How Professionals Manage Risk (Cisco)

Many options traders are totally against the idea of buying out of the money call options but they definitely have their place in portfolios where risk management is absolutely key. Cisco (NASDAQ:CSCO) at the moment for example is trading well below its November highs due to a subdued first quarter earnings report along with reported weak guidance. Sentiment is at its lowest point all year which usually means a bounce is coming

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Now usually the smart play here (from an options point of view) would be to sell premium. However implied volatility is on the floor at present which means that option prices are more inclined to rise in the near term rather than fall (we want them to fall if we are selling premium). Therefore the right trade to take on here would be to actually buy calls or call spreads as volatility should expand in the weeks ahead. In fact, volatility is mean reverting which means buying is definitely the preferable option here.

Just a note on options and why they are used at times over buying the stock outright. They are used as one can control risk far better especially when using call spreads as one’s risk is defined. In fact even with naked calls, the price of the option is the most one could lose at any given time. Here is how a professional trader would put up very little capital but would stand to make a large gain if the trade went his or her way.

If one buys the $30/$31 call spread (April 2017), it would cost around $0.35. Cisco is currently trading at $29.33. Now a dollar wide spread can only at any time be worth one dollar. So basically the investor is risking 1 to potentially make 3. Cisco would have to be above $30.35 (at expiration) for the trade to have any money in it. If consequently Cisco finished trading above $31.35, the trade would be a full winner with a 200% likely return. Personally I wouldn’t take this on because of where the Nasdaq is at present but this is how professionals think. It is all about risk/reward and putting yourself into enough positions where the probabilities play out..

 

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