McMillan on Options E-Book

Lawrence G. McMillan

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Trading Series
• Sprache: Englisch

Seitenzahl: 1031

Veröffentlichungsjahr: 2011

Beschreibung

Legendary trader Larry McMillan does it-again-offering his personal options strategies for consistently enhancing trading profits Larry McMillan's name is virtually synonymous with options. This "Trader's Hall of Fame" recipient first shared his personal options strategies and techniques in the original McMillan on Options. Now, in a revised and Second Edition, this indispensable guide to the world of options addresses a myriad of new techniques and methods needed for profiting consistently in today's fast-paced investment arena. This thoroughly new Second Edition features updates in almost every chapter as well as enhanced coverage of many new and increasingly popular products. It also offers McMillan's personal philosophy on options, and reveals many of his previously unpublished personal insights. Readers will soon discover why Yale Hirsch of the Stock Trader's Almanac says, "McMillan is an options guru par excellence."

Leseprobe

Table of Contents

Title Page

Copyright Page

Preface

SECOND EDITION

Table of Figures

Chapter 1 - Option History, Definitions, and Terms

UNDERLYING INSTRUMENTS

OPTION TERMS

THE COST OF AN OPTION

THE HISTORY OF LISTED OPTIONS

OPTION TRADING PROCEDURES

ELECTRONIC TRADING

EXERCISE AND ASSIGNMENT

FUTURES AND FUTURES OPTIONS

INFLUENCES ON AN OPTION’S PRICE

DELTA

TECHNICAL ANALYSIS

Chapter 2 - An Overview of Option Strategies

PROFIT GRAPHS

OUTRIGHT OPTION BUYING

USING LONG OPTIONS TO PROTECT STOCK

BUYING BOTH A PUT AND A CALL

SELLING OPTIONS

SPREADS

RATIO STRATEGIES

SUMMARY

Chapter 3 - The Versatile Option

OPTIONS AS A DIRECT SUBSTITUTE FOR THE UNDERLYING

OPTIONS AS A PROXY FOR THE UNDERLYING

THE EFFECT OF STOCK INDEX FUTURES ON THE STOCK MARKET

THE EFFECT OF INDEX FUTURES AND INDEX OPTION EXPIRATION ON THE STOCK MARKET

OPTIONS AS AN INSURANCE POLICY

THE COLLAR

HEDGING WITH OVER-THE-COUNTER OPTIONS

USING VOLATILITY FUTURES AS PORTFOLIO INSURANCE

SUMMARY

Chapter 4 - The Predictive Power of Options

USING STOCK OPTION VOLUME AS AN INDICATOR

USING OPTION PRICES AS AN INDICATOR

IMPLIED VOLATILITY CAN PREDICT A CHANGE OF TREND

THE PUT- CALL RATIO

FUTURES OPTIONS VOLUME

ON MOVING AVERAGES

SUMMARY

Chapter 5 - Trading Systems and Strategies

INCORPORATING FUTURES FAIR VALUE INTO YOUR TRADING

DAY-TRADING VEHICLES

THE TICKI DAY-TRADING SYSTEM

A SHORT-TERM TRADING SYSTEM

INTERMARKET SPREADS

OTHER SEASONAL TENDENCIES

SUMMARY

Chapter 6 - Trading Volatility and Other Theoretical Approaches

VOLATILITY

DELTA NEUTRAL TRADING

PREDICTING VOLATILITY

COMPARING HISTORICAL AND IMPLIED VOLATILITY

TRADING IMPLIED VOLATILITY

THE “GREEKS”

TRADING THE VOLATILITY SKEW

THE AGGRESSIVE CALENDAR SPREAD

USING PROBABILITY AND STATISTICS IN VOLATILITY TRADING

EXPECTED RETURN

SUMMARY

Chapter 7 - Other Important Considerations

SUPPORT ACTIVITIES

TRADING METHODOLOGY AND PHILOSOPHY

OPTION TRADING PHILOSOPHY

SUMMARY

Appendix A - Listed Index and Sector Options

Appendix B - Futures Options Terms and Expirations

Appendix C - Option Models

Index

Table of Figures

Figure 1.1 EXERCISE AND ASSIGNMENT OF STOCK OR FUTURES OPTIONS

Figure 1.2 EXERCISE AND ASSIGNMENT OF CASH-BASED INDEX OPTIONS

Figure 2.1 CALL PURCHASE

Figure 2.2 PUT PURCHASE

Figure 2.3 LONG STOCK/LONG PUT

Figure 2.4 LONG CALL/SHORT STOCK

Figure 2.5 STRADDLE PURCHASE

Figure 2.6 COMBINATION (STRANGLE) PURCHASE

Figure 2.7 COVERED CALL WRITE

Figure 2.8 NAKED PUT WRITE

Figure 2.9 NAKED CALL WRITE

Figure 2.10 SHORT COMBINATION

Figure 2.11 SHORT STRADDLE

Figure 2.12 BULL SPREAD

Figure 2.13 BULL SPREAD COMPARISON

Figure 2.14 BEAR SPREAD

Figure 2.15 CALENDAR SPREAD

Figure 2.16 RATIO CALL WRITE

Figure 2.17 CALL RATIO SPREAD

Figure 2.18 PUT RATIO SPREAD

Figure 2.19 CALL BACKSPREAD

Figure 2.20 PUT BACKSPREAD

Figure 2.21 BUTTERFLY SPREAD

Figure 3.1 THE COLLAR AS INSURANCE

Figure 3.2 VIX VOLATILITIES

Figure 4.1 SOUTHERN PACIFIC RAILROAD

Figure 4.2 AMERICAN CYANAMID

Figure 4.3 GERBER—OPTION VOLUME

Figure 4.4 CHIPCOM

Figure 4.5 U.S. SHOE

Figure 4.6 U.S. SHOE—OPTION VOLUME

Figure 4.7 MOTOROLA

Figure 4.8 SYBASE

Figure 4.9 SYNTEX

Figure 4.10 BETHLEHEM STEEL

Figure 4.11 ADM, 12/27/95

Figure 4.12 GRUPO TRIBASA

Figure 4.13 U.S. SURGICAL, 7/20/95

Figure 4.14 GERBER—IMPLIED VOLATILITY

Figure 4.15 GENSIA PHARMACEUTICALS

Figure 4.16 LIPOSOME TECHNOLOGY

Figure 4.17 IBM, 8/92-10/94

Figure 4.18 TELEFONOS DE MEXICO (TELMEX)

Figure 4.19 CBOE’S VOLATILITY INDEX ($VXO)—ENTIRE HISTORY

Figure 4.20 $OEX MOVEMENTS AFTER LOW $VIX READINGS

Figure 4.21 VOLATILITY INDEX—VIX

Figure 4.22 OEX

Figure 4.23 $VIX AND $OEX: 1997-1999

Figure 4.24 $VXO COMPOSITE SPREAD: 1989-2003(By Trading Day of Year)

Figure 4.25 PUT- CALL RATIO

Figure 4.26 55-DAY INDEX PUT-CALL RATIO

Figure 4.27 OEX DURING 1987

Figure 4.28 55-DAY EQUITY PUT-CALL RATIO

Figure 4.29 21-DAY QQQ PUT-CALL RATIO WITH QQQ OVERLAY

Figure 4.30 STANDARD PUT-CALL RATIO

Figure 4.31 $OEX: 1999-2000

Figure 4.32 WEIGHTED EQUITY-ONLY PUT-CALL RATIO: 1999-2000

Figure 4.33 STANDARD EQUITY-ONLY PUT-CALL RATIO

Figure 4.34 WEIGHTED EQUITY-ONLY PUT-CALL RATIO

Figure 4.35 $MSH PUT-CALL RATIO

Figure 4.36 $MSH WEIGHTED PUT-CALL RATIO

Figure 4.37 NASDAQ-1OO TRADING STOCK (QQQ)

Figure 4.38 MSFT: 1999-2000

Figure 4.39 STANDARD MSFT PUT-CALL RATIO

Figure 4.39A WEIGHTED MSFT PUT-CALL RATIO

Figure 4.40 STANDARD INTC PUT-CALL RATIO

Figure 4.41 WEIGHTED INTC PUT-CALL RATIO

Figure 4.42 21-DAY GOLD PUT-CALL RATIO

Figure 4.43 CONTINUOUS GOLD FUTURES

Figure 4.44 CONTINUOUS LIVE-CATTLE FUTURES

Figure 4.45 21-DAY LIVE-CATTLE PUT-CALL RATIO

Figure 4.46 CONTINUOUS T-BOND FUTURES

Figure 4.47 21-DAY T-BOND PUT-CALL RATIO

Figure 4.48 21-DAY S&P PUT-CALL RATIO

Figure 4.49 CONTINUOUS SUGAR FUTURES

Figure 4.50 21-DAY SUGAR PUT-CALL RATIO

Figure 4.51 CONTINUOUS COFFEE FUTURES

Figure 4.52 21-DAY COFFEE PUT-CALL RATIO

Figure 4.53 CONTINUOUS COTTON FUTURES

Figure 4.54 21-DAY COTTON PUT-CALL RATIO

Figure 4.55 CONTINUOUS LIVE-HOG FUTURES

Figure 4.56 21-DAY LIVE-HOG PUT-CALL RATIO

Figure 4.57 CONTINUOUS NATURAL GAS FUTURES

Figure 4.58 21-DAY NATURAL GAS PUT-CALL RATIO

Figure 4.59 21-DAY BP STANDARD PUT-CALL RATIO

Figure 4.60 21-DAY BP WEIGHTED PUT-CALL RATIO

Figure 4.61 21-DAY JY WEIGHTED PUT-CALL RATIO

Figure 4.62 21-DAY SF WEIGHTED PUT-CALL RATIO

Figure 4.63 21-DAY EC WEIGHTED PUT-CALL RATIO

Figure 4.64 21-DAY SI WEIGHTED PUT-CALL RATIO

Figure 5.1 OSCILLATOR: 1998-2004

Figure 5.2 NYSE ADVANCE-DECLINE LINE

Figure 5.3

Figure 5.4 HOG/HUG 1993 CONTRACTS

Figure 5.5 HOG/HUG 1992 CONTRACTS

Figure 5.6 HOG/HUG 2000 CONTRACTS

Figure 5.7 HOG/HUG 2001 CONTRACTS

Figure 5.8 HOG/HUG 2002 CONTRACTS

Figure 5.9 HOG

Figure 5.10 VALUE LINE/S&P 500 COMPOSITE: 1989-2003

Figure 5.11 VALUE LINE INDEX MINUS S&P 500

Figure 5.12 SXAU DIVIDED BY DEC GOLD FUTURES

Figure 5.13 SXOI DIVIDED BY DEC CRUDE OIL FUTURES: 1992-1995

Figure 5.14 SXOI DIVIDED BY DEC CRUDE OIL FUTURES: 1993

Figure 5.15 SXOI DIVIDED BY DEC CRUDE OIL FUTURES: 1992-2003

Figure 5.16 SUTY DIVIDED BY DEC T-BOND FUTURES

Figure 5.17 PD DIVIDED BY DEC COPPER FUTURES

Figure 6.1 NAKED STRADDLE SALE VERSUS NAKED STRANGLE

Figure 6.2 STRANGLE SALE

Figure 6.3 CALL RATIO SPREAD

Figure 6.4 STRADDLE BUY

Figure 6.5 RETAIL INDEX (RLX)

Figure 6.6 CALL BACKSPREAD

Figure 6.7 CALL CALENDAR SPREAD

Figure 6.8 COMPARISON OF DELTA AND TIME REMAINING

Figure 6.9 DELTA OF AT-THE-MONEY OPTION AS TIME PASSES

Figure 6.10 COMPARISON OF DELTA AND VOLATILITY

Figure 6.11 TWO-YEAR LEAPS CALL PRICING CURVE

Figure 6.12 GAMMA VERSUS TIME

Figure 6.13 POSITION DELTA OF RATIO SPREAD

Figure 6.14 PROFIT OF RATIO SPREAD

Figure 6.15 PROFIT AND LOSS OF RATIO SPREAD IF VOLATILITY CHANGES

Figure 6.16 WINGS PROFIT AND LOSS

Figure 6.17 PROFIT AND LOSS OF DOUBLE RATIO SPREAD

Figure 6.18 CALENDAR

Figure 6.19 BELL CURVE OR NORMAL DISTRIBUTION

Figure 6.20 LOGNORMAL DISTRIBUTION

Figure 6.21 FORWARD SKEW

Figure 6.22 REVERSE SKEW

Figure 6.23 CALL RATIO SPREAD

Figure 6.24 PUT BACKSPREAD

Figure 6.25 PUT RATIO SPREAD

Figure 6.26 CALL BACKSPREAD

Figure 6.27 OEX BACKSPREAD—STAGE 1

Figure 6.28 OEX BACKSPREAD—STAGE 2

Figure 6.29 OEX BACKSPREAD—STAGE 3

Figure 6.30 OEX BACKSPREAD—STAGE 4

Figure 6.31 AMI SHORT-TERM CALENDAR SPREAD

Figure 7.1 ORDER FLOW

Figure 7.2 EXAMPLES OF CLOSING STOPS

Figure C.1 BINOMIAL MODEL LATTICE

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Copyright © 2004 by Lawrence G. McMillan. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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ISBN 0-471-67875-9

Preface

When people learn that I have written another book, they usually ask one of two questions: “Is this an update of your other book?” or “What’s the difference between this one and your other one?” First of all, this is most assuredly not an update of Options as a Strategic Investment (OSI). This is a completely different, stand-alone book that relates option trading in actual examples. Second, there is a substantial difference between this book and OSI. This book is not intended to be a comprehensive definition of strategies—that is better derived from OSI, which is a reference work. This is a book in which the application of options to actual trading situations is discussed. There are plenty of actual trading examples, many of them derived from my own trading experience. In addition, there are a number of stories—some humorous, some more on the tragic side—that illustrate the rewards and pitfalls of trading, especially trading options. In addition, the content of this book covers ground that one does not normally find in books on options; that content will be discussed shortly.

There is a continuous discussion of futures trading, as well as stock and index trading, herein. The futures markets offer many interesting situations for option trading and strategies. To that end, the basic definitions of futures options—and how they compare to, and differ from, stock options—are included in Chapter 1.

While the book is not really meant for beginners, it contains all the necessary definitions. Thus, serious traders will have no trouble at all in getting up to speed. In fact, many of the techniques described in this book do not require familiarity with option strategies at all. The more elementary option strategy definitions are not expanded upon at great length here, however, as my objective is to describe practical applications. For example, it is not my intention to detail the explicit calculations of break-even points and explain follow-up actions for these basic strategies. Readers who feel a need to better understand the basics should refer to the aforementioned work, OSI, which describes virtually all conceivable strategies in a rather large amount of detail.

As for content, the book is basically divided into five major sections, spread out over seven rather lengthy chapters. The first part—Chapters 1 and 2—lays out the basic definitions and reviews option strategies, so that the framework is in place to understand and utilize the material in succeeding chapters. Even seasoned option professionals should enjoy reading these introductory chapters, for the trading tales that accompany many of the strategies are sure to elicit some nodding of heads. Graphs and charts are liberally used. Since things are more easily seen in graphs than in tables, over 120 such graphs and charts are included in this book.

The next three chapters—3 through 5—are intensive discussions of some very important trading tactics, based on options. However, they are more of a basic nature and don’t require a theoretical approach to option trading. In fact, a stock or futures trader should be able to absorb this information rather quickly, even if he doesn’t have a clue as to what the delta of an option is. Don’t get me wrong—I encourage every option trader to use a model via a computer program in order to evaluate an option before he actually buys or sells it. However, these chapters don’t require anything more theoretical than that.

Chapter 3 contains material that is extremely important to all traders—particularly stock traders, although futures traders will certainly benefit as well. I like to think of the information in this chapter as demonstrating how versatile options can be—they don’t have to be merely a speculative vehicle. A basic understanding of the concepts involving using options to construct positions that are equivalent to owning stock or futures contracts is shown to be necessary for many applications. For example, it allows a futures trader to extract himself from a position, even though the futures may be locked limit against him.

Later in the same chapter, there is an extremely detailed discussion of how the expiration of options and futures affect the stock market. Several trading systems are laid out that have good track records, and that can be used month after month. Finally, the use of options or futures to protect a portfolio of stocks is also discussed in some detail. If we ever go into another bear market, these strategies will certainly become very popular.

Chapter 4 is my favorite—“The Predictive Power of Options.” Since options offer leverage, they are a popular trading vehicle for all manner of speculators. By observing both option prices and option volume, you can draw many important conclusions regarding the forthcoming direction of stocks and futures. A large part of the chapter describes how to use option volume to buy stock (or sometimes sell it) in advance of major corporate news items, such as takeovers or earnings surprises. However, another lengthy discussion involves the put-call ratio—a contrary indicator—as it applies to a wide variety of indices and futures. The work on futures’ put-call ratios is, I believe, unique in the annals of technical analysis in that the techniques are applied to and rated on a vast array of futures markets.

Several trading systems—from day-trading to seasonal patterns—with profitable track records are described in Chapter 5. Many traders, even those who are technically inclined, often overlook the power of seasonality. Moreover, the use of options in intermarket spreads is explained. Options give intermarket spreaders an additional chance to make money, if applied in the ways shown.

For those with a theoretical bent, Chapter 6 may be your favorite. The use of neutral option strategies is discussed, especially with respect to predicting and trading volatility. One of my pet peeves is that the term “neutral” is thrown around with such ease and, as a result, is often applied to positions that have considerable risk. The intent of Chapter 6 is to not only set the record straight, but to demonstrate that—while neutral trading can certainly be profitable—it is not the easy-money, no-work technique that some proponents seem to be extolling. I am often asked how I base my decisions on taking a position, rolling, and so forth, so the backspread example in Chapter 6 is intended to be almost a diary of what I was thinking and how I traded the position over the course of six months.

The book winds up with a discussion of money management, trading philosophy, and some trading guidelines—all in Chapter 7. Some of my favorite trading stories and sayings are related in this chapter. I hope you enjoy them as well.

My hope is that this book will bring more traders into the option markets, as they realize that options can be used in many ways. Options don’t merely have to be treated as a speculative vehicle. In fact, you might be strictly a stock or futures trader but find that options can give you valuable buy and sell signals. Those with a more theoretical bent will find that volatility trading can be lucrative as well.

SECOND EDITION

After seven years, I felt a second edition was necessary because there had been sufficient changes in the derivatives industry to justify a rewrite with deletions and additions. For example, Chapter 1, which is mostly definitions, now includes Exchange Traded Funds, Electronic Trading, Single Stock Futures, and Volatility Futures. The main purpose of the second edition is to weed out material that no longer is viable—either because products had become delisted or illiquid or because strategies had become exploited—and to include new tactics and strategies that I apply in my own trading and analysis.

Chapter 3, which discusses various option special applications, now includes a discussion describing how a stock can be “pinned” to a striking price at expiration—what causes it, why it happens, and when to expect it. Furthermore, as options have become more popular as a hedging vehicle for stock owners—particularly professional stock owners—new strategies have developed. They are included in this new edition. One is the use of the newly listed volatility futures, and another is an expanded use of the “collar” strategy with listed options. New examples are included to describe both applications.

In the revised Chapter 4, one major addition is the inclusion of put-call ratio charts and theory on individual stocks. In the first edition, I had felt that there was too much insider trading in stock options and that such activity would distort the usefulness of put-call ratios on individual stocks. But, as time passed, I came to feel that large, well-capitalized stocks were less susceptible to manipulation and insider trading and that their put-call ratios could indeed provide another good sentiment-based indicator for traders. Another major aspect of put-call ratios included in this edition is weighted put-call ratios. This method, which incorporates the price of the option as well as its trading volume, is a highly effective improvement on the basic theory of using put-call ratios as indicators. On another related topic—using the volatility indices as a market predictor—we have done a good deal of research over the years, and much of that is now included in Chapter 4. This research not only includes the analysis of peaks and valleys in the VIX chart itself, but also shows how the comparison of implied and historical volatilities is an important indicator.

Chapter 5 still covers trading systems and strategies. One major change that has taken place in the markets in recent years is the loss of effectiveness of the New York Stock Exchange (NYSE) advance- decline figures. This is due to decimalization for the most part. As a result, we have adapted another method of looking at breadth—the “stocks only” approach. This adaptation is applied to some of our systems, and the improvement is significant. The section on intermarket spreads has been updated as well. For some spreads, this is nothing more than bringing charts up to date. But for others—notably, the January effect spreads—significant changes in the pattern of the spread have taken place; and, thus, changes in strategy for trading the spread are necessary as well. This also includes the way that intermarket spreads are implemented. There is less reliance on futures and more reliance on Exchange Traded Funds (ETFs), which are much more popular now than they were when the first edition was published. Finally, the seasonal trading systems are updated, and one more has been added—the late-January seasonal buy point. The systems presented in this chapter remain some of my favorite speculative trading vehicles; and with this new, up-to-date information, they should prove to be useful for all readers.

A more advanced approach to option trading is once again presented in Chapter 6. A significant amount of new information is included, most in the area of statistics and probability, that is, applying statistics to trading decisions. The concept of expected return is explained and illustrated, as is the concept of the Monte Carlo probability simulation. These concepts and tools allow the theoretically based trader to be more disciplined in his approach to the markets. He can concentrate on situations where options are mispriced (volatility skews, for example), solid in the knowledge that a consistent investment in positions with above-average expected returns should eventually produce above-average results.

Much of the data and tools necessary for the modern option trader can be found on the Internet, and there is some discussion of where to find data and tools in Chapter 7. I would, of course, be pleased to see readers visit our web site, www.optionstrategist.com, where a great deal of free information is presented. We also have a subscriber area, The Strategy Zone, on that web site, where more in-depth reports and data are available, along with a daily market commentary.

There is no doubt that options and other derivatives now hold a major place in the investment landscape, but it is disconcerting to see how many people still don’t seem to understand options. In fact, they are quick to place blame on derivatives when things go wrong. Only by dissemination of the kind of information in this book can we hope to overcome such negative and uneducated attitudes. When we have another bear market, option traders will probably do very well—whether they use options as a protective device or as a speculative one. Some have even gone so far as to predict that angry investors, who do not understand derivatives, will attempt to blame that bear market and its concomitant losses on options and other derivatives. That would be ludicrous, of course, but if we can convince more and more people of the viability of option trading, then affixing any future blame will be a moot point.

I’ve been in this business so long now that there are literally hundreds of people I could thank for helping me get to this point. However, in the interest of space and time, I will limit my kudos to those who specifically helped with this book and with the concepts behind it: Shelley Kaufman, who did all the graphics work in this book and who is an invaluable confidant on all matters; Peter Bricken, who first came up with the idea of monitoring option volume as a precursor of corporate news events; Van Hemphill, Mike Gallagher, and Jeff Kaufman, who provided information on expiration activity that is nonpareil and who have helped me to clarify my thinking on strategies regarding expiration; Chris Myers, who convinced me to write this book; Peter Kopple, off whom I can constantly bounce ideas; and Art Kaufman, who convinced me that I could go into business for myself. Finally, a special thanks to my wife, Janet, who puts up with my crazy hours, and to my children, Karen and Glenn.

LAWRENCE G. MCMILLAN

Randolph, New JerseyAugust 2004

1

Option History, Definitions, and Terms

There are many types of listed options trading today: stock options, index options, and futures options are the major ones. The object of this book is to explore some of the many ways in which options can be used and to give practical demonstrations that will help the reader make money.

Options are useful in a wide array of applications. They can be used to establish self-contained strategies, they can be used as substitutes for other instruments, or they can be used to enhance or protect one’s position in the underlying instrument, whether that is stock, index, or futures. In the course of this book, the reader may discover that there are more useful applications of options than he ever imagined. As stated in the Preface, this book is not really meant for novices but contains all definitions to serve as a platform for the larger discussion.

UNDERLYING INSTRUMENTS

Let’s begin with the definitions of the simplest terms, as a means of establishing the basic building blocks. Before even getting into what an option is, we should have some idea of the kinds of things that have options. That is, what are the underlying instruments that provide the groundwork for the various listed derivative securities (options, warrants, etc.)? The simplest underlying instrument is common stock. Options that give the investor the right to buy or sell common stock are called stock options or equity options.

Another very popular type of underlying instrument is an index. An index is created when prices of a group of financial instruments—stocks, for example—are grouped together and “averaged” in some manner so that the resulting number is an index that supposedly is representative of how that particular group of financial instruments is performing. The best-known index is the Dow Jones Industrial Average, but there are indices of many other groups of stocks; indices with a large number of stocks in them are the Standard & Poor’s (S&P) 500 and the Value Line Index, for example. There are also many stock indices that track various groups of stocks that are in the same industry: Utility Index, Oil Index, Gold and Silver Index, for example. There are even indices on foreign stock markets, but they have options listed in the United States; these include the Japan Index, Hong Kong Index, and Mexico Index, as well as several others. Indices are not restricted to stocks, however. There are indices of commodities, such as the Commodity Research Bureau Index. Moreover, there are indices of bonds and rates; these include such things as the Short-Term Rate Index, the Muni Bond Index, and the 30-Year Bond Rate Index. Options on these indices are called index options. Appendix A contains a list of available index options.

Finally, the third broad category of underlying instrument is futures. This is probably the least-understood type of underlying instrument, but as you will see when we get into strategies, futures options are extremely useful and very important. Some people mistakenly think options and futures are nearly the same thing. Nothing could be further from the truth. The “dry” definition is a futures contract is a standardized contract calling for the delivery of a specified quantity of a certain commodity, or delivery of cash, at some future time. In reality, owning a futures contract is very much like owning stock, except that the futures’ price is related to the cash price of the underlying commodity, and the futures contract has a fixed expiration date. Thus, futures contracts can climb in price infinitely, just as stocks can, and they could theoretically trade all the way down to zero, just as stocks can. Moreover, futures can generally be traded on very small percentages of margin, so that the risk of owning futures is quite large, as are the potential rewards. We discuss futures contracts in more detail later, but this brief description should suffice to lay the groundwork for the following discussion of options terms. As might be suspected, options on futures contracts are called .