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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Navigate options markets and bring in the profits Thinking about trading options, but not sure where to start?This new edition of Trading Options For Dummies starts youat the beginning, explaining the common types of options availablefor trading and helps you choose the right ones for your investingneeds. You'll find out how to weigh option costs and benefits,combine options to reduce risk, build a strategy that allows you togain no matter the market conditions, broaden your retirementportfolio with index, equity, and ETF options, and so muchmore. Options are contracts giving the purchaser the right to buy orsell a security, such as stocks, at a fixed price within a specificperiod of time. Because options cost less than stock, they are aversatile trading instrument, while providing a high leverageapproach to trading that can limit the overall risk of a trade orprovide additional income. If you're an investor with some generalknowledge of trading but want a better understanding of riskfactors, new techniques, and an overall improved profit outcome,Trading Options For Dummies is for you. * Helps you determine and manage your risk, guard your assetsusing options, protect your rights, and satisfy your contractobligations * Provides expert insight on combining options to limit yourposition risk * Offers step-by-step instruction on ways to capitalize onsideways movements * Covers what you need to know about options contractspecifications and mechanics Trading options can be a great way to manage your risk, and thishands-on, friendly guide gives you the trusted and expert help youneed to succeed.
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Veröffentlichungsjahr: 2015
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Trading Options For Dummies®, 2nd Edition
Published by: John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, www.wiley.com
Copyright © 2015 by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada
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Library of Congress Control Number: 2014954665
ISBN 978-1-118-98263-1 (pbk); ISBN 978-1-118-98264-8 (ePub); ISBN 978-1-118-98265-5 (PDF)
Trading Options For Dummies®, 2nd Edition
Visit www.dummies.com/cheatsheet/tradingoptions to view this book's cheat sheet.
Table of Contents
Cover
Title Page
Introduction
About This Book
Foolish Assumptions
Icons Used in This Book
Beyond the Book
Where to Go from Here
Part I: Getting Started
Chapter 1: Options Trading and the Individual Investor
Taking Your Own Financial and Strategic Pulse
Understanding Options
Differentiating Between Option Styles
Using Options In Challenging Markets
Chapter 2: Introducing Options
Understanding Option Contracts
Valuing Options
Making Sense of Options Mechanics
Birthing Option Contracts
Keeping Some Tips in Mind
Chapter 3: Trading Places: Where the Action Happens
The U.S. Options Exchanges
Navigating the Markets
Weighing Option Costs and Benefits
Grasping Key Option Pricing Factors
Chapter 4: Option Risks and Rewards
Understanding Your Trading Risks
Reaping Your Rewards
Profiling Risk and Reward
Part II: Evaluating Markets, Sectors, and Strategies
Chapter 5: Analyzing Mood Swings in the Market
A Few Words About Select Macro Factors
Assessing the Market’s Bias
Watching Call and Put Activity
Using Volatility to Measure Fear
Applying Breadth and Sentiment Tools
Chapter 6: Sector Analysis: Technical and Fundamental
Getting Technical with Charts
Identifying Relatively Strong Sectors
Using Sector Volatility Tools
Projecting Prices for Trading
Chapter 7: Practicing Before You Swing
Monitoring Option Greek Changes
Paper Trading a Trading Strategy
Using Trading Systems
Shifting from Knowledge to Mastery
Chapter 8: Designing A Killer Trading Plan
Managing Your Costs
Optimizing Order Execution
Part III: What Every Trader Needs to Know About Options
Chapter 9: Getting to Know Different Option Styles
Nailing Down Index Options
Watching Out for Style Risk
Exercising Your Options American Style
Exercising Your Options the Euro Way
Satisfying Option Obligations
Breaking It Down: American-Style Index Options
Chapter 10: Protecting Your Portfolio with Options
Putting Protection on Long Stock
Limiting Short Stock Risk with Calls
Hedging Your Bets with Options
Avoiding Adjusted Option Risk
Chapter 11: Increasing Profit Potential and Decreasing Risk
Leveraging Assets to Reduce Risk
Combining Options to Reduce Risk
Chapter 12: Combination Strategies: Spreads and Other Wild Things
Combining Options with Stocks
Varying Vertical Spreads
Chapter 13: ETFs, Options, and Other Sneaky Tricks
Exploring the Exchange-Traded Fund
Reducing Portfolio Volatility with ETFs
Tilting Your Portfolio with Sector ETFs
Part IV: Advanced Strategies for Options Traders
Chapter 14: Making Money without Worrying About the Market’s Direction
Limiting Directional Risk
Neutral View versus Neutral Position
Trading with Delta
Understanding Trade Adjustments
Chapter 15: Letting Volatility Lead You to Trading Opportunities
Analyzing Implied Volatility Levels
Understanding Ratio Spreads
Using Ratio Backspreads
Chapter 16: Trading Profitably When Markets Move Sideways
Winning Positions in Sideways Markets
Understanding Butterfly Positions
Understanding Condor Positions
Part V: The Part of Tens
Chapter 17: Ten Top Option Strategies
Married Put
Collar
Long Put Trader
LEAPS Call Investor
Diagonal Spread
Bear Call Credit Spread
Straddle
Call Ratio Backspread
Put Ratio Backspread
Long Put Butterfly
Chapter 18: Ten Do’s and Don’ts in Options Trading
Do Focus on Managing Risk
Don’t Avoid Losses
Do Trade with Discipline
Don’t Expect to Remove Your Emotions
Do Have a Plan
Do Be Patient
Don’t Suffer from Analysis Paralysis
Do Take Responsibility for Your Results
Don’t Stop Learning
Do Love the Game
About the Authors
Author’s Acknowledgments
Cheat Sheet
Connect with Dummies
End User License Agreement
Guide
Cover
Table of Contents
Begin Reading
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Introduction
Welcome to Trading Options For Dummies, 2nd Edition!
This book is about introducing you to option strategies for managing risk and navigating a variety of market conditions. It’s geared to managing risk first, with the knowledge that profits will follow. With that in mind, the approaches described focus on reducing potential losses from traditional stock positions and building an option strategy repertoire that allows you to maximize your chances of making sound trades whether the markets are moving up, down, or sideways. To incorporate the comprehensive steps required when trading, it also provides discussions on market and sector analysis, as well as things to look for when trying out a new strategy.
An option contract is a unique security that comes with contract rights and obligations. When used correctly, an option contract strikes a balance between risk of loss, the amount of money you put at risk, and reward, providing you with leverage while still allowing you to reduce overall trade risk. Of course, there’s another side to that leverage, increased risk, which will be managed, which is the main reason you should take the time to read through this book carefully. You need to understand the risks and characteristics associated with these contracts.
When applying for options trading with your broker, the broker will send you the reference guide Characteristics and Risks of Standardized Options. This publication, written by the Options Clearing Corporation (OCC), must be distributed by brokers to their clients prior to allowing them to trade options. It describes option contract specifications, mechanics, and the risks associated with the security. Together, that publication and the one you’re reading right now help you to understand your risks and use options effectively.
About This Book
There are hundreds of trading titles out there, including those focusing on option strategies. This book focuses primarily on approaches aimed at managing risk — the consistent theme throughout. By setting it up this way, you can read about different topics while keeping that key objective in mind. So go ahead, jump around to areas that interest you most.
This book can be read from cover to cover or used as a reference guide. Each strategy provided identifies risks and rewards associated with the position. It also identifies alternative strategies to consider for risk management, when applicable. There are a million ways to successfully trade the markets, but certain challenges are universal to all of them. Tools and techniques focused on addressing these challenges are also provided throughout.
To make reading and understanding the world of options trading a bit easier, we’ve used some conventions to help you along the way:
Italics:
We provide newly defined terms in italics in all parts and chapters.
Acronyms:
We try to spell out acronyms quite a bit so you don’t have to flip around a bunch to find out what VIS (very important strategy) stands for — we hate when we have to do that, too.
Glossary:
You’ll find an online glossary of option trading terms at
www.dummies.com/extras/tradingoptions
so you can find the definitions that you need fast.
Websites
: You’ll find references to websites that may provide additional information or make a task easier (like the one in the preceding bullet). And if you ever see a website split from one line to the next, rest assured that we’ve added no extra hyphens, so type the site in your browser just as it appears. If you’re reading the e-book, just tap the link to go to that website.
Foolish Assumptions
Here’s what we assume about you:
You have some experience.
We are all dummies, but we are not all beginners. If you’ve chosen this book, you doubtless have some familiarity with the stock market and the risks and rewards it presents to you. As a self-directed investor, you seek ways to manage those risks and rewards. However, if you’re not familiar at all with options or you’ve just had a little exposure to them, don’t worry — option fundamentals and mechanics are covered here and may be a great way to improve your knowledge base. Even if you have traded these instruments before, you can consider this a review if you’re looking for one.
You’ve read investing books before and you will read this section carefully at some point in order to avoid pitfalls and misunderstandings as you go through this book
. We assume that you know that this book won’t have all the answers to your trading needs but you also know that it was written in a careful and thoughtful way, including technical reviews and careful editing. You also know that as a second edition, the editing team has taken previous material and scrupulously revised it in order to both update and improve the content as needed.
You hold longer-term investments.
Regardless of whether or not you choose to actively trade options, we assume you hold longer-term investments such as stocks and mutual funds. For that reason, core strategies aimed at managing risk associated with longer-term holdings are included. The small amount of time needed to implement them may be well worth it.
You’ve already decided how to allocate your investment and trading dollars.
Although we distinguish investment assets from trading assets, we don’t address how to allocate those dollars because everyone’s financial situation is different. We do assume this is something you’ve already completed, because plans should strike a balance between the two (long term and short term) to grow assets.
You have computer and Internet access.
We can’t imagine trading or investing without a computer and reliable access to the Internet . . . so we assume you have both.
You use a broker.
We assume you contact a broker to further manage your risk when needed, and we assume you also have a comfort level with your broker’s web platform. It may serve as a resource for some of the ideas covered in this book.
Icons Used in This Book
To supplement the topics discussed in Trading Options For Dummies, 2nd Edition, we’ve also added icons to highlight different core ideas and give you some hard-earned trading insight. We use the following icons to point out these insights:
When encountering this icon, you’ll find slightly more detail-oriented tools and considerations for the topic at hand, but the information included with icons isn’t necessary to your understanding of the topic at hand.
This icon is used to give you experienced insight to the current discussion. Consider these to be asides that any trader might mention to you along the way.
Some topics previously discussed or assumed to be part of your base knowledge are identified by the Remember icon. If you hesitate for a moment when reading the core content, check for one of these to keep you progressing smoothly.
Concepts that reiterate ways to manage potential risks appear with this icon. It highlights important things to watch out for if you want avoid trouble.
Beyond the Book
In addition to the material in the print or e-book you’re reading right now, this product also comes with some access-anywhere goodies on the Web. Check out the free Cheat Sheet at www.dummies.com/cheatsheet/tradingoptions for helpful summaries of trading order types, charts for tracking investments, how financial indexes are constructed, and ways in which changing stock affects indexes.
This book also includes some free articles — which are kind of “extra” mini-chapters. Go to www.dummies.com/extras/tradingoptions if you want to check these out.
Where to Go from Here
Whether you’re seeking to improve longer-term investing or shorter-term trading results, you will find strategies aimed at both goals in this book. By using the techniques in the book and viewing yourself as a risk manager, your losses should decrease allowing you to move forward to increased profits.
You may decide to pick up this reference while evaluating your investments on a quarterly basis or keep it handy at your desk for weekly trading assessments. During your regular review routine, you may also find that current market conditions that once kept you on the sidelines are now ideal for strategies you reviewed here.
Ready to go? You have lots of options ahead. (Get it?)
If you’ve recently been perplexed with action in the markets, you may want to start with Chapter 5. It identifies different things happening in the options markets that may clarify stock market activity.
Those new to trading options or who feel you can benefit from a refresher, should consider perusing Part I. Because the markets are ever-evolving, Chapter 3 gets you up to speed on current conditions.
If you have a basic handle on option contracts and want to quickly access unique ways to capitalize on different stock movement, consider jumping to Part IV. This part includes a variety of approaches you just can’t match with stocks.
Chapter 18 provides my thoughts on what it takes to be a successful option trader. Because trading options comes with many of the same challenges encountered when trading any security, you may want to make it the first thing you read to help you succeed with your current trading.
Part I
Getting Started
Visit www.dummies.com for Great Dummies content online.
In this part…
An overview of options contracts
Rights and obligations of buyers and sellers
Trading securities on the exchanges
Risks and rewards of contracts
Chapter 1
Options Trading and the Individual Investor
In This Chapter
Getting to appreciate options
Analyzing options with any market in mind
Making the markets work for you
Whatever your level of experience, your general tendency to trade or hold positions for a long time, and your risk profile, as an individual investor you can add options on individual stocks, indexes, and exchange traded mutual funds (ETFs) to your investment war chest. You should do so with two goals in mind: risk management and growing your assets. And because there are so many ways to use options, just about anyone can use them — as long as you take the time to learn the associated risks and rewards and become familiar with the particular strategies that suit your purposes.
There is a difference between trading and investing, especially in terms of time frames. Investing is all about using the power of time and the benefits of compounding to build wealth over long periods. The traditional buy and hold strategy for stocks is a perfect example, as is the owning of rental properties for long periods to generate income.
Trading is by design a shorter-term proposition, where you may hold a position for minutes, hours, days, or weeks. Options can be used for both trading over the short term and the protection of longer-term investments, especially during times when the value of the longer-term holdings declines. No matter your time frame — whether you hold positions for short or long periods — your goal is essentially the same. You want to have more money at some point in the future than what you have now and increase your wealth using opportunities provided by the markets. This chapter is all about giving you the big picture on options and setting the stage for the more detailed chapters that follow.
Taking Your Own Financial and Strategic Pulse
Before you start any kind of trading or investing program, it’s a good idea to know three things:
Your risk profile
Your financial situation
Your time commitment possibilities
Any time you add a new trading strategy, only one thing is certain: the early stages will be challenging and will require a fair amount of your attention, or you will lose money, often in a hurry.
As you prepare to become an options trader, here are some simple steps to consider in order giving yourself a good start. Even if you are experienced in other forms of investing, or have experience with options, you should still stop and consider the following:
Check your financial balance sheet.
Before you start trading, go over your living expenses, review your life and health insurances, and put together a financial net worth statement. Make sure it’s healthy before you take extraordinary risks.
Set realistic goals.
Don’t trade beyond your experience levels, and don’t risk too much money in any one trade.
Know your willingness to take risks.
If you are a cautious person who thinks that mutual funds are risky, you may not be a good options trader. But you shouldn’t count yourself out either. There are many options strategies that could suit you, especially once you understand the built-in safety nets that make some of them really decrease your risk. Just make sure you read through the book and find the ones that make you comfortable before you jump in. The chapters in Part IV have excellent information on this topic.
Become a good analyst.
If you like to roll the dice without doing your homework, you could get in trouble with options pretty rapidly. In order to maximize your chances of trading options successfully, place a high priority on improving your technical and fundamental analysis skills. You should do this both for the entire market and for the underlying securities that are the basis for your options.
Don’t be afraid to test your strategies before deploying them.
Doing some paper trading on options strategies before you take real-life risks is a good idea.
Chapter 7
guides you through this process.
Never trade with money that you aren’t willing to lose
. Even though options are risk-management vehicles, you can still lose money trading them. And as you progress to more sophisticated and riskier strategies, your losses could be significant. Bottom line: Don’t trade options with your car payment or your rent money.
Understanding Options
Options are financial instruments that are priced based on the value of another underlying asset or financial measure. In this book, the focus is mainly on options with value based on stocks and stock market indexes, although there is also a very useful section on options based on exchange traded mutual funds (ETFs).
There are two kinds of options — calls and puts. When you add them to your current investing and trading tools and strategies, you can participate in both bullish (rising markets) and bearish (falling markets) moves in either underlying you select. You can use options to limit your total portfolio risk or to protect an individual existing position, such as a stock or ETF.
In the options market, it’s acceptable to call the security that an option is based on the underlying. You will see that terminology used in this chapter and throughout the book. If you’re going to trade options, you have to get used to the lingo.
To fully understand and use stock and index options to limit risk or as a standalone trading strategy, you must also have a thorough understanding of the asset on which they’re based. This understanding is likely to require another layer of analysis beyond your current approach. Because volatility is a key component of option prices, for example, you will have to look at the underlying’s volatility more carefully as part of your analysis in order to pick the best possible option for your particular strategy.
This book will help you by focusing on techniques that compare options to their underlying security or other securities. Chapter 9 goes into detail on several approaches that you can apply toward this goal when you analyze stocks and index options.
Contrary to what many in the mainstream may believe, your primary focus for trading any security is not to learn about how to profit from its use, but to understand the risks associated with its use, including all of the following:
Knowing what conditions, both in the markets and in the individual security, to consider when analyzing a trade
Using proper trade mechanics when creating a position
Recognizing, understanding, and following trading rules and requirements for the security
Understanding what individual variables make any position gain and lose value
The sections that follow address these key components of options trading to give you a good platform for creating rewarding positions and cutting any losses before they become catastrophic.
Knowing option essentials
A listed stock option is a contractual agreement between two parties with standard terms. All listed options contracts are governed by the same rules. When you create a new position, one of two things is triggered:
By buying an option, you are buying a specific set of rights
By selling an option, you are acquiring a specific set of obligations
These rights and obligations are standard and are guaranteed by the Option Clearing Corporation (OCC), so you never have to worry about who’s on the other end of the agreement. Chapter 3 provides more information and detail on the Options Clearing Corporation and its central role in options trading.
Time means everything to option traders. The one particular wrinkle in options, and the primary risk involved, is time risk, because options contracts have a limited lifespan. The price of a call option rises when its underlying stock goes up. But if the move in the stock is too late, because it happens too close to the expiration date, the call can expire worthless. You can literally buy yourself more time, though — some options have expiration periods as late as 9 months to 2 1/2 years.
When you own call options, your rights allow you to
Buy a specific quantity of the underlying stock (exercise).
Buy the stock by a certain date (expiration).
Buy the specific quantity of stock at a specified price (known as the
strike price
).
In other words, the price of the call option rises when the stock price goes up because the price of the rights you bought through the option is fixed while the stock itself is increasing in value.
Conversely, a put option gains value when its underlying stock moves down in price, while the timing issue is the same. The move in price still has to occur before the option contract expires or your option will expire worthless. Your put contract rights include selling a specific quantity of stock by a certain date at a specified price. If you own the rights to sell a stock at $60, but events such as bad news about the company pushes the stock price below $60, those rights become more valuable.
A significant part of your skill as an options trader is your ability to select options with expiration dates that allow time for the anticipated moves to occur. This may sound too challenging at the moment, but as you learn more, it will make perfect sense because it’s all about giving yourself time and giving the option time to deliver on your expectations. Of course, there are some basic trading rules of thumb that help, including the development of proper trade-management techniques, such as planning your exit from a position before you trade. Planning your exit is a simple but required part of any trade, and it is one good habit that will save you money and heartache if a position moves against you.
All stocks with derived options available for trading have multiple expiration dates and strike prices. There are two important pricing factors to keep in mind:
Options with more time until the expiration date are more expensive.
Options with more attractive strike prices are more expensive.
Information about options and your available choices are widely available on the Internet, especially from your broker. It takes time and practice to get to a point where you can pick the best options based on current market conditions and your outlook for the underlying asset. But as you read the different sections in this book, you will start to get a good feeling for how to go about this. Even more important is how you manage your emotions and how you gain trading discipline. This is best achieved by developing a maximally effective trading plan with easy-to-follow rules that includes planning for different scenarios. For more on this, see Chapter 8.
Trying different strategies before deploying them in real time
Options are different from stocks both in terms of what they represent — leverage, rights, and obligations instead of partial ownership of a company — and how they’re created, by demand. These important distinctions result in the need for additional trading and decision-making beyond the basic buy or sell considerations. Part of the learning process, as you transition from direct stock trading to options trading, is developing a new and complementary way of thinking. That includes not just evaluating the price of a stock or an index, but also how the price of the underlying asset along with other factors, such as supply and demand for the option and overall market conditions involved in options prices all come together. Your final decision, as the trade develops, may be to exercise your rights under the contract or simply exit the position in the market. Fortunately, market prices will help you with those decisions, and so will some thoughts from Chapters 9 and 18.
If you haven’t traded options in the past, your best approach (as we already mentioned) is to try out some trading strategies on paper and see how things work out. Your goal here is simple: You want to get to the point where you think of your option trades based not just on the option but on the underlying security.
Before you invest real money, you should be able to do the following:
Gain a comfortable feel for the activity and characteristics of underlying stocks or indexes on which you are looking to trade options and understand their relationship both to the market and to the options related to them.
To be able to mix and match sound strategies to particular market situations while keeping the preceding principles in mind.
Are these extra complications worth it? For many people, the answer is yes — especially when you consider the combined risk reduction and profit potential those options trading offers. And even though making the transition may sound difficult, the actual differences in stock and option mechanics are pretty straightforward and manageable. At the end of the day, the big advantage to options is the way they provide you with leverage while giving you a mechanism to control the rights to the stock rather than the stock itself.
An important aspect of this mental reshaping exercise involves paying special attention to how the real market action affects the value of options over time. Once you get this part of the puzzle locked in, the rest will fall into place more easily, and your paper trading will be more satisfying. Along with paper trading, you can also backtest options trading. And don’t worry about how long this learning process may take. Any time spent on decreasing your risk of big losses in the future is well spent.
Widely available options trading and technical analysis programs let you backtest your strategies. Some brokerage houses offer sophisticated analytical packages to their active traders for low prices or for free. Backtesting means that you review how a set of strategies has worked in the past.
Paper trading and backtesting an options-based trading approach may take a little more time than a stock approach. The advantage is that it could save you a lot of money. Consider paper trading as part of your trading plan. And even though it may slow down your pace, and possibly delay your getting started in real-time trading, this type of studious approach will let you address different option trading nuances in advance, and will get you in the habit of being a disciplined trader.
Noodling out where options will work for your trading
There is a time and a place for everything. And options are used best when deployed optimally — meaning when the risk reward ratio offers you the best mix of both profit potential as well as risk reduction.
When you buy an option contract, you have two choices: You can exercise your rights, or you can trade your rights away based on current market conditions and your trading objectives. You can do either one based on what is happening in the markets or to any individual position at the particular time and by executing the best strategy for what the situation calls for. The most important thing is that you know what your choices are before making the trade because you have planned for either situation.
You can use options to reduce your risk by hedging a particular position or by hedging your whole portfolio. If your analysis of the situation makes you so bearish that you are looking to capitalize from a falling market, options are a much less expensive and uncomplicated way of selling individual stocks short. Chapter 10 is all about portfolio protection.
Options also let you leverage your positions. Because options cost less than stocks, you can participate in a market for less than if you owned the actual shares. This is an excellent way to reduce risk, as you are spending less capital but potentially getting a similar rate of return to what you might receive if you owned the actual underlying stock, depending on your position size. You can apply this leverage even more astutely if you are speculating and are willing to cap your profits.
Differentiating Between Option Styles
This book is mostly about options on individual stocks. But index options are also an important part of the market, which may be of interest and use to you at some point in your trading life. The most important fact at this point is to understand the major differences between options on indexes and individual stocks. Here are some important general facts:
You can trade stocks but you can’t trade indexes.
The dates for exercise (of your option rights) and the last trading date for the option are the same for individual stocks, meaning that they fall on the same date. These two important dates can be variable for index stocks, meaning that you may be able to trade the option on a different day than the exercise date.
There are two types of options: American and European style. Each has its own particular set of characteristics that will affect your ability to make decisions about exercise. Always know which style option you are using and the particular factors associated with it before you trade.
Chapter 9
is all about option styles.
Using options to limit your risk
Getting the details of option risk profiles is important and will be useful. But actually devising and using strategies in trading is even better. You start by evaluating the many options that are available for asset protection. And although, you may not think that is sexy, spending the time up front to figure out what options work better than others in different situations isn’t only a good step in your learning process, it’s also practical. When using options to limit your risk:
You can reduce risk for an existing position partially or fully and adjust the hedging process gradually based on changing market conditions. See
Chapter 10
.
You can reduce risk for a new position to a very small amount by using a combination of options or by using single long-term options. See
Chapter 12
.
You will need a margin account for these strategies, and you can get one by filling out and signing the margin account agreement that you obtain from your broker. These are complex strategies that you can work toward as you gain experience. Some of these more complex strategies include
Vertical debit spreads
Vertical credit spreads
Calendar spreads
Diagonal spreads
The most influential factor on when to use these spreads will be market conditions. And this book will help you make those decisions.
Applying options to sector investing
One of the best recent advances in the financial markets has been the creation and proliferation of ETFs. Through these vehicles, you can make sector bets without having to drop down to the individual stock level of decision-making or research beyond some basic steps. ETFs are great trading vehicles because
You can trade them like stocks.
That means you can buy and sell shares in them at any time during the trading day instead of waiting until the market closes, as with non-exchange traded traditional mutual funds.
ETFs offer listed options.
That means you can apply all option strategies to sectors of the stock market by trading options on the underlying ETF. This often lets you make index bets without using index options with expiration and last day of trading may cause you some extra steps.
There are ETFs based on commodity indexes.
These let you participate in commodity markets without trading futures. When you add the extra dimension of options being available, you have a nice array of different strategies available.
ETFs are an excellent trading vehicle category, for all those reasons and more. You can design entire diversified portfolios with ETFs and then use options to hedge individual positions or the entire portfolio. Chapter 13 gives you all the details.
Using Options In Challenging Markets
You can participate in rising or falling markets through stocks and ETFs, assuming that you are comfortable with both owning these securities and selling them short. But what do you do in a sideways market, except maybe sitting it out or collecting a few dividends? You can craft option strategies for sideways markets whether you have any underlying positions or not. Chapter 16 tells you all about this great set of strategies.
Reducing your directional bias and making money in flat markets
Directional bias refers to the connection of profits to the direction of prices. To make money when you are long, you need prices to rise. And to make money when you’re short, you need falling prices. When you use option combination strategies, you design trades that let you make money when the underlying stock moves up or down. Consider this:
You can set up strategies that let you profit if the underlying rises or falls, depending on your trade setup.
Chapters 14
and
15
tell you all about these trades.
Options let you set up strategies that can make money in sideways markets.
Controlling your emotions
Perhaps the most difficult part of trading any market is the emotional responses that can be triggered by price movements in things you own, or wish you owned. Let’s face it, we are all emotional. It’s part of being human. The problem is that emotional trading is usually the path to big losses. That’s why we have rules and why you design an anticipatory trading plan, in order to control the emotion that goes along with trading.
A good trading plan has these key characteristics:
Access to the proper equipment:
Make sure you have all the technology you need: computers, mobile devices, and backup systems along with a quiet place to work.
Knowledge of time commitment:
Think about whether you will day trade or be a longer time position trader. If you can’t devote a couple or three hours at a time to monitor a position, day trading is not for you.
Access to good information:
Put together a good list of websites and a reliable real-time quote-charting service.
Flawless trade execution:
Pick an online broker that has some scale and can execute your trades in a timely fashion without leaving you in the cold.
An excellent educational component:
Work on your analytical skills, technical and fundamental, every day. You need to be a crack chartist and hone your decision-making skills.
Each chapter is this book reveals new information that is intended to make it easier to appreciate and execute the end game, the successful trading of options. Chapter 2 is all about the different types of options.
Chapter 2
Introducing Options
In This Chapter
Making sense of an option contract
Discovering an option’s value
Getting reliable option data
Starting out in options trading
There are many forms of options, but this book spends most of its time on listed stock options and listed index options, both of which trade on exchanges. These two distinct types of options function in two ways. First, they can be used to manage your risk by limiting your losses. And they offer you the opportunity for profits when used with the right strategy.
As silly as it may sound, to make the most out of options trading, it’s imperative that you really understand what options are and know the risks and potential rewards associated with them. That’s why this chapter details the information on the individual components of an option and how to recognize them in the market.
Understanding Option Contracts
By learning the basics of options contracts and then being able to compare them to other derivatives, you will be able to get a good working understanding of these securities and how to best use them both for risk reduction and for speculative gains. The next few sections are all about the basic concepts that will get you to a comfortable point in trading options and then lead to a good understanding of the risks and rewards associated with options trading.
Grasping option basics
A financial option is a contractual agreement between two parties. Although some option contracts are over the counter, meaning they are between two parties without going through an exchange, this book is about standardized contracts known as listed options that trade on exchanges. Option contracts give the owner rights and the seller obligations. Here are the key definitions and details:
Call option:
A call option gives the owner (seller) the right (obligation) to buy (sell) a specific number of shares of the underlying stock at a specific price by a predetermined date. A call option gives you the opportunity to profit from price gains in the underlying stock at a fraction of the cost of owning the stock.
Put option:
Put options give the owner (seller) the right (obligation) to sell (buy) a specific number of shares of the underlying stock at a specific price by a specific date. If you own put options on a stock that you own, and the price of the stock is falling, the put option is gaining in value, thus offsetting the losses on the stock and giving you an opportunity to make decisions about your stock ownership without panicking.
Rights of the owner of an options contract
: A call option gives the owner the right to buy a specific number of shares of stock at a predetermined price. A put option gives its owner the right to sell a specific number of shares of stock at a predetermined price.
Obligations of an options seller
: Sellers of call options have the obligation to sell a specific number of shares of the underlying stock at a predetermined price. Sellers of put options have the obligation to buy a specific amount of stock at a predetermined price.
In order to maximize your use of options, for both risk management and trading profits, make sure you understand the concepts put forth in each section fully before moving on. Focus on the option, consider how you might use it, and gauge the risk and reward associated with the option and the strategy. If you keep these factors in mind as you study each section, the concepts will be much easier to use as you move on to real time trading.
Use stock options for the following objectives:
To benefit from upside moves for less money
To profit from downside moves in stocks without the risk of short selling
To protect an individual stock position or an entire portfolio during periods of falling prices and market downturns
Always be aware of the risks of trading options. Here are two key concepts:
Option contracts have a limited life.
Each contract has an expiration date. That means if the move you anticipate is close to the expiration date, you will lose our entire initial investment. You can figure out how these things happen by paper trading before you do it in real time. You can read more about paper trading in
Chapter 7
. Paper trading lets you try different options for the underlying stock, accomplishing two things. One is that you can see what happens in real time. Seeing what happens, in turn, lets you figure out how to pick the best option and how to manage the position.
The wrong strategy can lead to disastrous results.
If you take more risk than necessary, you will limit your rewards and expose yourself to unlimited losses. This is the same thing that would happen if you sold stocks short, which would defeat the purpose of trading options. Options and specific option strategies let you accomplish the same thing as selling stocks short (profiting from a decrease in prices of the underlying asset) at a fraction of the cost.
Chapters 9
–
11
give you details on how you can profit from falling markets through options.
Comparing options to other securities
Options are a form of derivative, a type of security that derives its value from an underlying security. Stock options derive their value from the underlying stock. In order to better understand option valuations, it makes sense to know more about other derivatives and exchange traded mutual funds (ETFs), which are quasi-derivatives:
Commodities and futures contracts:
Like options, commodity and futures contracts are agreements between two parties. The major difference between a commodity or futures contract and an options contract is that the former obligates you, whereas an options contract gives you rights as an owner. This is because commodities and futures contacts set the price for a predetermined quantity of a physical item to be delivered to a particular location on a predetermined date. Options have no delivery date. On the other hand, commodities and futures contracts are similar to options in that they lock in the price and quantity of an asset. However, in both cases, you can trade away your rights and obligations if you exit the contract before expiration.
Indexes:
Think of
indexes
as collections of assets whose value is pooled together to measure the price of the group. Stocks, commodities, and futures are all index components.
Chapter 9
covers index options in detail. Here is the important difference: Indexes are not securities. That means you can’t buy an index directly. Instead, you buy securities that track the value of the index, such as mutual funds that own the stocks in a particular index — for example, Standard & Poor’s 500 Index.
Exchange traded funds (ETFs):
ETFs are mutual funds that trade like stocks on an exchange. Most ETFs are designed to track an index or an underlying sector of a particular market. ETFs can be considered quasi-derivatives because they don’t always hold the exact same securities of the index that they track. For example, some
leveraged
ETFs use more exotic securities known as swaps to mimic the action of the underlying index while adding leverage. Two of the most popular ETFs are the S & P 500 SPDR (SPY) and the Powershares QQQ Trust (QQQ), which tracks the Nasdaq 100 index. These two popular ETFs let you trade their underlying indexes, directly or through options.
Stocks and bonds:
Stock ownership gives you part of a company, whereas bond ownership makes you a debt holder. Each dynamic has its own set of risks and rewards. Comparison of the three assets, stocks, bonds, and options, yields a fairly straightforward picture. All three asset classes can lead investors to total loss of their investment. And though stocks give you a piece of the company, and bonds offer you income, options offer you no ownership of any tangible assets. Stocks offer indefinite holding periods, and bonds have a maturity date and options have a limited life.
A swap is an insurance contract whose terms are privately agreed upon by the participants. They can be thought of as non-exchange traded options and they can be used to bet on the direction of just about anything that the two parties agree upon. By design, swaps are very sophisticated securities that are not available to individual investors because of the financial requirements and the specific agreements required to be signed before you trade them. When you own shares in a leveraged ETF, check the prospectus carefully to see if this is what you are buying. We’re not suggesting that you don’t consider leveraged ETFs if they make sense for your portfolio. We use them often in our personal trading. It’s important for you to always know what you are investing in, even if it’s an indirect investment such as an ETF.
When swaps get out of control, the markets can suffer. This is what happened in 2008 as lots of big money players bet (correctly) that subprime mortgage holders would not be able to make their monthly mortgage payments. They were right, and the rest, as they say, is history.
Valuing Options
Part of knowing your risks and rewards results from understanding how an investment derives its value and what affects the rise and fall in its price. In order to value an option, you must know the following:
The type of option (put or call)
The market value of the underlying security
The characteristics of the past trading pattern of the underlying security calm or volatile
The time remaining until the option expires
Knowing your rights and obligations as an options trader
There are two types of options: calls and puts. By owning a call you have the right to buy a certain stock at a pre-specified price by a certain date. Owning a put give you the right to sell a certain stock at a specific price by a certain date. Put option prices go up when the price of the underlying security falls. Call option prices rise when the underlying security’s price rises. When you own options, you can assert your rights at your own discretion. So, between the time you buy an option and its expiration date, you can
Sell the option for a profit.
Sell it for a loss.
Exercise it.
Let it expire with no value (for a loss).
As an option seller, you are obligated to complete a specific set of requirements. In fact, selling options gives you fewer choices, and the actionable choices are heavily influenced by the action in the markets. As the expiration date nears, you can
Buy the option back for a profit.
Buy it back for a loss.
Let the option expire with no value (for a profit).
An easy memory trick to help you keep your rights and obligations in the correct framework is to think about buying the stock as calling it back while selling the option as putting the stock to someone.
Terms of endearment and importance
Here are key terms you have to nail down in order to make good option trading decisions:
Underlying security
: The stock that you buy or sell and that determines the value of the option.
Strike price
: The price you would pay if you decided to exercise your rights as an option buyer.
Expiration date
: The date the option and your rights disappear.
Option package
: The number of shares and the name of the underlying security that you can call away or put to someone.
Market quote:
The most current price of a security that is being bid on by buyers and offered by sellers of options.
Multiplier:
The number used to determine the value of the option and how much money you pay when you call away or put options to someone.
Premium:
The total value of the option you buy or sell. The premium is based on the market quote for the option and its multiplier.
Option rights don’t last forever, so it’s important to keep track of how much time you’ve got left in a position before it expires. To figure out how much time you’ve got until the expiration date, identify the expiration date and determine the number of days or months away that date is.
Making Sense of Options Mechanics
Good decisions are only as good as the information you have and how well you understand it. So, whether you trade options without ever considering owning the underlying stock or otherwise, you will need the best data possible in order to assess their value and develop your strategies. Just as important is knowing the basic structure of how options quotes work and how the expiration cycle operates. This section is about deciphering the information you will require to understand your rights and obligations when trading options.
You can gather option market information online, often free of charge, if you are willing to deal with delayed data — typically lagging by 15–20 minutes. A good premium charting service, or your broker’s online trading platform, will usually have excellent real-time data at your finger tips as well. Yahoo! Finance (www.finance.yahoo.com) is a good free site for all kinds of quotes and financial information. You can also find excellent options information at Optionetics (www.optionetics.com).
Identifying options
Although not all stocks have options, those that do feature multiple strike prices and expiration dates. The list of options for a stock is also known as the option chain. When you look through a stock’s option chain you see all the calls and puts available, along with specific data for each listing, including the following:
Open interest:
The number of existing contracts for this option
Market quotes:
May be delayed or in real time, depending on your data source
Recent trading levels:
Current or delayed
Option symbols have been standardized and radically changed since the first edition of this book. The old “root” nomenclature methodology that made it difficult to sometimes identify options for Nasdaq listed stocks with four letter symbols was replaced by the new Options Clearing Corporation (OCC) system. The new symbol system is much easier to decipher and has several components:
The underlying stock or ETF’s symbol
The expiration date, expressed in six digits using the
yymmdd
format
The option type, P for put, C for call
The strike price × 1000
Mini options are a different type of option. These options are based on smaller amounts of the underlying. They afford you rights and obligations for 10 shares of stock instead of the standard 100 shares feature the number 7 at the end of the symbol to distinguish them from standard listed options. Mini options are aimed at investors who have smaller positions but who want to reduce their risks based on the smaller number of shares in their possession.
Here is an example of the symbol for an Apple Inc. (Nasdaq: AAPL) 76.43 call option that expires on June 13, 2014:
AAPL061314C00076.430
For a mini option of the same underlying stock, expiration date, and striking price, the symbol would be:
AAPL7061314C00076.430
Turning with the expiration cycle
There are three expiration cycles, as listed in Table 2-1. All options feature at least four expiration dates throughout the year based on one of these cycles. Some listed options, such as those linked to important index tracking ETFs, have expiration dates every month. Long-term options (Long-term Equity Anticipation securities, or LEAPs) also have monthly expiration dates.
Table 2-1 Option Expirations by Cycle
Cycle
Months
I
January, April, July, October
II
February, May, August, November
III
March, June, September, December
Expiration dates are important because as time passes and expiration nears, options lose value. So, in order to manage positions in the best fashion, knowledge of the expiration dates is central.
All options have at least four monthly expiration dates available at all times. Each option features at least the current month and the following month expiration dates. For example, an option that runs with the January cycle also has a February expiration date while the next expiration will be in April, its normal cycle month. This option would also have July available, making four months of expiration dates available for trading. When January expires, February is the near month, so March options become available, along with April and July options. When February expires, October options then come online making four months of expiration dates and rounding out the cycle. The cycle repeats as the near month expires.
When you add LEAPs and mini options to the mix, the number of expiration dates can become confusing. Before you trade, make sure you are very clear on what you are trading and how much time the option has before it expires. Also pay attention to whether you have the type of option, call or put, that you suits your trading objective.
Option strike prices are generally available in increments of 0.50, $1, $2.50, and can be as high as $10, depending on the price of the underlying stock. There are exceptions to this general tendency, which becomes especially noticeable after pricey stocks split. That was the case with Apple in June 2014, which is why the strike price in the earlier example was peculiar. Most of the time, this is not the case.
