. Now that’s Good Money!

That’s right. According to your broker’s margin requirements, you could be trading eight times the size you are right now. Or if you’re feeling “conservative” maybe you could trade just four times the size. That’s still four times the good money. Sure will buy a lot of Mai Tais.

Listen, I know it’s always nicer on the other side of the beach. But please don’t go there. Yes, the party may be good, and it might last a long time. But one day the music will stop playing. When it does you’re going to be thrown in the deep end with the sharks.

Please understand that what you’re really doing is trading naked puts. Hang on there. This is not as sexy as it seems. It simply means that you don’t have the cash to buy those stocks if you’re ever assigned. You’re risk is for all practical purposes unlimited. It is dangerous… very, very dangerous.

One day you will get caught swimming naked. When that day comes, your broker will start liquidating your account to meet your margin calls. You will have no control. You will be left much, much poorer. Hey, they don’t call them “brokers” for nothing.

So please resist the temptation to increase your trading size. There’s nothing wrong with being naked, just don’t trade naked. There are better ways to increase your returns while maintaining a fixed amount of risk. Make sure the puts you sell are secured.

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TheMeatballEffect.com is a complete swing trading option strategy. Learn how to find option trades and how to manage them for maximum profit potential.

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