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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Learn the ins-and-outs of options trading with clear, practical guidance Essential Option Strategies is an introductory guide to options trading, designed to help new options traders better understand the market and the potential opportunities that exist. This book is designed to bring you up to speed with current practices and help you implement your own option trading strategies. You'll create a plan, track indicators, and understand underlying instruments, then apply that central investing knowledge directly to the options market. The discussion on pricing determinants and probabilities uses an intuitive approach to complex calculations, providing clear examples with no advanced math required, and extensive explanation of spreads, butterflies, and condors brings advanced strategies down to earth. Easy-reference appendices clarify the Greek terms and technical analysis charts, while focused discussion and expert insight throughout provide a highly informative crash course on options trading. Options trading has undergone a rapid evolution beyond stocks and commodities into asset classes including fixed-income, precious metals, energy, and more. This book helps you build a solid foundation in the fundamentals, giving you a knowledge base that applies no matter how the instruments change. This book is designed to help you: * Understand the options market inside and out * Avoid common mistakes * Learn some basic positions, and trades * Read charts and interpret probabilities Once the domain of the elites, the options market has been thrown wide open thanks to real-time price quotes, through brokerages, and the free flow of information online. The process of buying and selling options contracts is faster and more efficient than ever, and Wall Street is facing stiff competition from independent analysts and financial websites. As much as the market has changed, the fundamentals are the same--and Essential Option Strategies aims to provide expert guidance throughout the learning process.
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Table of Contents
Title Page
Copyright
Dedication
Foreword
Preface
Acknowledgments
About the Author
Part I: Getting Started in Investing
Chapter 1: The Opening Bell
Probabilities
Getting Started
Research
Data
Charts
Commissions and Fees
Virtual Trading Platforms
Summary
References
Chapter 2: First Days of Trading
Brief History of Stock Market Averages
Key Market Indexes Today
The Volatility Index
Futures
The Bond Market
Fed Watch
Economic Indicators
Earnings
Find Your Niche
Summary
References
Chapter 3: Know the Underlying
Where Do Options Trade?
Stock Talk
Exchange-Traded Funds
Short Selling
On the Margin
Summary
References
Chapter 4: Avoiding Mistakes
Position Size
Volume and Liquidity
Order Entry Techniques
Understand Risk
Summary
References
Part II: The Options Market
Chapter 5: Options Basics
Stock Options
Option Value
Exercise and Assignment
Volume and Open Interest
Index Options
Summary
References
Chapter 6: Introduction to Call Options
Call Options versus Stock
Risk and Reward of Long Call
Real-World Example
Short Calls
Index Call Options
Summary
Reference
Chapter 7: Introduction to Put Options
Long Puts versus Short Selling
Risk and Reward
Real-World Example
Protective Puts
Index Put Options
Summary
References
Chapter 8: Components of Options Prices
Delta and Other Greeks
Strike Price
Theta and Time Decay
Vega and Implied Volatility
Dividends
Rho and Interest Rates
Put-Call Parity
Summary
References
Chapter 9: Probabilities
Probabilities 101
Probability of Profit
Probability of Touching
Example
Delta to Measure Probabilities
Summary
References
Part III: Strategies and Positions
Chapter 10: Covered Calls
The Covered Call
Example
Summary
References
Chapter 11: Cash-Secured Puts
Short Puts
Example
Summary
Chapter 12: Long Vertical Spreads
Bull Call Spread
Example
Bear Put Spread
Example
Summary
Chapter 13: Short Vertical Spreads
Short (Bull) Put Spread
Example
Short (Bear) Call Spread
Example
Summary
Chapter 14: Calendar Spreads
Call Calendar Spread
Example
Put Calendar Spread
Example
Summary
Chapter 15: Butterfly Spreads
Butterfly Spread
Example
Iron Butterfly Spread
Example
Summary
Chapter 16: Condor Spreads
Condor Spread
Example
Iron Condor Spread
Example
Summary
Chapter 17: The Close
Risk Management
Options Orders
Using Options to Reduce Capital Commitment
Rolling with Spread Trades
Investing and Social Media
Final Thoughts
Appendix A: The Greeks
Delta Defined
Delta Neutral
Gamma
Theta
Vega
Rho
Reference
Appendix B: Strategy Recap
Long Call
Short Call
Long Put
Protective Put
Covered Call
Collar
Cash-Secured Put
Long Call Spread
Long Put Spread
Short Call Spread
Short Put Spread
Call Calendar Spread
Put Calendar Spread
Call Butterfly Spread (Long)
Put Butterfly Spread (Long)
Iron Butterfly
Call Condor Spread (Long)
Put Condor Spread (Long)
Iron Condor
Quick Strategy Guide
Appendix C: Charts and Volatility Studies
Stock Charts 101
Time Frames
Volume and Volatility
Glossary
Index
End User License Agreement
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Guide
Cover
Table of Contents
Begin Reading
List of Illustrations
Preface
Figure P.1 Live trading pits like this one are largely extinct
Chapter 1: The Opening Bell
Figure 1.1 My Watch List
Figure 1.2 Quick Quotes
Figure 1.3 Line Chart of Monthly Oil Prices
Figure 1.4 OHLC Bar
Figure 1.5 Daily Chart of S&P 500 Index (8/31/2015–11/30/2015)
Chapter 2: First Days of Trading
Figure 2.1 Inverse relationship between VIX and the S&P 500
Figure 2.2 Treasury Bond Yields, December 2015
Chapter 3: Know the Underlying
Figure 3.1 Daily Market Shares by Exchange, December 8, 2015
Figure 3.2 Stock Price—Last, Change, Bid, Ask
Figure 3.3 Example of a Stock Quote with Order Entry Screen
Figure 3.4 Quote Detail
Figure 3.5 Daily Stock Chart and Live News
Chapter 4: Avoiding Mistakes
Figure 4.1 Apple Stock Quote
Figure 4.2 Long Stock Risk Graph
Figure 4.3 Analyzing a Stock Trade
Figure 4.4 Buy Stock for $28 Risk Graph
Figure 4.5 Profit/Loss (P/L) Table for Long 100 Shares Purchased at $28
Chapter 5: Options Basics
Figure 5.1 Apple Inc. Options Chain
Figure 5.2 LULU Options Chain with Volume and Open Interest
Chapter 6: Introduction to Call Options
Figure 6.1 Long Call Risk Graph
Figure 6.2 Facebook Options Chain (9/30/2015)
Figure 6.3 Facebook Long Jan 85 Call Graph
Figure 6.4 Short Call Risk Graph
Figure 6.5 Short Apple July 130 Calls Risk Graph
Figure 6.6 Long SPX December 1950 Call Risk Graph
Chapter 7: Introduction to Put Options
Figure 7.1 Long Put Risk Curve
Figure 7.2 Twitter Options Chain (7/15/2015)
Figure 7.3 Risk Graph for TWTR January 37 Put
Figure 7.4 Protective Put Risk Graph
Figure 7.5 Twitter January 37 Protective Put
Figure 7.6 SPX Options Chain (7/31/2015)
Chapter 8: Components of Options Prices
Figure 8.1 Options Chain with Delta, Gamma, Theta, and Vega
Figure 8.2 VIX as of 12/24/15
Figure 8.3 Volatility Percentiles
Figure 8.4 Near-the-Money Options on a $30 Stock
Chapter 9: Probabilities
Figure 9.1 McDonald's Options Chain
Figure 9.2 Probability of Expiring ITM
Figure 9.3 Probability of Touching
Figure 9.4 Pfizer Options Chain with Delta
Chapter 10: Covered Calls
Figure 10.1 Covered Call Risk Graph
Figure 10.2 MGM Options Chain (1/13/2016)
Figure 10.3 MGM March 20 Covered Call Profit/Loss Graph
Figure 10.4 MGM March 20 Covered Call Probability Analysis
Chapter 11: Cash-Secured Puts
Figure 11.1 Short Put Risk Graph
Figure 11.2 MGM Options Chain
Figure 11.3 MGM Short Put
Figure 11.4 MGM Probability Analysis
Chapter 12: Long Vertical Spreads
Figure 12.1 Bull Call Spread
Figure 12.2 Apple Options Chain
Figure 12.3 Apple March 90–100 Long Call Spread Risk Graph
Figure 12.4 Probability Analysis for Apple Inc.
Figure 12.5 Apple Probability of Touching Analysis
Figure 12.6 Bear Put Spread Risk Graph
Figure 12.7 Goldman Sachs Options Chain
Figure 12.8 Goldman Sachs March 150–170 Put Spread
Figure 12.9 Goldman Sachs Probability Analysis
Figure 12.10 Goldman Sachs Probability of Touching
Chapter 13: Short Vertical Spreads
Figure 13.1 Bull Put Spread Risk Graph
Figure 13.2 Apple Options Chain
Figure 13.3 Apple March 91–93 Put Spread
Figure 13.4 Apple Probability Analysis
Figure 13.5 Apple Probability of Touching Analysis
Figure 13.6 Short Vertical Call Spread Risk Graph
Figure 13.7 Netflix March Options Chain
Figure 13.8 Netflix March Call Spread Risk Graph
Figure 13.9 Netflix Probability ITM Analysis
Figure 13.10 Netflix Probability of Touching Analysis
Chapter 14: Calendar Spreads
Figure 14.1 Call Calendar Spread Risk Graph
Figure 14.2 Facebook March Options Chain
Figure 14.3 Facebook May Options Chain
Figure 14.4 Call Calendar Spread Risk Graph
Figure 14.5 Probability of Expiring ITM Analysis
Figure 14.6 Facebook Probability of Touching
Figure 14.7 Put Calendar Risk Graph
Figure 14.8 The Home Depot March Options Chain
Figure 14.9 The Home Depot May Options Chain
Figure 14.10 The Home Depot March-May Put Calendar
Figure 14.11 The Home Depot Probability Analysis
Figure 14.12 The Home Depot Probability of Touching
Chapter 15: Butterfly Spreads
Figure 15.1 Long Butterfly Spread Risk Graph
Figure 15.2 Facebook March Options Chain
Figure 15.3 Facebook March 106-110-114 Call Butterfly Risk Graph
Figure 15.4 Probability of Expiring ITM Analysis
Figure 15.5 Facebook Probability of Touching Analysis
Figure 15.6 Apple Iron Butterfly
Figure 15.7 Goldman Sachs February Options Chain
Figure 15.8 Goldman Sachs February 145-150-155 Iron Butterfly
Figure 15.9 Goldman Sachs Probability Expiring ITM Analysis
Figure 15.10 Goldman Sachs Probability of Touching Analysis
Chapter 16: Condor Spreads
Figure 16.1 Long Condor Spread Profit-Loss Line
Figure 16.2 Facebook March Options Chain
Figure 16.3 Facebook March 104-106-108-110 Call Condor
Figure 16.4 Facebook Probability Expiring ITM Analysis
Figure 16.5 Facebook Probability of Touching Analysis
Figure 16.6 Iron Condor Risk Graph
Figure 16.7 Coach Options Chain
Figure 16.8 COH April 32-34-40-42 Iron Condor
Figure 16.9 Coach Probability of Expiring ITM Analysis
Figure 16.10 Coach Probability of Touching Analysis
Chapter 17: The Close
Figure 17.1 Example of an Advanced Order Entry Screen
Figure 17.2 Charting and News
List of Tables
Chapter 2: First Days of Trading
Table 2.1 The Original Dow Twelve and the Dow Thirty Today
Table 2.2 Largest S&P 500 Companies as of April 29, 2016
Table 2.3 Large-, Mid-, and Small-Cap Indexes
Table 2.4 Actively Traded Futures Contracts
Chapter 8: Components of Options Prices
Table 8.1 Stocks Up, Calls Up, Puts Down
Table 8.2 Synthetic Equivalents of Long and Short Stock, Calls, and Puts
Essential Option Strategies
UNDERSTANDING THE MARKET AND AVOIDING COMMON PITFALLS
JJ Kinahan
Copyright © 2016 by JJ Kinahan. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750– 8400, fax (978) 646– 8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748– 6011, fax (201) 748– 6008, or online at http://www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The products and strategies contained herein may not be suitable for your situation. Past performance of a security or strategy does not guarantee future results and you should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
Although JJ Kinahan is an employee of TD Ameritrade, the views expressed are his own, in his individual capacity, and do not in any way represent the views of TD Ameritrade, Inc., its employees or affiliates. This information is not published by TD Ameritrade and should not be considered an endorsement by TD Ameritrade of any particular investment strategy, product or service described therein.
The information provided is for general information purposes only and is not intended to be the primary basis for investment decisions, nor should it be construed as an individualized recommendation or personalized investment advice.
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606.
For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762– 2974, outside the United States at (317) 572– 3993 or fax (317) 572– 4002.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.
Library of Congress Cataloging-in-Publication Data is available.
Names: Kinahan, J. J., 1963- author.
Title: Essential option strategies : understanding the market and avoiding
common pitfalls / J. J. Kinahan.
Description: Hoboken : Wiley, 2016. | Includes index.
Identifiers: LCCN 2016021570 (print) | LCCN 2016036186 (ebook) | ISBN 9781119263333 (hardback) | ISBN 9781119291541 (ePDF) | ISBN 9781119291510 (ePub)
Subjects: LCSH: Options (Finance) | Investments. | BISAC: BUSINESS & ECONOMICS / Finance.
Classification: LCC HG6024.A3 .K556 2016 (print) | LCC HG6024.A3 (ebook) | DDC 332.64/53—dc23
LC record available at https://lccn.loc.gov/2016021570
Cover Design: Wiley
Cover Image: Stock market candle graph © Butsaya/iStockphoto
To Karen, Kaitlin, Kevin, and Kelly. Your love and support make all things possible.
Foreword
I began trading options on the floor of the CBOE in the early 1980s, just a few years before JJ. Back then, we were trader indifferent, which meant we would trade anything with anybody. Today, we would say the same about our approach to the products and strategies that we choose. These days, the counterparty to our trades is a computer with theoretical algorithm with unlimited funding. Back then, it was some kid just like us—nervous and sweating while trying to make a few eighths.
JJ and I traded together, played together, worked together, and learned together. Luckily, we were among the survivors. We excelled at our craft by managing our egos and not getting caught in the fat tails (volatility) of a few explosive moves. But the business changed as it grew exponentially, and open outcry faced certain extinction around 2000.
Now, the original trader cowboys are gone. Billions of new dollars, lightning-fast servers, and hard-coded theoretical models have taken over. Still, JJ, myself, and a handful of others decided we still had a lot left to learn and to share publicly. The same customers we lived off of were now our partners. And with strong beliefs that options remain the greatest strategic instrument in the world, our new mission was clear: Let's gather the gang together and share our stories. First came the technology to facilitate our mission, and next came the content.
In his first book, JJ reviews, discusses, and critiques almost every progressive strategy available. He puts great context around those ideas, so they are usable in real time. You'll see through his stories that the trader spirit remains in his words and transcends decades and advancements in technology.
Tom Sosnoff
Preface
A lot has changed in the options world since I started my career as a floor trader on the Chicago Board Options Exchange (CBOE) thirty years ago. Obviously, technology has transformed the exchanges, and with one or two exceptions, the live pits with crowds of screaming traders, like in Figure P.1, are largely a thing of the past.
At the same time, options markets are no longer confined to industrial countries or limited to instruments such as stocks and commodities. Contracts are now listed on a wide array of different asset classes, including fixed income, precious metals, energy, and even volatility. In addition, sufficient advances in technology have enabled many emerging economies to offer options as investment opportunities and as tools to manage risk.
My focus in this book is helping you, the retail client, understand some of the more actively traded securities in the U.S. markets, where options on equities and futures trade on more than a dozen different exchanges today, and only two—the Chicago Board Options Exchange and the Chicago Mercantile Exchange—are hybrid markets with both electronic and floor-based pit trading.
Figure P.1 Live trading pits like this one are largely extinct
Source: Shutterstock
Technology is not only driving how instruments are traded, but it has changed how information flows as well. It has leveled the playing field for individual investors. When I started my career, professional traders largely relied on the same sources for price information and financial news. Research was at a premium, and analysts provided reports only to their investment advisers, salespeople, and selected clients.
Today, real-time price quotes are readily available by looking online, through brokerages, and with mobile apps. Wall Street research faces competition from financial websites, blogs, and independent analysts. While information flows freely, social media drives increased interaction among individual investors and encourages the sharing of experiences and ideas.
I have seen the evolution firsthand and from a unique vantage point. Prior to joining TD Ameritrade, I worked for thinkorswim® (TOS), a Chicago-based brokerage firm with a focus on options trading. It was a revolutionary standalone trading platform specifically designed for individual traders. At that time, average daily volume across the listed options market in the United States was about 2 million contracts. Just ten years later, in 2009, that figure had increased to more than 14 million.
That same year, TD Ameritrade acquired thinkorswim and has continued to develop and improve the thinkorswim trading platform. This book includes many charts, examples, and ideas that have been developed over the years by the great team I am on at TD Ameritrade. As the markets change, so do our technology and tools.
Despite the fact that the number of trading instruments has increased exponentially, buying and selling is faster and more efficient, and information is more readily available than ever, some things in the options market are the same today as they were thirty years ago. For example, the determinants of an option price are the same today as in the 1970s. As you will see, there are basic tenets of investing that don't really change, and once you learn them today, they are likely to still apply thirty years from now.
The aim of this book is to share my experiences to help readers better understand the options market and explore the opportunities that exist today. I want to do it in a way that offers a commonsense approach without overwhelming the reader with numbers. But, at the same time, the book won't accomplish its objective unless the reader fully understands key concepts.
In summary, the fundamentals of the investment process don't really change, but the advances in technology have created an environment where individual investors have better information and tools than they did in the past. In fact, there has never been a better time to learn the options strategies that were once the domain of only the smartest professional traders.
The book kicks off with Part 1, appropriately titled “Getting Started in Investing.” Chapter 1, “The Opening Bell,” begins with very basic information you need prior to investing in stocks or options. For many, this is merely review, but for those of you who are newer to trading options or newer to investing in general, it offers basic information about financial markets today, how to get started, and suggestions for creating a trading plan.
From there, the discussion continues with a list of indicators to track in Chapter 2, “First Days of Trading.” Understanding underlying instruments such as stocks, futures, and indexes is important and covered in Chapter 3, “Know the Underlying.” I conclude Part I with a discussion about “Avoiding Mistakes,” the focus of Chapter 4.
Part II takes a basic understanding of investing to the options market. Chapter 5 covers options basics. Call and put options are defined in Chapters 6 and 7. Chapter 8 explains the determinants of options prices, and the math gets a bit more advanced when I talk about probabilities in Chapter 9. But don't worry, all of the examples are intuitive, and no advanced math is required.
Part III dives into more advanced options strategies. The basic strategies of covered calls and protective puts are covered in Chapters 10 and 11. Then my focus turns to spread trading. Long vertical spreads are the topic of Chapter 12, and short verticals are discussed thoroughly in Chapter 13. Calendar or time spreads are discussed inChapter 14. Chapters 15 and 16 explore two advanced strategies—butterflies and condors. Chapter 17, “The Close,” concludes Part III and covers the important concept of risk management.
For reference, Appendix A offers a look at delta, gamma, and the other Greeks. It offers definitions of each measure and serves as a quick reference. Appendix B shows different charts and basics of technical analysis. It also includes the payoff or risk graphs for the options strategies covered in Chapters 6 through 12. Appendix C is a primer on stock charts and volatility studies. A Glossary is provided at the end of the book as well.
I really hope this book helps you understand the fundamentals of the options market while also providing the confidence and tools you need to begin using strategies as part of a longer-term trading plan. Importantly, while I use real-world examples in this book, they are for educational and illustrative purposes only.
The securities depicted are sometimes real and sometimes hypothetical. They are specifically not solicitations or recommendations to trade a specific security or to engage in a particular trading or investing strategy. In addition, transaction costs, such as commissions and other fees, are important factors that should be considered when evaluating any trading opportunity.
The book starts at a very basic level, and for experienced traders, Part I might seem like a 101 material. But in the end, the reader will come away with a thorough understanding of options, techniques the pros use, and why the industry has experienced exponential growth since I started my career on the trading floor.
Please use this book to help you and your family pursue your investing and trading goals. Keep in mind that options trading entails significant risk and is not appropriate for every investor. Complex options strategies can carry additional risk. And futures and futures options trading is speculative and not suitable for all investors.
For me, the options business is something that I love and am passionate about. Hopefully, after digging through the early chapters, you will share the same appreciation about this business…and how it can provide tremendous opportunities for anyone willing to work hard and learn.
Acknowledgments
I was very happy to be given the opportunity to write a book designed to help retail investors as they embark on their journey into options investing. My goal was to provide information that demystified much of the difficulty by making the approach straightforward, using common sense rather than complicated math. I have been lucky to meet so many of you who are out there day after day working to get better. I admire your desire to learn and your commitment to improving your lives through investing. You are the inspiration for this book, and I hope you find it useful.
This was a large undertaking, and so many TD Ameritrade partners helped make it a success. A big thank you to CEO Fred Tomczyk, President Tim Hockey, and EVP Trader Group Steve Quirk for allowing me to pursue this undertaking. Thank you to the Active Trading Team for letting me work alongside you every day and seeing all your amazing accomplishments. I want to thank the Compliance Team. This took many hours of your time, and I greatly appreciate it. Thanks to the Marketing Team for all the help getting started and the constant guidance along the way. CAPAE Team, you are always a pleasure to work with, and Legal Team, thank you for your trusted counsel.
Fred Ruffy, it was great working with you. Thank you for the insight and suggestions. Thanks to the folks at Wiley. You are wonderful partners who made the process easy.
Thanks to both Zack Fishman and Paul Picchietti for taking a chance on me straight out of college and beginning to teach me the world of options. And also, thanks to Tom Sosnoff, from whom I have learned so much.
Most importantly, I want to thank my family—my late parents who did an amazing job of showing me the meaning of work ethic and sacrifice; my brothers and sisters for helping their youngest sibling every step of the way; and, of course, my wife, Karen, and our children, Kaitlin, Kevin, and Kelly.
About the Author
An options industry veteran, JJ Kinahan started his trading career in 1985 at the Chicago Board Options Exchange (CBOE). As a market maker, he traded primarily on the floor in the S&P 100 (OEX) and S&P 500 (SPX) pits. Later, he worked for ING Bank and Blue Capital. He then became managing director of options trading for Van der Moolen, USA.
In 2006 JJ joined the Chicago-based options trading brokerage firm thinkorswim where he served many roles, including developing educational content and helping build the tools that are integrated into the thinkorswim® platform today. JJ is now chief market strategist for TD Ameritrade, which acquired thinkorswim in 2009.
JJ is a frequent CNBC guest, a Forbes contributor, and often quoted in The Wall Street Journal, Financial Times, Reuters, and many other respected media outlets. He is on the Advisory Board at the CBOE. When not busy working or trading, he is an avid Chicago sports fan who enjoys reading, fishing, and spending time with his wife and three children.
Part IGetting Started in Investing
Chapter 1The Opening Bell
At 9:30 a.m. (EST) on every business day, a bell at the New York Stock Exchange sounds, and trading on the exchange floor begins. Investors buy and sell stocks like jockeys scrambling for positions at the Kentucky Derby. News flow drives the buying and selling decisions from one day to the next.
When the day's news doesn't deviate too much from expectations, the result is typically orderly and normal market action. However, when unexpected events result in dramatic changes in the expectations, large price moves and fast trading ensue. In other words, the day's news events can result in changes in investor sentiment and result in higher or lower levels of market volatility.
It can seem overwhelming. I remember when I left the trading floors after twenty-one years at the Chicago Board Options Exchange (CBOE). My focus shifted from a small number of instruments to a huge universe of different opportunities. I started trading in markets that were unknown to me. The results were horrible. Over time, I realized that it was better to keep a laserlike focus on markets that I understood and believed in. It is simply impossible to track the moves of every different market, much less trade them all effectively.
Moreover, the importance of news events will also vary from one investor to the next. A large pension fund taking positions in a widely held stock like Apple (AAPL) or General Electric (GE) for a longer-term portfolio isn't likely to react to a news report the same way as a stock trader buying and selling stocks for short-term profits. A retiree has a different set of goals than a recent college graduate. An options market maker on the CBOE is using equity options differently than a financial adviser selling options in an attempt to generate income for a customer's portfolio.
Although we all have different goals and objectives, the millions of participants in the financial markets digest the day's news, and the results move asset prices as the information becomes available. This is not only true of U.S. markets, but of financial instruments around the globe.
My focus in this book is primarily on U.S. Exchange listed equities, options, and equity futures markets that are open during the regular hours of 9:30 a.m. to 4:00 p.m., Monday through Friday, but there are many investments that trade beyond that. In 1985, regular trading hours were expanded beyond these hours. Premarket trading now begins at 4:00 a.m., and the after-hours session runs from 4:00 to 8:00 p.m.
Options, meanwhile, trade on thirteen different exchanges from 9:30 a.m. to 4:00 p.m. currently, and those hours may soon be expanded. Trading hours for futures and futures options vary by product, but more popular instruments like S&P 500 futures now trade nearly around the clock beginning Sunday at 6:00 p.m. and continuing through Friday evening. So when you come home at 2:00 a.m. after a few drinks at a neighborhood party, you can trade S&P 500 futures from your online brokerage account. However, that is not really recommended!
The expansion of trading hours and growth in financial markets is being driven by the exchanges to satisfy investor demand for new investment products and opportunities. At the same time, technology has created better efficiency and linked global markets. News flow travels fast and often results in sudden market moves that ripple from one economy to the next.
Yet, while today's faster and more complex market sometimes seems daunting to investors, the principles of investing have not changed. With a bit of time and effort, the fundamentals are easy to understand. So let's begin.
Probabilities
“How do I get started?”
I hear that question a lot. Many people understand the importance of investing and building wealth but don't know where to turn. Interest rates have been historically low for quite some time, and traditional banking instruments like money markets and savings accounts are not offering much in the way of yields. So what choices exist when seeking returns on one's hard-earned money?
Before I dive into specific instruments, let me introduce the probability concept. There are a myriad of different opportunities available to investors today, and all of them have varying probabilities of success. We can never predict the future with certainty, and so investments decisions are based on expectations about probable outcomes. We might say, based on our expectations, that an outcome is likely, is probable, or has a good chance.
Just like risk and reward, probability and strategy selection are two sides of the same coin. You have no doubt heard the expression, “high risk, high reward.” It refers to the fact that investments that offer the highest rewards typically have the greatest risk. Playing the lottery is an example of an extreme high-risk, high-reward endeavor. There is a very high rate of failure, but a winning ticket would mean a big payoff. On the other hand, burying your life's savings in the backyard is probably a low-risk, low-reward scenario (although risks increase if you bury everything near the family dog's bone stash).
In trading options, and remember, options are simply pricing probabilities, a strategy that has a very high probability of success and a low probability of loss is likely to have smaller potential for profit. On the other hand, a strategy with a small probability of profit should generate a larger potential profit when successful.
In later chapters, we will explore simple probability concepts and ways to compute probabilities for various options strategies. The important point to take home for now is that various investments or strategies are more than just good or bad ideas. Each strategy has a quantifiable probability of success.
Getting Started
What investments have the greatest probability of helping you attain your goals? There's no one single right answer, because every individual and institution is different. It's like asking, what's the best car to buy? It really depends on what you're using it for.
The first step to finding appropriate investments is to outline longer-term goals and objectives. Obviously, we all want to build more wealth, but unless we outline a concise plan, we are unlikely to set money aside each month or invest on a regular basis to achieve our objectives. The best investment choices often depend on a person's age, ambitions, and investment time horizon. For instance, as you will see in later chapters, some options contracts exist for a mere week, while others have lives that span many years. What is your investing time horizon, and how much are you putting away each paycheck?
Five Steps in the Investment Process
Set longer-term goals and objectives.
Develop a trading plan.
Identify investment opportunities.
Execute (open) trades.
Monitor, adjust, and exit open positions.
After the decision to invest has been made, the next step is to develop a plan. How will you try to reach your goals? Can you trade actively during the trading day, or will your investments be made only once per week or per month? Are you investing for five days, five years or fifty years? How much risk are you willing to take? What financial instruments—stocks, futures, bonds, options, commodities—will take part of the trading plan?
Developing a relationship with a brokerage firm is a key part of the trading plan. A brokerage (or broker-dealer) like my firm, holds customer funds and places buy and sell orders as instructed by you, the client. The first step is to open an account and submit any trading approval request forms. For example, investing in options requires applying for options trading approval from your broker.
While many investors focus on brokerage commissions and fees, there are a number of other things to consider besides price. The primary thing to consider is service. For example, does the firm have people that can answer my questions and help me when needed? Make sure they can help you pursue your trading goals. As you read through the chapters of this book, you will likely find the investments and strategies that match your longer-term goals and trading plan.
Research
Believing in your trading plan and your investment choices will lower your stress levels during times of increasing market volatility. Research is often a key to maintaining that conviction and also to finding attractive investment opportunities. In addition, it often makes sense to research companies or investments that you already know and love.
For example, let's say you own a pizza restaurant and a salesperson from The Pizza Sauce Company stops by your shop with samples of his newest sauce. You like the taste, and the price is $0.10 per can below your current supplier. You agree to sample a few cases and discover your customers love it. Your pies have never tasted better. Mama mia!
Convinced that The Pizza Sauce Company will soon gain substantial market share from its pizza sauce competitors, you check with your broker for any research available on the company. You discover that the stock is trading under the symbol PZZA. Two analysts currently cover the stock, and both agree that the company has a clean balance sheet, and shares are attractive at current levels, according to the research. Both analysts have a twelve-month price target of $26 per share.
At $20 per share, you note on the daily stock chart that the stock hasn't moved much during the past six months, but you believe that is likely to change once it becomes clear that the company is gaining market share over competitors. Your trading plan states that you do not invest more than 5 percent of your $200,000 portfolio, or more than $10,000, on one position. Instead, you place on order on your broker's platform to buy 250 shares of PZZA, for an investment of $5,000, or 2.5 percent of your portfolio.
Fast-forward one year, and as you had anticipated, The Pizza Sauce Company is outperforming its competitors, and the share price has increased to $25. You still hold 250 shares, now worth a total of $6,250, for an unrealized gain of $1,250.
However, a few weeks later, Pepperoni & Mozzarella Inc. says its cheese sales are falling short of previous expectations, and its stock drops 20 percent. The steep decline triggers a ripple effect that is felt across nearly every pizza company, as investors interpret the news as sign that pie sales are falling across the board.
Shares of The Pizza Sauce Company fall back to $22. However, your research continues to indicate that PZZA has strong fundamentals and is still gaining market share. Rather than sell hastily based on the headlines related to Pepperoni & Mozzarella, you are more likely to maintain your conviction in PZZA and possibly even buy more shares on the pullback. And that's exactly what you decide to do.
You place an order electronically to buy another 250 shares of The Pizza Sauce Company for $22 per share. You now own, and you are long, 500 shares at an average cost of $21 per share, for a total investment of $10,500. Assuming you earned 2 percent on the other assets in your account during the past year, the portfolio is now worth $204,150, or $193,650 plus the $10,500 of PZZA.
Long versus Short
Going
long
is taking a new position as a buyer. If you are long a stock, you want the stock to increase in price so you can sell it at a profit.
Going
short
is initiating an opening position as a seller. If you are short a stock, you want the stock price to fall so you can buy it back at a lower price. The mechanics of selling stock short are covered in detail in
Chapter 3
.
Your analysis was correct. Four months later, shares of The Pizza Sauce Company have recovered some losses and now trade for $25. You own 500 shares at a cost basis of $21, and the position is now worth $12,500 for an unrealized profit of $2,000. The total portfolio is now worth $207,700, or $195,200 and $12,500 of PZZA shares.
The stock position now accounts for 6 percent of your portfolio and exceeds the 5 percent threshold dictated by your trading plan. You sell 100 shares at $25 a share and reduce the position in The Pizza Sauce Company to 400 shares. The adjustment leaves you long 400 shares worth $25, or $10,000. You have booked $400 in realized taxable profits and have $1,600 of unrealized gains.
Indeed, as you will see in later chapters, sometimes the best investment opportunities happen when the news headlines seem the worst. At the end of the day, there is no substitute for timely, thoughtful research. Once you have a trading plan and have determined what instruments you will use to pursue your goals, find a broker who offers the type of research that will help you make informed decisions and keep you focused on the bigger picture when short-term events cause momentary setbacks. Research when combined with probability is a powerful combination.
Data
It wasn't that long ago when, outside the trading desks and the professional investment community, most investors relied on printed newspapers to see price changes to their stock positions. Periodicals like The Wall Street Journal and Investor's Business Daily provided tables of stocks listed alphabetically, and the prices represented the closing prices from the day before.
Five Components of a Stock Quote
Open: The first price of the trading day.
Last: The most recent price.
High: The highest price of the trading day.
Low: The lowest price of the day.
Close: The final price of the trading day. It will be the same as the last price at the end of the trading day.
Wow, a lot has changed since that time! Many websites readily offer free delayed intraday prices. Brokerage firms typically offer free real-time quotes to their customers as well. Offerings might include a symbol quote box where you can type in a ticker symbol or tables that include lists of multiple symbols along with relevant information, including last, high, and low prices.
Figure 1.1 is a snapshot of what I watch on the thinkorswim platform each day. It includes indexes like the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite, as well as some widely held names like Apple (AAPL), Netflix (NFLX), and General Electric (GE). I also watch some of the action in the futures markets, especially the S&P 500 Futures (/ES), and the US 30 year Treasury Bond Futures (ZB), as well as the Euro/US dollar (EUR/USD) currency pair.
Figure 1.1 My Watch List
I can also see the price quote for any stock by using the Quick Quote tool. First, identify the ticker symbol of the company you're researching. It's simply an abbreviation to uniquely identify a publicly traded instrument like a stock, index, or fund. For example, the ticker for General Electric is straightforward. It's GE. However, sometimes the ticker is less intuitive and requires a symbol lookup. This is easy to do using most brokerage platforms.
After the ticker symbol is identified, enter it into the Quick Quote box (Figure 1.2) to see the latest stock prices and the change for the day. In this case, the stock is Microsoft, and the ticker is MSFT. The stock is up $0.55 for the day and last traded at $54.48 per share.
Figure 1.2 Quick Quotes
The default setting for Quick Quotes on the thinkorswim platform also includes two other important pieces of information—the bid price and the ask price. The bid price is currently the best bid price by a buyer. If an investor wants to sell in the current market, he can expect to receive $54.47 per share. On the other hand, a buyer pays the asking price or $54.48 per share.
Bid versus Ask
Bid and ask reflects the current quotes to buy or sell a stock, option, or futures contract. The bid reflects a willingness to buy, and therefore a seller can expect to receive the bid price at the time of sale. The ask, or offering price, is a level that a seller or sellers are willing to receive for the security. A buyer typically pays the asking price.
Bids and asks are constantly changing, and there is no guarantee that you can buy or sell at the quoted prices. In addition, less actively traded names can see fairly large differences between bids and asks, which is also called the bid-ask spread. In later chapters we explore the mechanics of order entry and explore bids, asks, and bid-ask spreads in more detail. For now, the point to take away is that the last price is not necessarily an indication of the current market price to buy or sell. Bids and asks provide the latest market prices available to sellers and buyers.
Charts
A stock chart is simply a graph that shows price changes over time. In this book, I use two types. The first is a chart that shows the price of the underlying instrument, like stock, future, or index, over a period of time. The second is a payoff chart, or risk graph, and shows the potential risks and rewards of an options strategy. It is covered in more detail in later chapters. For now, let's discuss the basics of stock charting.
The simplest chart type is a line chart. For instance, it's easy to plot a line chart in a spreadsheet using data like date and price. Figure 1.3 shows a daily chart of hypothetical oil prices over twelve months. The line connects the twelve points where price and date intersect on the graph. It starts at $50 per barrel in January and ends at $53 in December.
Figure 1.3 Line Chart of Monthly Oil Prices
Traders plot charts for instruments like stocks, interest rates, or commodities to see trends over time. Obviously, few create the charts by hand or in spreadsheets. Charts are readily available on financial websites like StockCharts.com or Google Finance and also through online brokerage firms.
A second, more widely used chart is the open-high-low-close, or OHLC, chart. While the line chart is plotted using just the closing price, an OHLC chart includes bars that contain four pieces of price information.
Figure 1.4 shows an individual bar of an open-high-low-close chart. The small horizontal lines are the opening and closing prices. In this example, the stock opened at one price and closed at a lower price. The length of the vertical line represents the trading range of the day, because the top of the bar is the highest price and the bottom is the lowest.
Figure 1.4 OHLC Bar
Like the price chart, the horizontal axis (or bottom) of the OHLC chart represents time, such as days, weeks, or months. The vertical axis (or side) indicates price per unit, such as shares or contracts. Figure 1.5 shows an OHLC chart for a three-month period ended 11/30/2015. The time frame is plotted across the horizontal axis, and the change in price is depicted along the vertical axis.
Figure 1.5 Daily Chart of S&P 500 Index (8/31/2015–11/30/2015)
Notice that the OHLC bars are not all the same length. Longer ones suggest greater distances between highs and lows, and therefore increasing volatility in the security. Shorter ones suggest narrow trading, smaller daily moves, and periods of lower volatility or narrow trading ranges.
The time frame of an OHLC chart can be changed to weekly or monthly. If so, each bar represents the change over one week or one month. Short-term traders sometimes watch intraday bar charts at five-, ten-, or fifteen-minute intervals. Most of the examples throughout this book use daily OHLC charts.
More advanced charting tools are covered in Appendix B. If you have no previous experience with charting, take some time to learn how to identify areas of support and resistance with indicators like trend lines and moving averages. In addition, because the focus of later chapters is on options strategies, volatility studies are also useful. Those are covered in Appendix B as well.
Commissions and Fees
Brokerage firms vary in what they charge their customers. The costs associated with traditional brokerage activities like executing buy and sell orders have been somewhat commoditized, and costs are significantly lower today than they were twenty years ago. The growth of discount and online brokerages is a big reason.
But costs are relative to service. That is, brokerage services can range from very personal to simply taking orders online. Costs typically relate to service level and tools being offered. In short, you can expect to pay higher costs at some firms relative to others, and in an ideal world, the higher costs reflect the value being added.
At the end of the day, the investor's trading plan is a determining factor in broker selection. Are you trading once per month or five times per day? Some firms offer lower rates to active traders, and some charge more for broker-assisted trades.
Also, what types of investments are you buying and selling? Some firms offer certain products that others do not. In fact, futures are regulated under a different umbrella and require different account approvals compared to equities and equity options accounts.
Pattern Day Trader?
Certain rules apply to investors who trade frequently. A pattern day trader is defined as someone who buys and sells a security in the same trading day (intraday) and does it four or more times during a rolling five-business-day period. In order to pattern day trade, the investor must maintain a minimum of $25,000 in a margin account.
Lastly, what kind of technology does the firm offer? Not long ago, charting software, quotes, and live news were expensive. Some firms still charge for these services, and some don't. Other firms also offer premium subscriptions to newsletters, research, and other analytics. Lastly, the costs of trading vary by firm as well. Some of the fees active traders are likely to encounter include:
Stock trading costs
. Brokerage firms typically charge a commission to execute stock trades. Some charge a flat commission per trade, some a commission per share, and some a combination of flat plus per share. The rates vary quite a bit across the industry, and many firms will charge more for broker-assisted trades or phone trades compared to online orders.
Options trading costs
. The commission and/or fees on options trades vary from one firm to the next. Some firms charge a flat fee or commission plus a per-contract fee. Others might charge only a flat commission or only a per-contract charge. Some offer a combination of both and let the customer decide.
Futures trading costs
. As you progress in your trading, you may want to consider using futures to help hedge your portfolio. Similar to stocks and options, these costs may vary.
Virtual Trading Platforms
Over the years, brokerage firms have developed platforms to help individual investors better understand financial markets and how to buy or sell investment securities. The idea is not new, but the technology is. Virtual platforms offer an advanced way to paper trade, which simply means to write down and track your ideas on paper rather than implementing them with real money in the live market. Paper trading makes a lot of sense when attempting to learn new strategies and ideas.
In essence, a virtual trading platform lets you test-drive ideas without risking a dime. The goal is to help you develop an understanding of various financial instruments and the process of investing, which will help you build confidence as a trader.
Keep in mind that successful virtual trading during one period does not guarantee successful investing of actual funds during a later period, as market conditions are always changing. Backtesting is great for learning but has its limits. As you have probably heard many times, past performance is not an indicator of future results.
Many of the examples throughout this book are pulled from TD Ameritrade's paperMoney® virtual trading platform, and therefore, the bells and whistles will be duly highlighted in later chapters.
Summary
The first step in the process is to establish longer-term goals and objectives. Develop a trading plan that considers how much time you have available to trade, your risk tolerance, and the types of investments that might best help you to achieve your longer-term goals. Find a broker who offers the research and tools that meet your objectives. Identify potential trading ideas and test them on paper. Once new positions are opened, monitor, adjust, and exit them accordingly.
