Option Trading Concepts to Help You Build a Solid Foundation

9. Long versus Short Options

It's always a good idea to think in terms of risk. For example, taking a long position in a futures contract entails a significant degree of risk because every tick up or down impacts the position.

Buying a call, however, is less risky because it loses at a slower rate when the futures decline. The fact that it earns less than a long futures contract when the market rallies merely illustrates the universal trade-off between risk and reward. In other words, "You can't have your cake and eat it too."

Buying a call spread (that is, buying a call and simultaneously selling an out of the money call) is yet a further step down on the risk/reward spectrum.

Let's look at the "flip side." Selling a call is less risky than taking a short futures position. The fact that the call initially loses less than the futures contract as the market moves higher, however, does not mitigate the call's exposure to open-ended loss if the rally is substantial. So the benefit of positive time decay that comes with selling uncovered options comes at a "price."

And it's important to remember that the most a naked option seller can earn is the premium received from the sale. How much can he lose? An unlimited amount. This underscores the importance of managing risk especially when there are uncovered short options.

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