The warning label says: Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.

It is like drinking wine - drinking responsibly is enjoyable and has demonstrated health benefits. Options provide opportunities to control and manage risk or even to speculate (which is why options trading is viewed as risky by many). Options trading can be very useful in addressing the unknown market risks in a retirement portfolio. Like now for instance.

Stocks, commodities hit by risk aversion
Investors dumped stocks, commodities and emerging market assets on Tuesday on worries that economic growth will suffer from higher inflation and interest rates. Equity markets were punished as investors ditched riskier assets in favor of safe-haven government bonds and cash, with Japan’s Nikkei average <.N225> plunging more than 4 percent in its biggest one-day fall in two years. ..Reuters

The market is declining. There is a good chance of a significant decline sometime in the future - Fall 2006, perhaps. Between now and then, there will proabably be a rally of some sort. What to do? So this isn’t a good time to get short in anticipation of a fall decline. But what if the market doesn’t wait for fall for the big decline? Options!

Finacial Reality explains a very cool strategy for addressing the current situation with options. More expensive but less complex, just covering the downside with put options is insurance against a worst-case scenario.

Some options trading strategies

• straddle - An options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date. The strike prices may be the same or different. The fact that there are offsetting puts and calls makes it a straddle.
• out-of-the-money puts - relatively low-cost way to control risk. If there is a big change in the value of the underlying security, the option would be in-the-money and have value, potentially offsetting loses incurred in the underlying security position.

Do the math…

Using NASDAQ-100 Index (NDX) options with September 06 expiration, the cost to implement the straddle strategy with overlapped the strikes with both puts and calls in-the-money (NDX 1526.54) is shown. The example uses puts and calls at different strike prices but both are in-the-money when the options are purchase and expected to be in the money at expiration.

Yes, I had help with this. I retrieved the Quotes for Chains for the NASDAQ 100 Index (Symbol NDX) and selected Expiration Sep 06. As of today, calls less than 1526.54 are in-the-money. Puts greater than 1526.54 are in-the-money. The positions were chosen to be in the expected range for the NASDAQ through September.

At expiration, the calls or the puts are expected to be in-the-money so I should get money back. The difference between the strike prices is 100 points (1575-1475). So long as the the NASDAQ is in this range, I get $10,000 back (100 units x 100 points).

Straddles can be purchased with a put and call at the same strike
price. However, it may cost more as only one - the put or the call,
will be in the money at expiration.

The cost of the out-of-the-money puts as protection against a sudden
significant decline (NASDAQ 1450 or below.) Puts less than 1526.54 are
out-of-the-money.

It gets a lot more complicated than this, but this scenario is an interesting demonstration.

There is good news and bad news. If options are out of the the money at the expiration date, that premium is lost. If the options were a hedge or risk control, that may have been a small price to pay for a good night’s sleep. If this was a big gamble, well… yes, all the money is gone.

More than 90% of all options expire out of the money, so the option writers make money. Occasionally, the option writers are wrong and they lose a lot of money. But if used appropriately, opions can be a very useful investing tool.

Learn more…

• Options Trading Tips for Success - requires three key elements - bargain-hunting instinct with the ability to identify undervalued and overvalued options, sound and well-designed game plan that provides consistent action over time and that works in all market conditions and discipline to follow the game plan.
• OptionsXpress Educate - links to educational information about investing in general and specificly about trading options
• Options Basics Tutorial - An introduction to the world of options, covering everything from primary concepts to how options work and why you might use them.