Setting Limits on Options

Today was a much better day for the market as it rose 2.9% in rebound from the 10% loss from the prior two days. We purchased a put option to complete the spread we started yesterday when we wrote a put option option against the S&P index (SPX). Today we purchased the DEC 20, 2008 $ 850.000 PUT(SPXXJ: OPRA) at $35. The put was purchased as insurance against the PUT we sold on Thursday that had same expiration, but an exercise price of $875. With the strong market gains today, this PUT option became more attractively priced, and we felt the insurance to limit potential losses was prudent. The market volatility is still too high, and declines can be steep and severe making options very risky. Managing risk is critical in this market. We expect the combined position to make money at expiration as we do not think the market will drop below 875. If the market does crash, we will incur only a small loss, and still pocket the premium we sold in either case.

Setting limit orders on options when buying or selling is advantageous in this market. Because of the extreme volatility options prices can fluctuate wildly throughout the day. Investors that set the prices on entry and exit can really profit in this market by taking advantage of the volatility. A good strategy is to set the buy price really low or the sell price really high, and the volatility on a quick bounce will often trigger the transaction. This is a good strategy if the investor is not pressured to buy or sell and is comfortable if the transaction doesn't close. In today's trade, I set a $35 buy price when the option was trading at $45. The option briefly traded at $35 only long enough to execute before moving quickly back to the $40 range. With the volatility in today's market, big price swings are common and limit orders can offer advantages.