So in light of this uncertainty, I’ll share my father’s strategies for both profit and preservation of risk capital in the face of future wild stock-price swings.

Paul Sarnoff’s Option Trading Rules

1. Never go short any stock. If you think the stock will drop, buy puts. That way, you will limit your losses if you are wrong and you will make a bundle if you are right.

2. Never go long any stock. If you expect the stock to rise, buy calls instead. If it rises, you make a greater percentage profit with the successful call than if you had bought the stock.

3. Never buy any put or call “at market.” I try to select the put or call of the week, which in my opinion and expectation, represents the best value and best promise for profit — if my expectations become reality. When you buy “at market,” you are at the mercy of often not so merciful sellers. You get the seller’s price, not your price. Although your order may not always get filled, you always know your risk with limit orders. Those who buy “at market” sometimes make good profits and sometimes they suffer greater losses. Don’t chase options. Be patient and buy at or lower than my recommended price.

4. Never position long shares of stock without simultaneously buying “protective puts.”

5. Never sell short any shares of stock without simultaneously buying “protective calls.”

6. My final rule for you to ponder is for you to consider any options you buy the way you would for your children. Options, like children, have to be watched. Make sure that you, or your broker, watch over the options you buy. They are very volatile — and many brokers may not care to ride herd on what your options are doing, as they proceed either to success or extinction.

You have to handle your options in the manner suggested by a man my father considered America’s greatest 19th-century poet. No, he wasn’t Walt Whitman. In the last stanza of The Game of Life, the poet recommends:

In battle or business, whatever the game,
In law or in love, it is ever the same;
In the struggle for power, or the scramble for pelf,
Let this be your motto — Rely on yourself!

— J.G. Saxe, 1869

Sincerely,

Steve Sarnoff
Editor, Options Hotline
July 8, 2008

Six Useful Tips When Investing in Options was originally featured in the Penny Sleuth.