I get a lot of questions from option traders. Lately, my readers have been asking me about how I trade. What they really want are “black and white” rules they can use. Unfortunately, there aren’t many rules like this. I do have three though — and I’ll share them with you here.

The rules I share here don’t guarantee that you’ll make money. In fact, you may lose money if you don’t have a solid trading strategy. I share these rules simply to give you some insight into my unique style of option trading.

Now that we’ve gotten that out of the way, here are my three “hard and fast” rules…

1. Don’t buy any options that expire in the near term. 2. Don’t buy options that are out of the money. 3. Don’t hold an option contract through its expiration.

Instead of a list of things NOT to do, you can think of these from the flip side…

1. Only buy options with plenty of time remaining before expiration. 2. Only buy options that are deep in the money. 3. Always trade option contracts before they expire.

These are the only “hard and fast” rules I follow when trading options. From there, it depends on the underlying stock set-up. And there aren’t any black and white rules that address the dynamic forces in the market.

Put another way, I do have additional “rules” I depend on. But they’re contingent upon a number of variables and factors that require close scrutiny and analysis.

Perhaps my rules offer a new perspective on how to trade options. After all, many of the experts will tell you to make trades based on the latest news or earnings reports. Personally, I advise against this. Certainly, you want to be aware of the news and what things are happening that affect stocks, but you don’t want to base trades on such transient and unpredictable forces.

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Diversification is critical for long term portfolio health. We’ve all heard about the benefits of not putting all your eggs in one basket, but conventional wisdom needs to be updated every now and then.

An industry has been built around smooth talking salesmen advising people to diversify their portfolios into a variety of stock and bond products. These well-dressed businessmen extol the benefits of such and such value or growth stock fund. They sound sophisticated when they tell you that small caps are countercyclical to large caps, and so forth. The reality is that stocks are stocks and regardless of how you splice up and segment them into categories, they hold inherently similar correlations.

Exchange-traded funds (ETF’s) change the old notions of portfolio management. Individual investors can now add commodities (precious metals, corn, wheat, soy, cattle, oil, natural gas, etc.), currencies, and specific sectors of the economy just as easily as they can add stocks.

Currencies, in particular, offer individuals a powerful alternative for hedging inflation and the decline of the US dollar, and adding a new level of diversification to offset adverse movements in stocks and bonds.

Overall portfolio risk can be measured in the variance of returns, which is a function of the individual assets held. To decrease total system variance it is best to include assets that are negatively correlated to each other.

Someone holding predominantly US stocks in their portfolio should consider adding currencies that are negatively correlated. It turns out that Swiss Franc, Japanese Yen, and Swedish Krona move in opposite directions as US stocks, while Australian dollar, Mexican Peso, and Canadian dollar move in the same direction.

Holding Swiss Franc, Euro, Yen, or Krona would have yielded roughly between 12% and 17% in capital appreciation over the last year. Not only that, but each ETF has a dividend yield, representative of interest rates within each country.

There are multiple consderations in portfolio theory, but applying the basics can have far reaching benefits. Those concerned with dividends should hold the highest yielding ETF’s, which include British pound, Australian dollar, and Mexican peso. On the flip side, income investors should avoid Swiss Franc and Japanese Yen.

Currency ETF’s offer a great alternative to traditional methods of diversification and are great to offset further declines in our own currency. Consider that commodities price growth is largely attributable to US dollar depreciation and you can see how foreign currencies can insulate individuals from energy, food, and other commodity-driven inflation.

Diversification is the best way to reduce portfolio risk. It has long been understood that spreading your capital wisely can save you from unexpected asset deterioration, but exactly how to do that needs to be reconsidered.

There are a host of new products available to individual investors. Traditionally, people have been told that buying stocks and bonds is good enough to build a diversified portfolio. Still others, who really think they’re savvy, spread their bets into small, mid, and large cap stocks. These people may even buy variable maturity debt securities, such as long and short term Treasuries or municipal bonds. While these techniques are a good start, the modern investor should use all the tools at their disposal, not just what worked in the past.

With the emergence of exchange-traded funds (ETF’s) there has sprung forth tremendous new tools for diversifying individual portfolios. Stocks and bonds can now be supplemented by precious metals, natural gas, oil, agricultural commodities, real estate, sub sectors of the economy (retail, financials, energy, etc.), targeted global markets, and currencies.

A great way for American investors to hedge inflation and the decline of the dollar is to purchase currency ETF’s. These instruments enable investors to gain exposure to specific foreign currencies, which are often uncorrelated to US stocks and bonds.

Negatively correlated assets held in the same portfolio reduce overall risk. Risk, as measured by variance of returns, can actually be lowered simply by holding assets that do not move in the same direction. For instance, if stock A decreases 70% of the time stock B increases, and vice versus, then you could construct a portfolio that has less total risk than either A or B by including both.

Someone holding predominantly US stocks in their portfolio should consider adding currencies that are negatively correlated. It turns out that Swiss Franc, Japanese Yen, and Swedish Krona move in opposite directions as US stocks, while Australian dollar, Mexican Peso, and Canadian dollar move in the same direction.

Including the negatively correlated currencies over the last year would have seen between 12% and 17% capital gains. This is due merely to appreciation relative to the US dollar. In addition to relative currency gains, each ETF offers dividends representative of each countries interest rates.

An income investor should consider holding Mexican Peso, Australian Dollar, and British Pound, while avoiding Yen and Swiss Franc. There are many factors to take into consideration, but applying basic portfolio theory to your own holdings can have signficant long term results.

Currency ETF’s offer a great alternative to traditional methods of diversification and are great to offset further declines in our own currency. Consider that commodities price growth is largely attributable to US dollar depreciation and you can see how foreign currencies can insulate individuals from energy, food, and other commodity-driven inflation.