How to Stay Cool in a Hot Stock Market

1. Don’t buy underlyings.

Underlyings are treacherous, nasty little things that will changes prices just to annoy you. That may sound a little paranoid, and perhaps it is. However, whether or not companies have some sort of malicious corporate consciousness is irrelevant. The point is that it’s best to behave as if every stock is out to get you.

2. Don’t buy long options.

Time decay will be against you. If you buy an in the money option, then it has to go much deeper in the money for you to profit. Buying an out of the money option is hoping for a miracle.

3. Never hedge with long options.

That would involve buying long options. That’s not good.

4. Never “leg in” or “leg out” of a spread.

If you had vast reserves of cash, you could take advantage or price swings by selling puts in a bear rally and calls in a bull rally. I did this recently. It worked. It was great.

But it almost didn’t work. In fact, it almost failed in a spectacular way. When I had more short puts than short calls, the market’s continuing decline devastated my buying power. I was barely able to hold onto my positions long enough to rectify the situation by selling some calls.

5. Delta is your worst enemy.

Delta is bad. It means the rate of change of the value of your position with respect to the price of the stock. If delta is large in absolute value (i.e. “big and negative” or “big and positive”), then price swings could devastate you. They could also make you rich, but it’s a real gamble, analogous to betting on a coin flip.

You can minimize delta by selling both puts and calls on each underlying. You can still take a slightly bullish or bearish stance, just don’t make any position completely directional.

6. Theta is your best friend.

When you sell short options, time is on your side. My motto is, “stocks go up, stocks go down. Time goes forward.” All things being equal, the profit on a short options position will go up over time.

7. The law of large numbers is your other best friend.

You win some you lose some, but if you keep rolling a loaded die, you win in the long run. (That’s my other motto.) Have enough diversity that one position run amok won’t ruin you. That means several underlyings representing several sectors.

You can never have enough diversity. You never know when a market move will reveal some connection you hadn’t realized. For example, the recent airline crunch hit the financial sector too, especially the already hurting CIT, which does business with the airlines. If you were unlucky enough to have bullish positions on both an airline stock and CIT (I only have CIT), you would see two of your positions decline significantly.

This wouldn’t be so bad, as long as you have other positions not greatly affected by the crisis. You can’t win em all.

But you can win overall.