A guy was trading convertible arbitrage and also setting up option strategies. The head of the department was a well-known arbitrageur who didn’t blink at positions of several hundred thousand shares in a risk arbitrage position. However, he didn’t really understand options too well. So one day he asked this guy to explain his position in XYZ options. Apparently the position had been marking to market at a small loss, and the head of the department wanted to know why. The reason was that XYZ had been rallying in October and November, coming out of its oversold bottom of the 1973–1974 bear market. The position was a one-by-two ratio call spread. It was on the order of being long 100 calls and short 200 calls. The spread had an upside break-even point of about 300. Thus, it was net naked short about 100 calls. So the trader explained that the position was good for another 80 points on the upside over the next three months, and that it could make about $300,000 at expiration. However, the head of the department wanted to know what the result would be if XYZ went higher. When told that this would be a loss of $500,000, he said “What if the Arabs take over XYZ? We’re screwed. Take off the position.”
Now that’s paranoia. What were the odds of the Arabs even wanting a computer company? Probably something way less than 0.1 percent. Still, it was too much risk for this otherwise heavy-risk taker. At the least, the department head, an experienced trader, knew what made him uncomfortable, and he didn’t want to pursue that strategy any longer. Your comfort level extends beyond just deciding whether to trade options strictly from the long side or the short side. It goes deeper— more toward your approach to the overall market. Some people prefer hedging, some prefer speculating. Hedgers generally limit their overall profit, but they also have less risk than speculators do. If hedged positions drive you crazy because you know you’ll have a losing side as well as a winning side, then perhaps you should trade options more as a speculator, forming opinions and acting on them accordingly. The important thing to realize is that it is much easier to make money if you are “in tune” with your strategies, whatever they may be. No one strategy is right for all traders, due to their individual risk and reward characteristics and accompanying psychological demands. Many traders don’t like speculating, preferring a more conservative tack. If that is your philosophy, that’s fine. You should look for hedged positions with a statistical edge and not attempt to day trade or engage in other forms of short-term speculation.