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7 Key Points About Trading Short Options

Swing trading with short options, especially uncovered, is a higher-risk strategy than the opposite focus on long options only; but the degree of risk might not be as severe as you think at first glance. This is true for six reasons:

1. You can cover the short call with ownership of stock. In this case, you combine a covered call strategy with an uncovered put.

2. The short put risk is not as severe as the short call risk, especially on lower-priced stocks, where the distance between strike and tangible book value per share is lower than for higher-priced stock. If you time entry and exit with one eye on the volatility of the positions, you can also make your swing play a volatility play.

3. Applying reversal signal use with strong confirmation vastly improves timing, so the risk of short-option swing trading can be much lower than just selling uncovered options without checking the stock chart.

4. The question every option trader has to ask: Is the option risk greater than the market risk of stock ownership? This often leads to a realization that uncovered options are actually a leveraged form of market risk exposure; it often is a more substantial risk, especially on the short call side, but if you accept that risk knowing its extent, then swing trading with options makes sense.

5. Risk exposure is somewhat mitigated by option premium. In the short strategy, you receive income when you open short calls or puts, so profits are taken by a buy to close order, or by waiting out expiration. Given the fact that profits are difficult for long positions due to time decay, the same decay works in your advantage when you sell.

6. Risk exposure is further limited by picking the right strike proximity. Clearly, you don't want to sell options deep in the money, and even those at the money are by quite risky. But at the right moment in the option cycle (within one month of expiration, for example) slightly out-of-the-money strikes can produce desirable returns. Remember that these positions are ideally open for only a few days, so the annualized return can be very nice, especially if you are executing swings in and out of several stock positions and quite frequently.

7. Collateral requirements have to be met when uncovered short options are opened. Any uncovered short option has to be accompanied with collateral on deposit in your margin account. The collateral can be reduced using offsetting long positions, but the collateral rules are complex. Download a free manual that explains collateral from the CBOE, at Margin Manual and figure out specific collateral requirements at CBOE Margin Calculator

Michael Thomsett blogs at TheStreet.com, CBOE Options Hub, and several other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website