Chapter One Options Basics The objective of this manual is to build on your knowledge of stock trading by applying the common principles of technical analysis – support, resistance, and trends – to options trading. For many people, options are an area of the stock market they’ve never heard of. Others have heard of options, but only about the risk and all of the money people have lost trading options. As a result, the uniformed are consequently afraid of options. This manual is designed in a way that you will have a working knowledge of options and an excellent foothold on your path to becoming an options specialist. This Manual outlines several different strategies as they apply to options, and outline the risk associated with each. A common mistake that many investors who are new to options make is to attempt to master every strategy they learn. We are going to cover a large amount of information in this program, and you should make sure to spend enough time on each one to become familiar with them all. However, as you work to learn each strategy, you will identify strategies that appeal to your investment style, tolerance for risk, and attitudes more than others. That is perfectly natural; in fact, the most effective options traders identify only the strategies that work best for them and then use them again and again over time. You may decide that Covered Calls are the thing to do, while buying Calls and Puts might be more risky than you are willing to deal with. That’s fine! You can trade options very profitably with just one or two strategies if that is all you are comfortable with. This chapter will cover the following topics:
How to gain broker approval to trade options. The basic components that make up an option. Describe the principles of leverage and risk as they relate to options contracts. Discuss the Greeks associated with options and the impact they have on options.
Basic Requirements to Trade Options Anybody can trade options, provided a few conditions are met. First, in order to trade options, your broker needs to give you permission. Just because you have a brokerage account doesn’t mean that you can trade options right away. In an addition to setting up your brokerage account, you also have to fill out an Options Authorization application. You can call your broker to have this mailed to you, visit their local branch office if they have one, or you can likely download the application from their web site. Some brokerages will also allow you fill out the application and submit it online. This application will ask for similar information for what you provided when you established your brokerage account, such as your investment experience and objectives, but the questions will be options-specific. Depending on your answers to those questions, your broker will assign you a level of options permission. These levels are fairly standardized as follows:
Level 1: Options trading is limited to writing (selling) covered calls only.
Level 2: Options trading is limited to level 1, along with buying call or put options.
Level 3: Options trading is limited to levels 1 and 2, along with the use of options spread strategies.
Level 4: Options trading is limited to levels 1, 2, and 3, along with the selling of naked equity options.
Level 5: Options trading is limited to levels 1, 2, 3, and 4, along with the selling of naked index options.
Levels 1 and 2 are the levels that most traders start with. If you are only approved for level 1, don’t worry; you can be very successful as an options specialist using covered calls. If you are approved for at least level 2, however, you will be able to utilize most of the option strategies discussed in this manual. However, if you want to take full advantage of this class and become an option specialist, you should apply for a level 3 trading permission. Most brokers will accommodate you in this request. Levels 4 and 5 include much more sophisticated strategies that are advantageous to those who can use them, but are best suited to experienced
traders who know how to manage a margin account effectively. The option trades used with levels 4 and 5 are discussed in the advanced options class. Commissions We assume that you have been trading stocks now for some time and are used to the idea of paying a commission on your stock trades. Commissions apply to options just as well as stocks, but you will want to make sure to check with your broker, because options commissions are usually slightly different than those for stocks. They are typically charged at a rate of around $1.50 per contract, with a minimum commission fee for small contract numbers. Your broker can give you their exact commission structure. This commission will play a factor in evaluating your break even and profit points in your options trades, so make sure you understand it completely. Basic Option Terms An option gives the buyer the right, but not the obligation, to buy (call) or sell (put) the stock that option is tied to. Furthermore, the option is for a specific price (strike) and for a specific period of time (expiration). It is an instrument that you can use to reserve the right to buy or sell the stock at the price you want if the stock moves in the direction you thought it would in the time frame of the contract. The question is, when should you use a call and when should you use a put? Example 1 below demonstrates the direction in a stock or the stock market each type is designed for.
There are two types of options. We’ll describe them briefly here and give a more detailed example of each later in this chapter.
Call – the right, but not the obligation, to buy a stock at a set price for a set period of time.
Put – the right, but not the obligation, to sell a stock at a set price for a set period of time.
Stocks are traded in shares and options are traded in contracts. Each contract controls 100 shares of a stock. When you purchase an option, you have control of 100 shares of the stock, at a certain price and for a given time. This may sound like a completely foreign concept to you at first glance. But stop and think about what the word option really means. If you have options you have choices; plain and simple. You can buy the stock (call) or sell the stock (put) at the strike price but you DO NOT HAVE TO. You have the choice. As a budding option specialist you need to remember that we do not buy options to exercise them. We buy options to sell them. Options allow you to make an investment based on the direction you think the stock is likely to move. In addition, options allow you to do so with a smaller amount of money than it would take to buy the stock outright. If you are right about the move you can profit from the increase in the price of your option and sell it back to the market at a higher price (buy low, sell high). This is a powerful concept you should make sure to remember. Options cost considerably less than would be required to buy the stock outright. If the stock moves in the direction you want, the amount of the move in your option will be greater as a percentage of your initial investment than if you paid for the stock up front. This is called leverage. Leverage Leverage is the reason most people get excited about options and this is a good example. Let’s say that you have been limiting the stocks that you can trade based upon price. Let’s further say that your limit has been $45 because your astute risk
management plan has such a cap. Great! You’ve got a nice system in place for trading stock and if it has worked for you then stick with it. However, as an options specialist you are truly unlimited in that you can now afford any stock (with a few exceptions). Not all stocks have options and some stocks that do have options are thinly traded and we don’t want to trade them anyway. As an example, Apple (AAPL) is currently trading around $170 a share and it might have been off your “radar” due to its price. With an option you can now control 100 shares of Apple for a fraction of what it would cost to buy 100 shares of the stock.
Take a look at the option pricing above and the highlighted option in red is the $170 strike for the July 2008 option. If we wanted to buy that option to control 100 shares of Apple, it would cost us $585. Think about that for one minute. If we went out and bought 100 shares of Apple stock it would cost us $17,000. Obviously there’s a catch, right? You are correct and we will discuss that catch later but remember this; options have just opened the door to trade nearly ANY stock. Strike Price Every option includes a strike price. This strike price is the price at which you will buy or sell the stock. Strike prices are usually listed in $5 increments, although a lot has to do with the volume of the stock traded and the price of the stock. Looking at the example above of AAPL you can see that the strike prices range from $155 to $180.
The strike price is always listed on any options quote. For example, if you wanted a quote on a call option for General Electric, you might see it listed by your broker in a manner similar to this: GE HZ Aug 32.5 Call Bid 1.05 Ask 1.10 The strike price of this option is $32.50. That means that if you bought this call, you would reserve the right to buy 100 shares of GE stock for $32.50. The buyer of this option is willing to pay $1.05 for the call and that is the Bid. The seller of the option wants $1.10 for this call and that is the Ask. As a result, we have a bid/ask spread just as we do in stocks.
Expiration Date Every option also includes an expiration date. All stock options expire the third Friday of the month, each month. That month is listed in your option quote as well, and can be easily seen from an options pricing table. In the AAPL table you can see that the strike month is July 2008 so on the third Friday of July, 2008, these options will expire. Premium An optionâ€™s premium is the amount you have to pay to buy it. Just as with stocks, you will always buy at the Ask price and sell at the Bid. Looking at our GE call option again, we can see how much we have to pay for it. GE HZ Aug 32.5 Call Bid 1.05 Ask 1.10. Our premium for this call is $1.10. Just as when you buy stock, you have to multiply the Ask price by 100 for the total dollar cost of the trade, in this case $110 minus commissions. In-The-Money (ITM) An option becomes In the Money when the price of the stock moves past the strike price of the option. If the price of GE went to $35, for example, our call with a
strike price of $32.50 would be In the Money since we can now buy GE much cheaper than its current price. Puts are a little different. Since you reserve the right to sell the stock at the strike price, put options become In the Money when the stock drops past your strike price. Our GE put would be In the Money if the price of GE dropped below $32.50 since we could sell the stock at a higher price than it is at now. Figure 1.1 demonstrates the relationship between a stockâ€™s price and in-the-money call and put options. Fig. 1.1
The further the price of a stock moves above a given strike price, the deeper inthe-money the call option with that strike price will become. By the same token, the further the price of a stock moves below a given strike price, the deeper inthe-money the put option with that strike price will be.
Out-of-The-Money (OTM) An option becomes Out-of-The-Money when the price of the stock fails to move past the strike price of the option. If the price of GE were to fall to $30.00, for example, our call with a strike price of $32.50 would be out-of-the-money since the strike price we could buy the stock at is higher than the current price. The reverse is true for a put option. If the price of GE were to rise to $35.00, our GE put with a strike price of $32.50 would be out-of-the-money since the price we could sell the stock is lower than the current price. Figure 1.2 gives an illustration. Fig. 1.2
Exercise If you have bought an option and the stock has moved in the direction you anticipated, you may decide to exercise your option. Exercising your option means that you will buy or sell the stock at the strike price of the option, depending on whether you have bought a call or put option. As an example, with our GE call at
$32.50 if we chose to exercise that call then we would have to spend $3,250.00 to buy the 100 shares that each call option represent. As an option specialist we do not want to exercise an option but rather sell it back before expiration for a profit. The option allowed us to trade a stock using leverage and if we choose to exercise that means we are going to need the cash in our account to complete the transaction. In a sense, we’ve defeated the purpose of the leverage of using options. Call Options A call option gives you the right, but not the obligation, to buy 100 shares of the stock you are interested in at the option’s strike price. This is a bullish trade. If you have identified a stock in your analysis that you think is poised to go up, you can find its options by logging in to your broker’s website. Here is an example of a typical options chain:
Letâ€™s look at a currently listed CSCO call option: CYQAY.X Jan 2008 27.5 Call Bid 1.75 Ask 1.77 Suppose that your analysis of CSCO leads you to believe that it is likely to increase in value in the near term. In fact, your analysis of support and resistance zones indicates that it could move up by several dollars. This would be a terrific reason to buy shares in CSCO stock, right? Of course! It is also a terrific reason to buy a call option.
Why Use Calls? Whether you buy the stock or the call option, you are thinking the stock will increase in price. The call option, however, gives you a wider range of choices to make at a lower cost than buying the stock. Suppose that CSCO was priced right now at $26.00. If you wanted to buy 100 shares of this stock, you would pay $2,600.00, plus commissions. That is a significant amount of money for most investors. That doesn’t mean it’s a bad idea, but it does lock you in to a specific course of action. You have plunked down $2,600 of your hard-earned money to buy 100 shares of stock in CSCO. Your choices at this point are limited and depend completely on which direction the stock actually moves, but regardless of which direction the stock moves in, you have $2,600 at risk. Now suppose that CSCO drops in price to $22, a drop of $4 per share. Your $2,600 purchase is now worth only $2,200; you’ve lost $400 and now you have decide if you are going to stay in the stock, hoping that it comes back to your purchase price, or sell and cut your loss short. If the stock goes up to $30, of course, you are much happier since now you have a $400 profit in the stock, which is a handsome return of more than 15%. Now you need to decide whether to take the profit by selling the stock or try to let the stock continue its upward run and increase your profits even more. Now let’s use your CYQAY.X Jan 2008 27.5 Call. At the point where CSCO is at $26 and you think it is going to go higher, you could buy this call option at $1.77, a total investment of $177 for a single contract (you could buy more contracts if you wanted to, but we will work off of the idea of a single contract for simplicity), plus commissions. You still want the same thing as if you bought 100 shares of the stock, but you have paid a dramatically lower price for your bullish bet. Rather than placing $2,600 at risk, you risk only $177. If CSCO drops to $22, you aren’t going to be very happy about the trade since your option is probably not even worth the commission you would pay to sell it, but how much have you really lost? $177. This is a much smaller loss than the $400
you would have lost by buying 100 shares of the stock. You still have most of your money in your account and can keep trading. Of course, if CSCO suddenly climbs to $30, your options trade will look much better. Your option gives you the right to buy the stock at $26, and since it is now at $30, you would immediately be in the black on your trade if you decided to exercise this option. All you had to do to give yourself this ability was to pay $1.77 up front, rather than paying everything up front. Thatâ€™s not a bad price to pay in exchange for this kind of flexibility. There is another choice, however, that may be even more attractive. Since the stock has increased in value by $4 per share, your option will likely have a comparable move in price. Suppose that the Bid price of your option is now $5.50 per share. You could sell your option back to your broker and pocket $3.00 per share, a total return of around 120%. Put Options What if your analysis of a stock led you to believe that the stock was likely to drop significantly in the near term? Certainly youâ€™re not going to buy the stock, but is that the end of the story? Not if you buy a put option. Since a put option gives you the right to sell the stock at the strike price, you want the stock to drop below the strike price. You will get price quotes for put options in the same table as for call options. The put options are listed on the right hand side of the Equity Options page. The example below shows the current list of options for GE with the put options listed on the right:
Let’s consider a put option on GE: GEMS.X Jan 2008 37.50 Put Bid 1.95 Ask 1.99 Hoping to make a profit on a downward move in a stock is the most common reason people buy put options. This is a pretty aggressive play, however, and if you aren’t accustomed to reading negative patterns in a stock, you will want to ease into this kind of trade gradually. Let’s walk through a trade on this option to establish the concept. You will cover this in more detail in the following chapters.
Our asking price for this put option is $1.99 per share, so it costs you $199 total for a single put contract. GE is currently at $36.73. If the stock starts to climb, your put contract is going to be worth less than what you paid for it, but since you only paid $199, you aren’t putting a major amount of money at risk. But if the stock drops the way you forecast, your put option will increase in value. Let’s suppose GE falls to $32.64 per share, a drop of $4, or 11%. You could exercise your right under the put contract to sell the stock at $37.50. Since you don’t own the stock, you make the sale possible by simply buying the stock at $32.64, giving you a tidy profit of $4.00 per share right away, minus the $1.99 you paid to buy the contract. Now your option, which only cost $1.99 per share, will be worth considerably more. In this case, let’s suppose the value has increased to $5.00 per share, giving you a net profit not counting commissions of $3.01 per share, or $301. This may be somewhat less than if you exercised the contract in this case, but you only had to pay a total of $199 to get into the option trade and then sell the contract. If you were to exercise the contract, you would buy the stock at $32.64, a total cost of $3,264. Put options have the same element of leverage as call options, making them an attractive way to play the downside of a stock or the market and realize significant profits if you are right about a breakdown in price. Again, remember that this is an aggressive way to trade options; it has the potential to be a major drain on your capital if you aren’t very familiar and comfortable with identifying and trading negative trends. Leverage – Pros and Cons In both of the examples from the previous section, we saw significantly more price movement from the option contracts than we did from the stocks themselves. This phenomenon is the primary reason option trade options; they move faster than stocks. In other words, if you are right about which way a stock is going to move, you will be able to make larger profits as a percentage of your investment in a shorter amount of time than you would by buying or selling the stock.
It is exciting to think about buying an option to control 100 shares of stock for only a few hundred dollars rather than the thousands of dollars it usually takes to buy or sell the stock itself. Many beginning investors draw the natural conclusion from this that they can use their investment capital to control more shares and make even more money. If you bought the call option on CSCO we used earlier, for example, buying three contracts would increase your total profits from $300 to possibly $900. This is a correct assumption, but it comes with a critical downside element that must be recognized. Just as an option will increase in value more quickly than the stock, it will also drop faster if the stock doesn’t move the way you wanted. If you bought the 37.50 Jan 2008 Put option on GE we discussed earlier, and instead of dropping, the stock increased in value to $40, will anybody be willing to pay you anything close to the $1.99 per share you paid for that option? Not at all. In fact, in an example such as this, that option may only be worth a small fraction of what you paid for it originally. Many investors new to options lose significant portions of their investment capital because they don’t correctly understand how leverage can affect them, and place too much money in their first options trades. Even if your first few options trades are successful and you see significant profits from them, don’t get caught in the trap of thinking “if I had bought more contracts, I would have made more money.” Beginning traders who put large portions of their capital into options trades will generally reduce the value of their trading account significantly, even if they start out with profitable trades. This is because they don’t account for the downside of leverage and fail to plan adequately to deal with an option trade that has gone against them. Frame the successful, profitable trades in the context of the money you put into that trade. Frame the losing trades in the same context so you can identify the points in price when you need to get out of the trade without being emotionally tied to it. Don’t think, “I only have a couple of hundred dollars in this trade. It’s only a little bit of my total capital. If I lose it, that’s okay.” The reason to avoid this mindset is that if you start thinking in these terms, your winning trades won’t make up for your losing ones and you will gradually deplete your account. Think of options trading as a gradual process. Not only are there a lot of different strategies you can use, but there are also a lot of dynamics you have to understand
before you can correctly interpret how much risk you are taking. Understanding those dynamics takes time and experience. Start your options trading small; buy one or two contracts at a time at the most. As you build experience, familiarity and confidence, you can begin to use larger allocations as you deem appropriate. The specific rules you should follow for buying and selling options will be covered in the chapters to follow; for now, keep in mind that the same kind of money and risk management principles covered in Technical Analysis apply to options just as they do to stocks. You still need to make sure you “cut your losses short and let your profits run”. Timing The leveraged aspect of options is part of what makes the timing of an option so critical to the success or failure of your trades. Remember, options have a specific, clearly defined lifespan - they disappear after their expiration date. If you bought an August option, and the stock didn’t move the way you wanted before the third Friday of the month, any money you had left in the option would disappear as of the third Saturday. Because of this, your success will depend more on your ability to be right on time than on simply being right about the direction of a stock. Let’s think about this idea for a minute. You already have had some experience in performing technical analysis, identifying reversal points in a stock pattern, and determining support and resistance levels before starting this course. This should mean that you can often identify which direction a stock is likely to move in the future. This is a critical skill for successful stock trading and for options trading, but the time sensitive nature of options gives you a much smaller window of opportunity. Maybe your analysis leads you to conclude a stock is bouncing off of a support level and should begin a new rally. Your analysis leads you to buy a call option that is two months away from expiration. After a month, however, the stock still hasn’t rallied; in fact, suppose it has begun to drift sideways as stocks sometimes do. Even though the price of the stock may not have changed, your option is going to be worth less because now you only have a month left before it expires. Suppose that a week after the option expires, the stock does in fact rally as you had originally predicted. Unfortunately, it doesn’t help you because your option has
expired. You were right about which way the stock would move, but you weren’t right about when it would happen. As you gain experience and familiarity with options you will find that the timing of your trade, and how much time you buy, will often do more to dictate success or failure than any other single factor. That doesn’t change the fact that you have to perform your normal analysis; it just underscores the importance of learning how to handle the timing of a trade. The Greeks If you’ve ever played golf you know that there are literally a million different factors that can impact the trajectory of that little ball. Did you keep your head down? Did you follow through on the swing? Were your feet square? Did you select the right club? Was there wind? These and questions like them account for the movement of the golf ball. Golf is a lot like trading options in that there are factors that can impact the price of the option; fortunately, there aren’t nearly the number as in golf. Each of the factors listed below are what’s referred to as the Greeks of an option. In addition, they are all used to calculate the price of an option using a complex mathematical formula. The most common pricing model is the Black Scholes Model and can be defined below.
As an option specialist we can know that this formula works and is used every day by other option trader. However, our brokerage figures the option’s price using this model and the output is known as the theoretical value of an option. Obviously
theories can be wrong and in options this model is wrong on occasion as well. Therefore, we need to discuss each of the components of the model to better understand what goes into pricing options. Delta In the Greek language, Delta is the fourth letter of the alphabet and in mathematical calculations means difference, or change. In regards to options, Delta is concerned with the following:
The relationship between the underlying asset’s share price and the option’s theoretical value. Specifically, the affect a change in the share price has on the option’s value. The likelihood that the option will become in-the-money by its expiration date.
The graph above shows what happens to the delta of both a Call and Put option as they move from not having any intrinsic value to being at-the-money, and eventually in-the-money. As they graph indicates, the deltas of a Call and Put are contrary to one another. While a Call option has a positive delta, a Put option has a negative one.
For example, if the price of stock XYZ increases by .75 and the value of its associated Call option increases by .25, the Delta is equal to 50% or .50. In this example, we can see that the option’s value is increasing at a pace that is slower than that of the stock’s price. The value of the option is not in line with the stock’s price until the Delta reaches 100% (1.00). At least this is the case for Call options, which span from zero percent to 100%. As you would imagine a Put option’s value may range from –100% to zero percent.
Call Options As stated above, the delta of a Call option is a value between zero and 1. What this means is that with every increase of an underlying asset’s share price the value of the Call option increases according to the value of the option’s delta. This also works in the opposite direction. If the asset’s value decreases, so does the value of the Call option (according to the delta amount).
The graph above shows the movement of the Call option’s delta as the stock price fluctuates. You should notice that when the delta shifts to a value of 1, the Call option’s value also shifts (one-for-one) in the same direction.
Put Options The deltas of Put options are negative and have a value that ranges from -1 to zero. As the underlying asset’s share price goes up, the Put option’s value also
decreases according to its resulting delta value. As the share price goes down, the Put option’s value increases according to its resulting delta value.
You can see from the graph above how exactly the Put option’s value changes with every change in the underlying asset’s share price. As the stock price changes, so does the option’s value. Gamma Option Gamma refers to the movement of an option’s delta as its underlying stock shifts one point. Basically, Gamma indicates how the underlying asset’s share price influences the option’s delta. When you know an option’s Gamma, you know the rate at which the delta of the option will change in relation to the share price. This indicates an option’s volatility in relation to fluctuations of the underlying asset’s share price. The Gamma is often referred to as the second dollar move or how much your delta will increase after it already moves the initial dollar.
The graph above presents the exercise value of how Gamma and an underlying assets share price changes. As the graph shows, Gamma goes up as the option moves from being in-the-money to out-of-the-money with the peak being reached when the option is at-the-money. In other words, Gamma is at its highest level when your option is at-the-money or closest to the actual stock price. An important thought to remember is that the Gamma for Call and Put options is equivalent. Whether the option is a long Call or a long Put, the Gamma is a positive value. If the option is a short Call or a short Put, the Gamma is a negative value. Therefore, your expectations will change, depending on the Gamma. For any long option you have, you should hope that the underlying assetâ€™s value shifts upward. In the converse, your anticipation for your short options is that you will be able to sell more as the delta shifts downward. Theta Since options have a specific life span, it makes sense that its value changes throughout that period of time. Option Theta tells you the extrinsic value or how much an option changes (loses) each day before its expiration date. Thus, Theta is the estimation of how much of the optionâ€™s value has decreased for any specific
day it is being traded. Since Theta has a negative influence on an option’s value, it is always represented as a negative value. As an example, assume you have an option with a value of 3.25 and a corresponding Theta of -.25. You can expect that tomorrow the option’s value will decline to 3.00 (3.25-.25) as long as the underlying asset’s price opens the same as the previous closing.
The graph above shows what happens to an out-of-the-money Call option as it continues toward its expiration date. The amount the option’s value declines each day is ultimately what the Theta determines. As the expiration date becomes closer, the option’s value declines at a faster rate. Notice the highlighted area which represents the last 30 days of an options life. This is when the theta is eroding the value of the option at its fastest rate. Vega The Option Vega represents the option’s value as the volatility increases by one percent. For both Calls and Puts, Option Vega has a positive value. For example, assume you have an option with a value of 3.5 and a Vega of .25. If the volatility
shifts upwards 1%, the value of the option increases to 3.75. As you can see, Vega is influenced by a downward or upward shift (depending on when it becomes at-themoney) in the value of the underlying asset’s price.
The graph above shows how Option Vega and an underlying asset’s share price changes. The graph looks very similar to the graph for Option Gamma. Vega goes up as the option’s value becomes in-the-money and goes down as the option’s value goes out-of-the-money. In addition, like Gamma, the Vega of Call and Put options is equivalent. By now you should have a pretty good understanding of how an option is priced. Thankfully, we don’t have to figure out all of the mathematics involved as most option friendly brokerages apply the formulae. As a result, we can focus on trading the options rather than what the theoretical value should be of each option. Summary Options can be a rewarding way to maximize your portfolio, if used correctly. This chapter covered the basics of an option so you should know the difference between a call and a put. We also discussed the advantages of options, when compared to stock, focusing on the leverage aspect options afford us. In addition, we also discussed the associated risk with options as that same leverage can work against
us. Lastly, and probably most important, we talked about the Greeks and how they combine to give us a theoretical price for our options. Now that you have a working knowledge of the components of an option, the next chapter focuses on trade setups for calls and puts. In addition, a more detailed look at how to properly price an optionâ€™s value to make a more informed decision is discussed.
Chapter Two Volatility Earlier in this course, we discussed the fact that options carry a higher level of volatility than their underlying stocks. This increased volatility leads to greater profit potential as well as increased risk. It will be critical to your success as an options specialist to not only be aware of the volatility of a given option contract, but also the different ways an option’s volatility is measured. Once you have an understanding of how to measure and evaluate an option’s volatility, you will be ready to learn trading strategies that are designed to take advantage of specific types of volatility. Options have a number of factors that can affect their price, such as price movement of the underlying stock, time, and supply and demand of the contract itself, to name just a few. Option specialists pay attention to these dynamics using measurements referred to as options Greeks. Earlier in this manual we discussed the Greeks and the effect each has on the pricing of the option using the BlackScholes pricing model. One of the key Greeks we focused on was the delta and how that tells us the amount of money we will make with every $1 move in the underlying stock. As effective as the Delta can be in identifying how much opportunity or risk there may be in a given option contract, it doesn’t provide any insight about the effect of increased supply and demand on a contract. This is an important consideration that option specialists are careful to account for, particularly when they are thinking about using option spread strategies. Option traders often neglect to think about the effect of supply and demand on the contracts they want to trade, because most of the movement an option contract makes is dependent on the movement of the underlying stock. It is important to remember that although options are dependent on the underlying stock’s movement, they are also separate and independently traded securities in their own right. They have their own market and exchanges just as stocks do. For this reason, an increase or decrease in the demand or supply of a given contract
can have a dramatic effect on that contract’s price – even beyond the effect of the underlying stock.
Christmas shopping is a good example of how supply and demand can artificially inflate an item’s value. What happened a few years ago when Tickle Me Elmo dolls first hit stores? A simple stuffed toy that would normally run around $30 suddenly cost a lot more; when stores ran out of their supply and people were still clamoring for them, the price reached unimaginable levels. Online auction sites, newspapers ads and the like were offering dolls for hundreds of dollars – far more than anybody would be willing to pay under normal circumstances – and getting it. The same thing often happens to options; it can happen when a stock begins to make a significant move, or sometimes even on nothing more than speculation that the stock could start to make a move. Suppose for a moment that you are looking at a $25 stock, and that your analysis of the stock indicates that it may be about to start a new upward trend. You notice that the stock also offers options. You look at the calls with a $25 strike price for the next few months. Suppose that the $25 contract with a three month expiration is currently priced at $3.50. Daily volume on the option is pretty light, at around 50 contracts. A week later you look at the stock again, and sure enough, it has begun a sharp move to the upside – in fact, the stock is now at $30 only one week later. The three month call is now worth $9.50 – an increase of $6 per share on the option, while the stock only moved $5 in the last week. As you look at the option, you notice that today’s volume was over 1,000 contracts. What happened? Not only did the stock make a dramatic upside move in favor of the call contract, but interest and activity in the contract also picked up dramatically in the week since you last checked. It makes sense that as the stock went up in price, more traders would have become interested in buying the $25 call. If the interest level picks up dramatically or quickly, the option’s price will inflate even more than the effect of the stock’s price movement. Market makers can ask for a higher price for people who want to buy the call, knowing that interest is high.
Volatility Measurements Let’s look at some of the measurements that are used to evaluate an option’s volatility. Specifically, in this section we will discuss the following:
Theoretical Value Historical Volatility Implied Volatility
Theoretical Value (T-Val) An option’s theoretical value is exactly what it sounds like – it is nothing more than an assumption about how much a given contract should be worth. This number is calculated based on a number of factors and assumptions about price movement using an algorithm referred to as the Black-Scholes formula. Some traders also like to refer to the T-Val as an option’s “fair value” – how much the option’s price would be under normal circumstances. This is a useful number to use as a reference against the option’s current trading price to evaluate whether the option is overvalued or undervalued. As a general rule, traders like to think of options whose current trading prices are above their T-Val as overvalued, and options with prices below the T-Val as undervalued. It makes sense that an “overvalued” option suggests higher volatility when you think about it in terms of supply and demand; thus, T-Val can act as an effective way to monitor and track the net effect of an increase in an option’s volatility. It is quite normal to see any option with any reasonable level of activity priced higher than its T-Val, however, so the more important consideration when looking at the differences in these numbers is how large the difference is; particularly when you are looking at using an option that is overvalued. It isn’t unusual to see actively traded options with actual trading prices between 10-25% higher than their listed T-Val. For example, if an option that is currently priced at $3.50 has a listed T-Val of $3.15; the option would be considered overvalued by 10%. This probably isn’t a significant development since it would merely reflect normal market activity. On the other hand, if the T-Val were only
$2.30, the implications would be a little more significant, because the option would then be overvalued by more than 30%. Extremely overvalued options are indicative both of significant price action from the underlying stock as well as dramatic increases in demand for that specific contract. This may not be an automatic warning sign that the stock is about reverse direction; but it can be an early indication that demand for an option contract could be reaching an exhaustion point. Traders who buy options in such an environment are at risk of falling into what is often referred to as a volatility trap; where a sudden decline in the option’s demand could result in a concurrent decline in its price, even if the underlying stock continues to move in the same direction. For this reason, be careful to check the underlying’s stock trend and overall strength before making any assumptions about its options. If an option’s current trading price is lower than the stated T-Val, it can usually be inferred that the option’s volatility is decreasing, because lack of interest in the contract is producing fewer trades with that contract, which is why they are generally considered undervalued. This can come about because the contract’s position is opposite the underlying stock’s current direction (a call when the stock is dropping, for example, will logically generate less interest), but can also yield opportunistic trades under the right conditions. Undervalued options as reflected by a lower current trading price versus the T-Val can often indicate early opportunities before most options traders catch on. For this reason, undervalued options are not very common; however, if you see a stock that you believe is poised for a strong move in a certain direction with undervalued options in that direction (call options when you think the stock will move up, put options when you think the stock will move down), you may have a high-value opportunity ahead of you. If the stock begins to make the move you forecast, options traders will begin to buy the same contract you jumped on earlier. Not only will the move in the underlying stock’s price drive the contract’s price higher, but as more traders jump on your bandwagon, the increased demand will also inflate the value of your contract and accelerate your profit even more. Historical Volatility Historical Volatility is used to measure the past movement of a stock in order to forecast future risk. It is typically expressed as an annualized percentage unless specified otherwise; a stock with Historical Volatility of 18.62 suggests that the
stock has moved approximately 18.62% from its average price over the past year. Keep in mind that this doesn’t suggest which direction that movement was, only how much it has deviated from that average price. You can use Historical Volatility to guesstimate how much risk is involved in a stock, but for the purpose of option trading, it is more useful to use in comparison to an option’s Implied Volatility. Implied Volatility Implied Volatility is applied specifically to an option contract. Like Historical Volatility, it is typically expressed as an annualized percentage. It is primarily useful in identifying over-inflated options. Comparing an option’s Implied Volatility with the underlying stock’s Historical Volatility provides a quick and simple evaluation. It is typical for the implied volatility of at-the-money options to be relatively close to the historical volatility of the underlying stock. A slight variance above or below this level is neither positive nor negative. On the other hand, if the implied volatility of the ATM options is significantly higher than the underlying’s historical volatility, you are probably looking at an over-inflated, overvalued option. This may not be an indication to stay away from purchasing the option depending on your technical analysis of the underlying stock, but it can be warning sign. If interest in that contract begins to dwindle, its value could drop, even if the stock continues to move in the option’s favor. Occasionally you may also find ATM options with significantly lower implied volatility levels relative to the underlying stock’s historical volatility. This isn’t common, but when it does happen make sure to check the underlying stock’s technical analysis carefully. If the stock appears poised to move in the option’s favor, it could be an early sign of an opportunity to enter the trade ahead of the market. If the stock does move in the direction you want, the option will likely increase in value from the stock appreciation as well as from the increase in buying demand – basically giving you double your pleasure!
WARNING! Be aware the ITM options will typically have incrementally higher
levels of implied volatility the deeper in the money you go. By the same token, outof-the-money options will show incrementally lower levels of implied volatility the further out-of-the-money you go. Be careful about assuming any potential opportunities from these options based on implied volatility information, since these will usually be misleading.
Here is an example of a volatility chart that shows both the historical volatility and the overall implied volatility for all the underlying’s options.
You can see that the implied volatility is currently at 48% with the 30-day historical volatility currently at 38%. The implied volatility is for all options, calls and puts, and all strike months. Below is an example of a specific option’s implied volatility from the same options used to create the chart above.
Notice how this particular option’s implied volatility is less than the average option of the underlying. This is a key detail to look at before purchasing an option because each option has its own implied volatility. An important rule of options trading is to “NEVER BUY OPTIONS WHEN THE IMPLIED VOLATILITY IS HIGH!”
Pricing Options All the variables of options are akin to the game of golf in that there are 1,000 “things” that impact the trajectory of the ball and there are 1,000 “things” that impact the price of an option. Ok, not literally, but there are a lot of things to consider when deciding which option to buy and which to sell, etc. The following exercise is just that, an exercise. Most brokerages provide you an option chain that will show the theoretical value, Delta, and other key items needed to make a more informed decision. Below is an option chain from a brokerage and the name of the stock doesn’t really matter in this exercise. What does matter is that the stock is currently trading at $175.16 a share. The other item to know is that it is mid July so there are 102 days until these options expire. For our exercise we are assuming a $12.12 move in the stock from our entry to our exit.
Let’s start with the ATM option as that is usually where the “action” is. The $175 call has a theoretical value of $17.99 yet the Ask is only $17.60. This gives us a
clue that the ATM option is under priced. We like that! We also know that with the stock trading where it is that we have a whopping $0.17 intrinsic value so the remaining $17.44 is time and volatility (extrinsic value). Looking at the OTM $180 strike we can see that the theoretical value is $16.12 while the Ask is only $15.20. We also know that there is no intrinsic value in this option so the whole $15.20 is extrinsic. Finally, the ITM $170 strike has a theoretical value of $20.71 yet the Ask is only $20.20. We also know that this option has $5.16 of intrinsic value in it so the remaining $15.04 is extrinsic value. The other important piece we need to decide which of these options to buy is the Delta. The Delta for the $170 call is .60, the $175 call is .56 and the $180 call is .52. Now we can figure out our risk/reward and our return on investment with the $12.22 expected move in our stock.
To find the expected gain we take the Delta times the move we expect the stock to make. For this example, the expected move is $12.12. Remember that the Delta will increase the further ITM we get. Therefore, look at the Gamma and you can see that all three of the options we are looking at have a Gamma of .09. The Vega is the change in volatility and it is about a wash for these three options as well. To find the Return On Investment (ROI) we take the expected gain and divide that by the cost of trade (the Ask of the option). This is a purely priced ROI based solely on the stock reaching our target price. In other words, these figures are purely theoretical and do not take into consideration any change in volatility or time decay. This exercise is more for you to understand the process than it is to
decide which option to buy. At this point, you should have a good understanding of all the variables that go into pricing an option. Combine that with what you learned in the previous chapter about the Greeks and you are well on your way to becoming an option specialist. The next
step is to apply what you have learned from technical analysis and thus far in the options arena and apply it using different option strategies.
Chapter 3 Identifying Option Trading Opportunities Many traders who are new to options try to over-simplify options trading by thinking: “If I think the stock is going to go up, I buy a call. If I think it will go down, I buy a put.” This is a common mistake that beginning traders make. Just as it is necessary to establish a trading plan and trading rules before you ever place a trade in the stock market, you need to begin establishing a trading plan that is specific to options trading. In order to be successful, you must first understand all of the variables that can impact your trading. Understanding how options are issued, when they expire, what price each contract is associated with, and how to measure the leverage, time decay, and potential reward or risk are critical elements you must understand. For example, time decay (theta) in options will often make a trader who is correct about the direction a stock is going to move actually lose money because they didn’t give themselves enough time. If you don’t account for this risk up front, you are far more likely to make a mistake and not purchase enough time. Another important rule of options trading is to “BUY ENOUGH TIME!” In this chapter, we will discuss using call and put options to take advantage of short-term moves up or down in the stock market. We will discuss the technical and logistical aspects of each option type. Call Option Review Simply put, a call option is purchased if you believe that the stock underlying the option will go up in value over a given period of time. If the stock does move up in the time period the option specifies, you have the choice of either exercising the option, or simply selling the contract back to the market. If you exercise the option, you will first buy the underlying stock for the option’s strike price, and then you can sell it at the going market rate or hold it for as long as you wish.
Yet another rule of options trading is that “WE BUY OPTIONS TO SELL THEM!” Recall the section on leverage in chapter 1 and the fact that we can buy an option on just about any priced stock because of the leverage. If you choose to exercise the option, you need that money in your account to buy the stock at the option strike price. However, if you sell the option back to the market, you will get back the money you originally paid for the option, plus the amount the option has increased in value. The market is aware of the fact that you can exercise and sell the stock for a profit. In fact, they price that into the option and trade it accordingly. In other words, you will roughly make the same amount by selling the option back. The price increase in the option will be dictated by a variety of factors besides the price increase in the stock. These variables, such as how much time value the contract still has and how sensitive it is to an increase or decrease in the stock’s volatility, are the Greeks we discussed in chapter 1. TEST Your Trade TEST is an acronym that we will use to help us determine all the parameters of our trade before we even enter it. We want to use this to help us remember all the variables that are needed to increase the odds in our favor. Think of TEST as a way to keep your emotions out of trading and allowing you to make a more informed decision on which option to purchase. The first T is the most important and it stands for Target. If we don’t know where the stock is headed, we will not know what to expect and, as a result, allow irrational thoughts to impact our objectivity. We do not want this to happen so we need to define a target. Let’s look at a few charts to define a target to clarify this point.
Here we have a target that is defined by a previous high in the stock. These are always the first place to look for a target as they show where the stock is capable of going. In this example we can see that there is about a $15 move from where the stock is now to where it has been recently.
Here is an example of a moving average as a target. Typically you can look to the left of a chart to see how the stock interacts with certain moving averages. Doing so will allow you to better define a target as some moving averages are better than others. There is no definitive answer to which one is better than the other as each
stock reacts differently. However, most stocks will use the 50 SMA and the 200 SMA as levels of support and resistance. These are just a few examples of how to define a target and more will be shown later. Before proceeding any further we should be able to determine if that move is sufficient for our risk/reward tolerance. If so, then we proceed to the next step, the entry. The E is for Entry and we are going to introduce a new indicator that can help us to better define our entry. The new indicator is the Average True Range (ATR) and this is a simple look at the range (high-low) of a given period. Welles Wilder introduced the ATR as another measure of volatility. Large ranges indicate high volatility and small ranges indicate low volatility. The range is measured as the high minus low and can come in quite handy helping to define an entry. The default setting for the ATR is 14 periods and we want to change that to a 20 period measurement. The reason is because that will give us a month’s range of the stock we are looking to trade. Now we have a gauge of the potential move of our stock and an idea of how volatile the stock is. Both pieces of information can help in defining our risk tolerance as well as our entries and exits. Let’s take a few stocks that most people know and compare the different ATR of Apple and Yahoo. Apple’s ATR is currently at $6.50 on the daily charts and Yahoo’s is currently at $1.15 on the daily charts.
Notice that we have two very different numbers for the ATR on two separate and unique stocks. You should also notice that the stocks have different prices where AAPL is currently at $175.16 a share and Yahoo is currently at 23.91 a share. This helps to give some point of reference for the ATR and allows us to define our entry.
We want to take a percentage of the ATR and use that to tighten our entry and make it more unique for the stock we are trading. Let’s start with 10% of the ATR which would give us $0.65 for AAPL and $0.11 for YHOO. What we want to do next is add that to the prior day’s high and that allows us to better define an entry. In a sense, we are using the capability of the stocks movement to get in a trade. There is no set percentage of the ATR we should use but more of a way to better define your risk tolerance. Perhaps you want to be a bit more conservative and use 30% of the ATR to make sure that the stock is moving in the right direction. However, in doing so you also remove that much from your reward as it took longer to get in the trade. That’s not a bad thing per se, just a fact that anytime we reduce the risk in a trade we will reduce the reward. As a side note, most traders will use an arbitrary number like $0.10 or $0.03 above the prior day’s high. You can see from our example that AAPL could easily break the prior day’s high by $0.03 but to break it by $0.65 is a much more defined move in that direction. Now that we have the target and the entry defined we need to define where we would get out of the trade if it goes against us. In other words, where would we close the trade knowing that we were wrong in the direction the stock was headed. This is not as easy as it sounds and will help you to better define your risk tolerance. The S stands for Stop and we definitely want to define a stop on all of our trades so this section is key. Nobody likes getting stopped out of a trade for a loss and there is only one thing worse; getting stopped out only to see the stock go the direction you thought it would. Knowing that you were correct in the directional move of a stock but getting stopped out because of a strict stop-loss is not only devastating to your account, but even more devastating to your psyche. In fact, the odds have increased that you will begin trading on TILT, looking to “get even” or “make up” for a poor decision. We want to avoid that type of reaction all together and we can with the help of the ATR. Yes, the ATR got us into a trade and it will help us to get out of a trade as well. We need to define a level of support and then use a percentage of the ATR to set our
stop. Looking at our example of Apple and Yahoo, we can use levels of support as a starting point and then take a percentage of the ATR and subtract it from that level of support.
YHOO gapped up on news and that typically signifies a new level of support from where it gapped. Taking a look at the chart we can see that the green dotted line represents the most recent high before the gap. With that, we have defined a stop at the $22 price level for our Yahoo trade. We could choose the low of the swing (represented by the blue dotted line) and that would be a riskier stop as it is approximately $4 from where we would get in the trade. Using our percentage of the ATR for YHOO we can take the total and subtract that from our stop. In the first example we can use the same 10% ($0.11) and subtract that from $22 which would give us a stop of $21.89. We would look for a close below that level to signify a trade that has gone against us and we need to exit.
With AAPL we can see a good level of support right at the $170 price level (represented by the green dotted line). We can also see a moving average underneath all the candles (represented by a blue circle) which would be a less conservative stop. Using the $0.65 stop (10% of the ATR) we would subtract that from the $170 support to give us a stop of $169.35. We would look for a close below that level to signify a trade that has gone against us and we need to get out of the trade. There is another type of stop for option trading that is arbitrary in nature as well and that is a percentage stop. As an example, letâ€™s say we spent $3.00 on an option and our stop was a 30% loss. We would enter a stop to sell our option if the price ever got to $2.10 (30% of $3.00). This works for the most part, but volatility swings can create a 30% change in option pricing yet the stock doesnâ€™t break support. At this point we have several choices to define our stop and need to make a decision. Deciding which type of stop to use on both YHOO and AAPL will come as you define your risk tolerance. In addition, we add the next step, Timeframe, to lend a hand in defining our stop accordingly.
The last T is for Time-frame and will help us define our trading style. There are, on average, anywhere from 2-8 bars in a trading range and that can help us define our time-frame. We can use the following chart as an example of different timeframes and the trading styles associated with them.
Looking at the chart we can see that the duration is the key to the range. Most beginning option traders are comfortable with swing trading and that is what we will focus on for this example. The duration of the swing from the low to the high is typically between 2 and 8 candles (days). This is quick enough that we can find some opportunities to trade every week, but not too quick that we canâ€™t learn. The setups will be found on the daily charts and the confirmation will come from the weekly charts. The entry/management of the trade will come on the daily charts as well. The only difference is that if you are able to trade intra-day then you can use an hourly chart for an even more defined entry and exit. We now have all the information to properly enter our trade. More importantly, we will have defined the profit, loss, return on investment, and more before even submitting the order. Doing so allows us to remove emotional reactions during trade management. Letâ€™s use an example and discuss how we would enter this trade into our brokerage account. Long Calls
Recall from chapter 1 that a call gives us the right, but not the obligation, to buy a stock at a given price. In addition, we also have the time restriction associated with our call which limits the amount of time we can hold the option.
A long call consists of the purchase of a call option and is done when you are extremely bullish about a stockâ€™s direction. As the stock price increases, your call option increases in price. In a long call your risk is defined by the total net debit for purchasing the call. The reward is limitless as the stock rises. However, time decay in your option will eat away at some of the gains and increases as expiration approaches. Risk/Reward:
Maximum profit = infinite Maximum risk = the net debit Break-even point = the strike price of the call you purchased plus the net debit Letâ€™s take a look at an example to better understand when to buy a call option. Remember that buying a call is similar in direction to buying the stock so we want a stock that is in a sustained uptrend. There are other set-ups such as bouncing off of support, a rising uptrend, as well as breakouts that we can use the strategy of buying a call. However, the overall trend needs to be bullish as we are assuming the stock will continue to climb higher.
This is a 6-month chart for Apple (AAPL) and we can see that the stock has pulled back off of a test of the $190 level. We can also see that the 200 MA has provided some support and it appears as though AAPL will make another attempt at the $190 level. We want to confirm our trend on the weekly chart and see if it agrees with our analysis.
From this weekly chart of Apple we can see that the overall trend is up and that the $190 target looks achievable. We can even see a more aggressive target of $200 as well. The next chart shows us the target that we will use as well as the stop so we can define our trade using the ATR. Take a moment to remember the ATR of APPL is $6.50 and we will use 10% of that ($0.65) for our entry and our stop. The assumptions are that we are trading out-of-market which means that the market is closed. Therefore, we use the last candle to get our high for the day. For Apple we had a high for the day of $177.13 and we will add the $0.65 to that for a
total of $177.78. This is the price we want AAPL to trade at and will enter to buy our call when it does.
We can also see our technical support at the $170 level and will use that, along with the $0.65 from the ATR, to set our stop. We will subtract the $0.65 from our $170 to get $169.35 as our stop. This is the price AAPL will close below in order for us to get out of this trade. Now that we know where AAPL is headed (Target) to get in (Entry), where to get out (Stop) we need to decide how long it will take to get there. Once again we can use the ATR to help us understand the potential of APPL. We know that the daily ATR is $6.50 and the weekly ATR is $13.00. We also know that if we enter the trade at $177.78 and get out when AAPL reaches $190 that we have a $12.22 move. Remember earlier we discussed the first rule of options trading which is to buy enough time. Therefore, knowing that it would roughly take about two weeks to reach our target, we need to allow at least a month. Why? We want to make sure that we have plenty of time to allow AAPL to make it to $190.
We know that from the Greeks that Theta will eat away at our option on a daily basis, even when the markets are closed. We also know that if AAPL makes it to our target faster than we anticipated that we can sell back any of the time we have left in our option. Letâ€™s take a look at the option chain for AAPL.
We have several months to choose from as well as several strikes. By the date on the option chain we can see that the July options are the front month and their Theta is the highest. Therefore, we need to either buy the August or the October expiration. The August options will give us 39 days of time (3rd Friday in August) and the October options will give us 102 days of time (3rd Friday in October). The
August options are cutting it close and the October options provide more time than we need. However, remember that the market will buy back our time let in the options at a fair price. As a result, we should be looking at the October options to structure this trade. Below is a window from a brokerage that shows the October calls for AAPL. We want to structure our trade using the option chains from our brokerage because that is where we are making the transaction.
With AAPL trading at $175.16 we know that the $175 strike is the At-The-Money (ATM) strike. We also know that the $180 strike would be the Out-of-The-Money (OTM) and the $170 strike would be In-The-Money (ITM). Options that are ITM are more expensive because there is actual intrinsic value in the option. On the other hand, OTM options are less expensive because they have no intrinsic value. Earlier, in chapter 2, we discussed the theoretical value, extrinsic value and intrinsic value of options. Let’s use that knowledge to make a more informed decision about which option to buy. Start with the ATM option as that is usually where the “action” is. The $175 call has a theoretical value of $17.99 yet the Ask
is only $17.60. This gives us a clue that the ATM option is under priced. We like that! We also know that with AAPL stock trading where it is that we have a whopping $0.17 intrinsic value so the remaining $17.44 is time and volatility (extrinsic value). Looking at the OTM $180 strike we can see that the theoretical value is $16.12 while the Ask is only $15.20. We also know that there is no intrinsic value in this option so the whole $15.20 is extrinsic. Finally, the ITM $170 strike has a theoretical value of $20.71 yet the Ask is only $20.20. We also know that this option has $5.16 of intrinsic value in it so the remaining $15.04 is extrinsic value. The other important piece we need to decide which of these options to buy it the Delta. The Delta for the $170 call is .60, the $175 call is .56 and the $180 call is .52. Now we can figure out our risk/reward and our return on investment with the $12.22 expected move in AAPL.
Recall that to find the expected gain we take the Delta times the move we expect the stock to make. For this example it is $12.12. To find the Return On Investment (ROI) we take the expected gain and divide that by the cost of trade (the Ask of the option). You also need to know that these figures are purely theoretical and do not take into consideration any change in volatility or time decay. We also want to look at the open interest in the options because we want liquidity. Typically this can be accomplished by trading options on stocks that have an average daily volume of at least 500,000 shares over the past 90 days. In any case, you want to check the open interest to make sure there are others interested in what we are about to buy. A key rule of options trading is â€œNEVER CONTROL MORE THAN 10% OF THE OPEN INTEREST!â€?
Below is a checklist that is also available in the InvestView website under the “modules” then “options” and finally “system” links. The worksheets are broken down into Pre-trade, During-trade, and Post-trade sections. Below is an example of the Covered Call Worksheet.
The worksheet for a long call is below and can be used to assess a potential trade for probability. Remember, we want to increase the odds in our favor with each
trade so the more of the items you can answer, the greater the odds of being correct. Pre-trade checklist: o Is the trend bullish? o How long will it take to reach the target? o Did you double the time calculated to reach target? o Is the average volume over past 90 days for the stock greater than 500K? o Would you be controlling more than 10% of the open interest? o Can you get 5% - 10% return on your investment? o Is the call option volatility high (buy low, sell high)? o Have you verified earnings date and checked news headlines? During trade checklist: o Is your stop at a technical level on the candlestick chart? o Is the sector your stock in bullish as well? o Are the major indices in agreement with your stocks direction? Post trade checklist: o Did you reach your target? o If so, how far above the target did the stock close at expiration? o If not, were you stopped out? o If you were stopped out was it your original stop or an adjusted one?
Recall from chapter 1 that a put gives us the right, but not the obligation, to sell a stock at a given price. In addition, we also have the time restriction associated with our call which limits the amount of time that we can hold the option. A long put is initiated with the purchase of a put option. Buying a put allows you to participate in the downward movement of a stock with defined risk. As the stock price decreases, your put option increases in price. In a long put your risk is defined by the total net debit for purchasing the put. The reward is limitless as the stock falls. However, time decay in your option will eat away at some of the gains and increases as expiration approaches. Risk/Reward:
Maximum profit = infinite Maximum risk = the net debit Break-even point = the strike price of the put you purchased minus the net debit Letâ€™s take a look at an example to better understand when to buy a put option. Remember that buying a put is similar in direction to selling short the stock so we
want a stock that is in a sustained downtrend. There are other set-ups such as bouncing off of resistance, a declining downtrend, as well as breakdowns that we can use the strategy of buying a put. However, the overall trend needs to be bearish as we are assuming the stock will continue to fall lower.
On this daily chart of Wynn Resorts we can see that the overall trend has been down. Notice where both the 200 SMA and the 50 SMA are with respect to the candlesticks. You can also see that for the past 2 months the 13 EMA has been a good level of resistance. Furthermore, that is where we are right now so this is looking like a good candidate so far. We can see that the ATR is about $4.50 and if we take 10% we are looking at $0.45 to subtract from the prior dayâ€™s low. The prior dayâ€™s low was $79.90 and if we subtract the 10% of the ATR we get an entry of $79.45.
The weekly candles confirm our trend and even give us some nice targets to aim for in the long put. Once again, look at the 200 SMA and the 50 SMA and see where they are in relation to the candlesticks. The prior candle to the current weekly candle was a break of the 200 SMA and a doji. The doji signals indecision while the break of the 200 SMA would definitely bode well for our long put. Looking at the chart below we can better define our target and our stop for the long put trade.
There is a great technical stop right at the 13 EMA, which also shows us some resistance to the left of the chart. This price level is $92.85 so we will take the 10% of the ATR and add that for a stop of $93.30. The target is prior support and should be attainable as the stock has been there before and appears to have momentum. The actual price of the target is $66.25 so we are looking at a potential move of $13.25. Looking below we can see that the options for WYNN are available for various strike months as well as strike prices. We need to determine how long it will take for WYNN to reach our target to help us decide which month to look at. On the daily charts the ATR is $4.50 and on the weekly charts the ATR is about $10.00. If you remember, in the long call example earlier we doubled our expected estimate. We should do the same with the long put but there is one thing working for us now that wasnâ€™t then. Stocks typically fall faster than they rise. That doesnâ€™t mean that we can buy less time, it just means that the odds are we might reach our target faster than anticipated.
Since the August options only give us 37 days until expiration, we need to focus on the September options. Doing so gives us about double the number of days to reach our target and the actual cost is not that much more for double the time.
WYNN is currently trading at $83.50 so the $85 puts would be ATM and the $90 puts would be ITM and that leaves the $80 puts OTM. These are the three strikes we will use in our exercise to help us understand the proper pricing of options. Starting with the ATM option as that is usually where the â€œactionâ€? is. The $85 put has a theoretical value of $9.89 yet the Ask is only $9.20. This gives us a clue that the ATM option is under priced. We like that! We also know that with WYNN stock trading where it is that we have a $1.50 intrinsic value so the remaining $7.70 is time and volatility (extrinsic value). Looking at the OTM $80 strike we can see that it has a theoretical value of $7.31 yet the Ask is only $6.80. We also know that there is no intrinsic value in this option so the whole $6.80 is extrinsic value. Finally, the ITM $90 strike has a theoretical value of $13.07 yet the Ask is only $12.10. We also know that this option has $6.50 of intrinsic value in it so the remaining $5.60 is extrinsic value. The other important piece we need to decide which of these options to buy it the Delta. The Delta for the $90 put is -.55, the $85 put is -.47 and the $80 put is -.38. Now we can figure out our risk/reward and our return on investment with the $13.25 expected move in WYNN.
Recall that to find the expected gain we take the Delta times the move we expect the stock to make. For this example it is $13.25. To find the Return On Investment (ROI) we take the expected gain and divide that by the cost of trade (the Ask of the option). You also need to know that these figures are purely theoretical and do not take into consideration any change in volatility or time decay. We also want to look at the open interest in the options because we want liquidity. Typically this can be accomplished by trading options on stocks that have an average daily volume of at least 500,000 shares over the past 90 days. In any case, you want to check the open interest to make sure there are others interested in what we are about to buy. The worksheet for a long put is below and can be used to assess a potential trade for probability. Remember, we want to increase the odds in our favor with each trade so the more of the items you can answer, the greater the odds of being correct.
Pre-trade checklist: o
Is the trend bearish?
How long will it take to reach your target?
Is the average volume over past 90 days for the stock greater than 500K?
Would you be controlling more than 10% of the open interest?
Can you get 5% - 10% return on your investment?
Is the put option volatility high (buy low, sell high)?
Have you verified earnings date and checked news headlines?
During trade checklist: o
Is your stop at a technical level on the candlestick chart?
Is the sector your stock in bearish as well?
Are the major indices in agreement with your stocks direction?
Post trade checklist: o
Did you reach your target?
If so, how far below the target did the stock close at the close of the trade?
If not, were you stopped out?
If you were stopped out was it your original stop or an adjusted one?
You should have a good understanding of both the put option and the call option and how they work. Combining this knowledge with that of the previous two chapters we will build upon that and discuss more advanced option strategies. If you feel as though you donâ€™t understand the basics of a call option and put option then please review the previous chapters as well as this one. In addition, contact your coach and work on the areas that you feel less comfortable with.
Chapter 4 Stock and Options Combinations
To many investors, option trading involves an extremely high level of risk, so the prospect of entering this market makes them nervous and fearful. While there most certainly are options trades that represent that extreme high side of the risk equation, there are also very conservative strategies that options can be used for. One of the most conservative options strategies for any investor is selling covered calls. Covered calls can be used as an income-generating strategy as well as a way to enhance an overall growth strategy. Smart investors make a point to incorporate covered calls into their trading system regardless of their objective.
Another strategy that can be effective for stock traders is protective puts, which can act as an insurance policy against sudden or long, sustained drops in a stockâ€™s price. This chapter will outline the proper way to apply both of these strategies.
A covered call is simply a call option that you sell on a stock you own. Remember, a call option gives the option buyer the right to buy the stock at a specific price â€“ a lower price than where the stock will be if it goes up and the buyer chooses to exercise the option. This is a right, not an obligation, the buyer has. As the seller, you take on the obligation to
sell the stock to the buyer at the option’s strike price if they choose to exercise the option. Since most investors buy a stock because they like the company, why would you want to sell a call option on a stock you own, when you run the risk of having to sell the stock at a cheaper price?
The first answer to this question is to remember that successful investors don’t buy stocks just because they like the company; they do it because they think it is going to go up or because there is some other benefit owning the stock gives them at the time. Successful investors will buy and sell stocks as quickly as their analysis tells them it is necessary; selling covered calls gives them a way to take in extra income on a stock while they own it that they wouldn’t have seen if they relied only on price appreciation. The second reason to sell covered calls is that writing a covered call provides a measure of downside protection, and adds income to your investment portfolio.
When you sell an option on a stock you own, you receive a premium for that option. You recall that when you buy an option, you pay the Ask price, and when you sell it back to the market, you receive the Bid price. This is also true when you sell a call using the Covered Call strategy. You will receive the Bid price for that option. This premium is immediately credited to your brokerage account and provides a buffer against loss if the stock begins to drop.
Suppose you own 100 shares of a $40 stock. You sell a call option and receive $2.00 from the premium, or $200. After you sell the call, the stock begins to drop. The advantage you have over other investors is that your covered call has given you a $2.00 buffer. Unless the stock drops below $38, you haven’t lost anything. The downside protection afforded by covered calls is a reason many long-term investors make regular use of this strategy.
It is important to remember that you don’t have complete downside protection with covered calls; in our example, if the stock suddenly dropped to $35 per share, you would quickly be in a net negative situation and would have to take some kind of action to protect yourself. Nevertheless, for stocks that you might take a longer-term view of, covered calls are a good way to even out the volatility of the stock and weather minor drops in price.
Most investors who use covered calls do so primarily for the income they provide. If you are in a situation where you need to live on your investments, covered calls is a perfect fit. Traders can easily earn 2-5% per month on a monthly basis when using covered calls. That works out to a much better return on your money than you would see from a bank, CD, or Treasury note! Each time you sell a call option, the premium you receive is deposited immediately in your trading account to be used at your discretion.
Many investors who are seeking long-growth in their portfolio will read the last paragraph and say, “That isn’t me. I don’t think covered calls would help me out at all.” Not true! Although covered calls are considered an income source, they can also used within the context of an aggressive growth strategy.
Let’s say you purchased 100 shares of a stock at $30 and it has increased to $40, and your technical analysis indicates the stock is approaching resistance. You have a 30% profit in your trade, so it’s time to get out, right? Maybe, but before you make that decision, you might want to look at the current prices for the call options on that stock. Many stocks at the top of an upward trend don’t start downtrends right away. Instead, they will often hover at or around their high price for a period of time before they begin to go down. This period of time can last anywhere from days to months, but it isn’t uncommon to see this kind of pattern last a few weeks at least.
Suppose you could add an additional $2 per share to your account by selling a call that will expire in one month. Why not add some extra income to your return if your analysis leads you to think the stock might be topping out but isn’t likely to drop quickly? Instead of a $10 profit, you give yourself a handsome $12 potential profit – and $2 of that comes to you immediately! If the stock continues to go up, you will get called out and lock in your profit and move on to another trade; if you don’t get called out and the stock hasn’t dropped, you can decide whether to move on or try it again.
Now suppose you repeated this process at the end of each profitable stock trade you made. An extra $2 per share on a single trade may not sound like much, but what if you were to repeat this process again and again over a period of time? Your trading account would grow exponentially over time. This is one of the secrets of the market that not everybody knows – covered calls can (and should) be a major component of a successful, long-term wealth building strategy.
Maximum profit = strike price of short call minus the purchase price of the stock plus the premium for selling the call
Maximum risk = unlimited Break-even point = the purchase price of the stock minus the premium from the call
Previously, we discussed the fact that the more time an options contract has built into it the more it is worth (extrinsic value). As an options seller, you can take larger premiums by selling more time. However, as a general rule, you should focus on selling short-term call contracts. This is because selling short-term, monthly contracts on a consistent basis will give you a greater return percentage over time than selling a single long-term contract. Selling long-term contracts also increases the amount of time you are exposing yourself to
being exercised by the individual that bought your call contract. Remember our old nemesis Theta, that time eroding Greek? Well, in a covered call we are selling an option so we actually want the Theta to work for us by eroding the value of that option we sold.
Letâ€™s use some examples to illustrate the benefit of selling short-term call contracts. Look at the options chain below.
Interest Nov 06 45
Suppose that these contracts are approximately one month away from expiration. The current price for YHOO is currently at $25.33, meaning that the at-the-money contract is at $25.00. If you were to sell this contract, you would receive the Bid price of $1.70 – an immediate return of approximately 6.9%. This may not sound like much – you only get $170 on an initial investment of around $2,533, right? Wrong! That 6.9% is what you get for selling a one month contract. If the stock doesn’t move higher than $25.00, the contract will expire worthless; you’ll still have the stock and be able to sell another contract for another month. 6.9% is actually an uncommon return on a single covered call contract; 2 – 3% is more typical. Suppose you get 2.25% every month for 12 months – that’s 33.8% return on your money just from writing covered calls!
One wrinkle you should be careful not to forget is the effect of commission costs on your returns. Remember that when you sell a covered call, you will be charged a commission on that trade. Your covered call premium needs to be high enough to give you an attractive return after commissions. If your commission costs are eating at a significant portion of your premiums ($20 to $30 or more per trade), then you should probably try to find a broker with lower commissions.
Now let’s compare our 33.8% return from short-term call writing to a longer period of time. Look at the options chain below.
This chain is for April 2007 contracts, which for our purposes is still around six months away. We could sell the $25.00 strike price for $3.20, which is an immediate return of 12.6%. Wow! This is measurably higher than $1.70, but when you consider the fact you wouldnâ€™t be able to sell another contract for at least six months, you are actually getting a lesser annualized return by using this longer-term contract â€“ around 20% vs. the 33.8% we could realize by sticking with short-term contracts. Remember also that if you were to sell this contract, you would be obligated to deliver the stock at $25.00 for the next six months. A lot can happen in six months. For example, the stock could appreciate significantly higher than $25.00, giving the individual who bought your option a great deal and leaving you with only a minimal gain.
On the flip side, the stock could experience a significant, extended downtrend. This is the greatest danger associated with selling long-term contracts. When you sell a covered call,
you are required by your broker to hold on to the stock for as long as you are liable for the call contract. If the stock takes a sudden downturn, you cannot sell the stock until you eliminate the obligation for the call contract. You can remove this obligation by buying a call at the same strike price (this is called buying the call back), but in the meantime, you are sitting in a declining stock. This risk is greater because over time any stock will experience declines. Concentrating on short-term contracts lessens this risk since you are committing yourself to a smaller amount of time.
Remember that the closer to expiration an options contract is, the more time decay erodes the value of the option. This is another reason selling short-term contracts is valuable â€“ time decay erodes the value of the option faster. As the seller, time works for you, rather than against you as we are used to with the normal buying mentality. If the stock stagnates or hovers relatively close to the price it was at when you sold the stock, you wonâ€™t lose any value in your principal, but the likelihood of the stock expiring worthless increases, which lessens the value of the option. Suppose you sold the November 25 strike price from Figure 5.3 at $1.70, and one week before expiration, it was worth a mere $.30 because of the effect of time decay. You could buy the call back at $.30, keep the $1.40 difference and remove your obligation should the stock suddenly move past $25.00 before the expiration date. This is a money management technique that you wonâ€™t always have occasion nor need to use, but you will find situations where it will be in your best interest to do so.
Choosing a Strike Price
Next, you must decide what strike price you want to sell at. Just as when you buy an option, you have to decide whether you want to sell an in the money or out of the money call. Many investors look at this question primarily from the viewpoint of how much money they will get in their premium. This limited attitude only addresses the immediate benefit of the trade and not the potential risk or downside of the covered call itself.
Remember that in the money options are more expensive than out of the money contracts. This means that selling an in the money covered call would translate to a higher immediate
payment to your account. It also means that the person who buys your option could immediately exercise the option and buy the stock for a lower price than it is at right now; this is the rare exception because most traders won’t exercise an options contract until or close to the expiration date. However, if you sell in the money options, remember that if the stock is still in the money as you approach the expiration date, you probably will be exercised.
Most buy-and-hold, long-term investors avoid selling in the money options, while traders who are simply trying to supplement and enhance growth use them actively. If you do decide that selling an in the money option might work for you, make sure that the strike price you sell the option at isn’t so low that it completely offsets the premium you receive if you are exercised. You want your covered call trades to produce a net profit, not result in a zero sum transaction.
Out of the money options don’t produce higher premiums like in the money contracts, but in order to be exercised, the stock will have to increase in value above the strike price you have sold at. This is the approach used by most traders who use covered calls for income purposes, because if they do get exercised, they will be selling the stock at a higher price than where it was previously, and they keep the premium they were paid at the beginning of the trade. Although the premiums aren’t as high as for in the money options, out of the money premiums can still be very attractive and produce a win-win scenario for the astute covered calls trader.
We don’t favor selling one type of contract over another. The simple fact is that each approach has its advantages and drawbacks. Sophisticated covered calls traders don’t limit themselves to only selling one type of contract; they evaluate each potential covered call on a case-by-case basis to determine which approach would work better. Later in this section, we will examine scenarios in which selling in the money options provides the greatest overall benefit in using covered calls, and when staying out of the money works best.
After you have identified a stock you would like to sell a covered call on based on the movement of its short-term trend and determined how much time to sell, identify the at the money strike price. If it is in the money, identify the first out of the money contract. If it is out of the money, identify the first in the money contract. Write down the strike price and the Bid price for each contract so you can begin to analyze each one.
The first scenario is straightforward and easy to deal with; the option expires worthless and you do nothing but keep the premium that was credited to your account when you sold the call. Realistically speaking, this is the most common scenario for covered call sellers. It is also the least expensive, since you only pay a commission to your broker when you sell the call contract.
The second scenario can be straightforward if you donâ€™t mind being exercised and selling out of your stock; you need to remember, though, that you will have two commissions to pay: one when you sell the contract, and another when you sell the stock.
What can complicate this situation is if the stock has made a significant upward run, well above the strike price of the option you sold. Being exercised would mean selling the stock at a dramatically reduced price compared to where it has risen; many traders in this situation will buy the call back before expiration to remove their obligation and allow them to ride the stockâ€™s upward run. It is important in this situation, however, to compare the increase the stockâ€™s price to the cost of buying the call back. If the stock has increased
in value, the call option you sold will also have gone up; often, the net result is the same as if you sold the stock at the option’s strike price. The counterbalance to this problem is your analysis of the stock’s upward momentum. If you think the stock has reached the peak of its run, it may not be worthwhile to buy the call back; on the other hand, if your analysis leads you to conclude the stock may still have room to continue increasing in price, you will find it easier to justify buying the call back.
The third scenario is the most urgent of all, particularly if the stock has begun a downward trend. Remember that as long as you your covered call position is open, your broker will not let you sell you stock. The downward trend mandates action before your loss becomes more severe, however, so you will need to buy the call back, and then sell the stock. In some cases, it is possible to sell the stock before buying the call back, but since this would place you in a naked position, meaning that you don’t own the stock on a call you have sold, you should pay particular attention to the sequence of your orders.
In this scenario, you will lose money, and you will incur your highest commission costs, because you have three transactions – sell the call, buy it back, and sell the stock. There is a silver lining, however; buying the call option back will cost you less than you took in when you sold it, and the difference will give you some cushion against your loss. This situation is one of the principle reasons the direction of the trend is so important – if you focus on stocks in upward or flat trends, this extreme scenario will be the rare exception to your covered call experience.
When it comes to planning your exit, make sure that you account for all three of these possibilities. If your analysis of the stock leads you to believe that it won’t rise above the strike price of the option, be content to sit through the play and enjoy your premium when the option expires. If there is a good chance you could be exercised, be prepared to evaluate whether to buy the call back or allow the exercise to happen. Analyze the downside of the stock as well so you can identify specific price points at which you need to take action.
This analysis is simpler than most traders think. If you paid $26 per share for the stock, for example, and sold a call option for $1.50, your actual cost for the stock is only $24.50. Technically, you could allow the stock to drop to that price and you would still break even. The point at which you would need to determine whether to get out of the stock to avoid a downtrend in this case would be when the stock dips below $24.50.
About Stop Losses
One thing about using covered calls that you should always remember is that when you write a covered call contract, your broker will generally not allow you to place a stop loss on the stock. This is because if you were to get stopped out of a stock you have written a covered call on, you would still be liable for the contract even after selling out of the stock. You would be in a naked call position, which you might not have permission for. Most brokers prefer to avoid this added complexity and simply don’t allow it. This means that when you write a covered call, any stop losses you might use are mental stop losses only; identify a price level where you would simply have to move on, but be very careful about watching the stock every day to see if that circumstance comes to pass. Daily vigilance is very important to a successful covered call strategy.
Protective Puts (Collar)
A protected put, or collar, refers simply to buying a put against a stock you already own. Using protective puts isn’t appropriate for all traders or trading systems. If you are a stock trader who focuses primarily on short or intermediate-term swings in a stock’s price, protective puts will likely not be a cost-effective strategy. If your preference is to use options to take advantage of the same swings and moves, protective puts also is not likely to benefit you. However, if you have owned, currently own, or like the idea of buying a stock and holding it for as long as you can to maximize a strong long-term trend, protective puts may be an effective way to minimize loss on significant short-term changes in the stock’s price.
Protective Put Trading Rules
Here are a few of the basic guidelines you should follow in developing trading rules related to how you would use protective puts.
Sentiment: you should use a protective put only for as long as you believe the stock should continue to maintain its long-term upward trend. If you see information (news, earnings, etc.) about the stock that leads you to change your opinion about the stock’s ability to maintain its long-term trend, close the trade and move on to something else.
Time: traders tend to differ on how much time they purchase for the put contract. Some prefer to use shorter-term contracts extending no more than 2 – 3 months because of their generally cheaper premiums; others prefer to buy as much time as they can to minimize commissions and trading frequency. Remember, the more time you buy with a put option, the larger the premium will be. The less time you buy, the more frequently you will have to repurchase a new put contract to replace the expiring one.
Profit-taking: The longer the stock continues to maintain its trend and move up, the less your put option will be worth. Often, you may find it more worthwhile to let an option expire worthless than it would be to sell the option back to the market before expiration. If the stock has been dropping and the put option is profitable, think about selling it and realizing your gain. If the option is profitable and close to expiration, take your profit. You will then need to repurchase another put option with a later expiration date to maintain the stock’s protection.
Stop Losses: Traders who use protective puts don’t generally set stop loss levels with their broker – for the stock or for the put option. This makes sense, since if the stock drops, the profit in the put option is intended to offset the loss in the stock. If the stock increases in value, the intent to protect the stock with the put option doesn’t change, so a stop loss on that contract is also not necessary. However, it is appropriate to have “mental stop losses” in mind to indicate either points at which you should simply get rid of the
stock because it has changed the direction of its long-term trend, or high prices at which you might need to purchase a put option with a higher strike price. Using the long-term trend line is usually effective as the mental stop loss point for the stock, and future possible resistance based on previous highs or lows can be effective for identifying points to replace the current put contract with a new one.
Proportionality: In order to realize the maximum possible benefit for the protective put position, you should purchase enough contracts to match the number of shares you own as closely as possible. Remember that a single option contract controls 100 shares of the underlying stock. If you own 500 shares of the stock, for example, you should purchase at least five put contracts. Although this wonâ€™t guarantee that any profit in the put option from a sudden drop in price completely offsets the loss in the stock, it will give you as much protection as possible.
Below is the checklist found in the Investview website under the tools section for the options module. Remember, this is for your benefit and will allow you to increase the odds in your favor that the trade will go the way you want it to. Answer as many questions as you can to give yourself enough information to make an informed decision.
Pre-trade checklist: o o o o o o o o
Is the trend mildly bullish? Is the short-term target reachable in 2-6 weeks? Is the average volume over past 90 days for the stock greater than 500K? Is there a call that is slightly Out-of-The-Money (OTM)? Would you be controlling more than 10% of the open interest? Can you get 5% - 10% return on your investment? Is the call option volatility high? Have you verified earnings date and checked news headlines?
During trade checklist: o o o
Is your stop at a technical level on the candlestick chart? Is the sector your stock in mildly bullish as well? Are the major indices in agreement with your stocks direction?
Post trade checklist: o o o o
Did you reach your target? If so, how far above the target did the stock close at expiration? If not, were you stopped out? If you were stopped out was it your original stop or an adjusted one?
By now you should have a good understanding of covered calls and the potential they offer. We have built upon our understanding of long puts and long calls and added covered calls to our arsenal. We are now ready to pick up the pace and look into the world of option spreads.
Chapter Five Basic Spread Strategies
A standard option trade – buying a call or put, for example – carries the highest possible opportunity for profit. It also carries the highest possible risk. We’ve previously discussed the effects of time and leverage when you buy an option contract. Although the opportunity for profit is much higher in these trades than if you simply bought or shorted the underlying stock, the higher level of risk forces many more conservative traders away from options trading. The lower cost of options in general makes it possible to construct option trades to take advantage of specific types of situations or patterns while dramatically lowering the risk involved in the trade. This is done by combining at least two option contracts on the same stock; this type of trade is called a spread trade. In this chapter we will cover three of the simplest types of spread trades:
Calendar Spread Bull Call Spread Bear Put Spread
A calendar spread involves the simultaneous purchase of a LEAP (long term equity anticipation security) and selling the same number of near-term options. The calendar spread is similar in nature to a covered call except that a LEAP option is used instead of
stock. As a result, less capital is required to enter a calendar spread while achieving a similar reward.
The idea behind a calendar spread is to purchase an in-the-money (ITM) LEAP and then sell (write) a near-term option that is out-of-the-money (OTM). Ideally you will want to repeat the process for the following month and possibly two months. The risk is the chance you could be called away and lose all the time value that you have in your LEAP.
There a few caveats associated with calendar spread trading you need to be aware of:
Trading Authority: A calendar spread is considered a technically naked position despite the fact that the longer-term contract covers the short call. Brokerages think of this as a naked trade because you donâ€™t actually own the stock; you only own the right to purchase it. For this reason, using calendar spreads usually requires at least a level 4 trading authority and margin approval on your account. By comparison, covered call writing requires only a level 1 trading authority, with no margin requirements.
Capital: Literally speaking, the only capital required for a calendar spread is the cost of the longer-term option. However, since you are selling the call option and accepting the risk of being assigned, your broker will require you to have enough cash and margin in reserve to cover the cost of buying the stock in the event you are called out. This amount cannot be used for other trades while you hold the calendar spread.
You can use this strategy to generate income on sideways-trending stocks, or you can incorporate it as part of an overall growth strategy. The rules for applying this strategy in these scenarios are the same as it would be for covered calls. Letâ€™s look at some examples of each application and compare the benefit of writing a covered call versus applying a calendar spread.
Maximum profit = premium for short option plus intrinsic gains on LEAP Maximum risk = net debit Break-even point = Stock price when long call is equal to net debit
You learned about using covered calls to generate income off of the stocks you own in the last chapter. Selling calls in this situation can be an extremely attractive way to take advantage of sideways trends in stocks you have held for a long period of time. Successful traders, whether they are trading to generate income to live on or to simply build wealth, make sure to incorporate options selling strategies such as covered calls in their trading systems.
Options provide another way to achieve the same result as covered calls, but with a lower capital outlay required on your part using a strategy referred to as a Calendar Spread. A calendar spread is applied by first buying one or more longer-term contracts, then selling an identical number of short-term contracts. The principal advantage of using calendar spreads is that rather than having to allocate thousands of dollars of your capital to purchase a stock in 100-share lots, you can use smaller amounts to control the same number of shares with your options contracts. If the stock rises above the strike price of the call option you sold and you are called out, your longer-term option will be exercised to cover the trade. If you plan the trade properly, this should yield a net profitable result.
Income The first, most common use of calendar spread trading is to generate income. In Chapter Three, we discussed the general characteristics a stock should have to make a covered call an attractive option. These criteria are the same if you intend to apply a calendar spread. They are:
ď‚ˇ ď‚ˇ ď‚ˇ
Flat Trend (usually produced by a channeling stock trading between narrow support and resistance levels) Low Volatility Good fundamentals
Technical indicators such as Stochastic can also be useful in determining the timing of a covered call trade in an income-generating situation. If the stock you are considering is trading in a narrow range between support and resistance, Stochastic will help you identify if the stock is likely to bounce off resistance and move lower by turning down in the upper band. The signal is even more important if it crosses below the 80 line.
Although writing a covered call provides an attractive return that cannot be dismissed, the calendar spread, if you can use it, gives you a way to take advantage of the leverage associated with options, on both sides of the trade. Time decay works in your favor in the
short call, and the delta of the longer-term contract improves your total returns if you are assigned. This enhances your returns well above the level associated with covered calls.
Growth Enhancement Just as using calendar spreads for income looks for the same stock characteristics as using covered calls for income, calendar spreads to enhance growth returns use the same criteria as covered calls to enhance growth. The criteria are as follows:
You already own the longer-term contract. This approach assumes that you are using the long-term option either as a replacement for owning the stock or as an alternative to owning a short-term option. The upward trend has begun to stall, or even retrace back to its primary trend line. Sell an out-of-the-money short-term call at the next closest strike price.
In this scenario, the fundamental strength may not be as important as it would be when you are trying to generate income in a sideways trend. In fact, higher volatility in an upward trend should increase the premium you receive as well as the likelihood you will be assigned. Just as in a covered call play in this situation, being called out of this type of calendar spread would be a good thing. You should lock in an attractive profit in the longterm contract, with the short call premium adding to that overall return.
Since this calendar spread starts as a simple long-term option play, you should manage the risk of the spread in the same way you would an uptrending stock. Adjusting your stop loss as it moves upward will protect your profit while allowing you to remain in the stock as long as it shows strength. When you sell the shorter-term call, you can add the amount of the premium you receive to your stop loss as a buffer. If the stock drops below this price, you would have a net loss in the spread, while still protecting a net profit in the long-term option.
Letâ€™s look at an example for a calendar spread with a stock that is in an overall uptrend; Ishare Brazil (EWZ). Looking at the chart below we can see that the stock likes to make nice wide swings from higher highs to higher lows. We are currently at the bottom of the higher low and resting on the 200 SMA. If you look to the left you can see that EWZ has found support at the 200 SMA each time it has touched it.
We also want to look at the weekly chart since we are buying a LEAP on this stock. The chart below is two years of weekly candles and it confirms our belief in the strength of this stock to continue in the pattern it has produced for the last two years.
We now need to decide which LEAP option to buy and then which front-month option to sell. Remember, we donâ€™t want to get called away in the first month because we are paying much more for our LEAP because of the increased time. If we get called away, we lose all that time value. Below is the current option chain to coincide with the chart for EWZ.
Typically we want to be about 2-3 strikes ITM for a couple of reasons; to get a high delta to simulate stock ownership and to get a small theta. Both of these reasons will work for us by allowing us to simulate purchasing an $82 stock for a fraction of its actual cost, yet still get the gains in price movement. In looking at the theoretical value of the LEAPS we can see that both the $75 and $80 strikes are underpriced. However, we need to consider the front-month strike we will sell and assume that it will be 1-2 strike OTM. Therefore, we would consider the $75 call and perhaps even the $70 call. From a Delta standpoint, the $70 call gives us $0.08 more than the $75 call but it also costs $3.20 more. The difference in Theta between the two is a wash but the Vega (volatility) is higher, as is typically the case, for the closer ATM options. That basically tells us that the $75 call is more susceptible to volatility. With that being the case, letâ€™s focus on the $70 strike for this example. We can buy the $70 strike for $16.20 per contract which would equal $1,620.00. If we were to buy 100 shares of the stock for a covered call we would need to shell out nearly $8,200. That will come in handy when we look at our return on investment using the calendar spread strategy over the covered call. This is the power the knowledge of an option specialist can bring you in trading.
Now that we know which option we are buying we need to decide which option to sell. We know that we want time to work to our advantage so we need to sell a front-month option if possible. We also need to be careful and not sell an option that is too close to ATM or we lose our time premium in our LEAP. Another consideration is if we can get enough premium for the call we sell. In this example, the front-month options are the August options.
EWZ is currently trading at $81.35 and the ATR for the daily candles is $2.45 and the ATR for the weekly candles is $6.60. We arenâ€™t going to use those as we did in the long put and long call but rather to help us gauge how much of a movement to expect before the August expiration (30 days). We can also look at the weekly chart for EWZ and see that it has, in the past, taken about 5-6 weeks to break out above the previous high. The previous high for EWZ is $100 and we know that that level is a difficult one to overcome. We have about 4 weeks in our options and that should not be enough time to reach the $100 price level. In addition, we can also see that after the last break of the previous high the stock trended sideways. We like that and will use this analysis to sell the $90 strike call. By selling the $90 strike we are willing to give up our LEAP if called away. Most option friendly brokerages will allow you to place this trade as one net debit so letâ€™s do the math. We will buy our LEAP for $16.20 and sell the August $90 call for $1.00 which would give us a net debit of $15.20. We would buy an Aug/Jan09 calendar spread for a net debit of $15.20. This is the maximum amount of money we can lose in this trade as well. Think about that for one minute and compare that to the covered call. If the stock were to get some
bad news or some calamity happen in the markets we stand to lose much more if we owned the stock. Assuming we got filled on our order and bought the calendar spread for a net debit of $15.20 we can look at the scenarios of how this would play out.
Below is the worksheet for the calendar spread that is found at the Investview website under the options module. Remember, these are questions that you can ask yourself to increase the odds of success in your trade. Answer as many as possible to allow yourself to make an informed decision.
Pre-trade checklist: o o o o o o o o
Is the trend sideways to mildly bullish? Is the average volume over past 90 days for the stock greater than 500K? Is the short-term option expiration within 2-6 weeks? Is there a front-month call that is slightly Out-of-The-Money (OTM)? Is there a LEAP that is 2-3 strikes ITM? Would you be controlling more than 10% of the open interest? Is the call option volatility high (buy low, sell high)? Have you verified earnings date and checked news headlines?
During trade checklist: o o o o
Is your stop at a technical level on the candlestick chart? Is the sector your stock in mildly bullish to sideways as well? Are the major indices in agreement with your stocks direction? Have you achieved a 40% gain?
Post trade checklist:
o o o
Did you reach your target? If so, how far above the target did the stock close? If not, were you stopped out?
o If you were stopped out was it your original stop or an adjusted one?
Bull Call Spread
A bull call spread consists of buying a lower strike call and selling a higher strike call. The idea is that you believe the stock is going up but it may take some time to reach your target. You may also want to reduce the risk in the trade. You should be able to place the trade as a spread meaning it will have a bid and ask for the spread. Your broker should be able to buy your call and sell the OTM call in one transaction.
Your risk is reduced by the amount you receive for selling the OTM call. As a result, whenever you reduce your risk you also reduce your reward. As an example, if you bought the $50 strike and sold the $60 strike your spread is $10 (60-50). The spread cost $3 to enter so the maximum you can make on the trade is $7 (10-3=7). You also know the maximum you can lose on the trade (3) which is your net debit.
Maximum profit = the difference between the spread minus the net debit Maximum risk = the net debit Break-even point = the strike price of the put you purchased minus the net debit
Letâ€™s walk through an example so we can see how a bull call spread works. Below is a 6 month chart of Arkansas Best (ABFS). The trend is mildly bullish as the stock has climbed steadily but also trends sideways for months.
This is a nice trend for a covered call, calendar spread, or a bull call spread. Look at the close-up below of the technical levels we will use to help us create the bull call spread.
We can see that there is good support at the $35 level and weâ€™d like to think that it will continue to provide support. However, if you look at the gap up (circled in red) you can see that there is also a chance that the stock could fall and fill that gap. Rather than not taking a trade we can account for the possibility of a gap fill while still remaining bullish on ABFS. Letâ€™s look at the option chain to see if we should pursue this trade any further.
What we will be looking for is a call option that is beyond our target of $42 that could provide us enough premium to cover a gap fill. That gap fill is about a $3 move down in the stock so we would like to get about 1/3 of that in premium to help offset the potential loss. In looking at the chain below we can see that the $40 and the $45 strikes would both provide enough to meet our needs.
We want to look at a few of the Greeks before entering this spread and we’ll start with the Delta. Remember that the Delta is how much the option increases with every $1 move in the underlying stock. In a spread we will make the Delta move but we are also responsible for the Delta in the option we sell. Whatever is left over is referred to as the Net Delta and we want it to be at least 0.25.
If we were to buy the $35 strike with a Delta of .65 and then sell the $45 strike with a Delta of .32 we would have a net delta of .33 and that beats our criteria. It also reduces our risk by $1.25 which we will use to give us some cushion if ABFS decides to fill the gap.
Most option friendly brokerages will place this order as a spread for you meaning that they will have a separate bid/ask spread for the spread. This is also known as the “spread of the spread” and is a must have for option specialists. In our example, we are buying the $35 strike for $5.70 and then selling the $45 strike for $1.25. The total net debit for this trade would be $4.45. However, if you look at the bid/ask spread of both options there is a $.50 and $.20 spread in the $35 and $45 strikes respectively. In the spread of
the spread we would actually have a $.70 spread and we can definitely shave some off of that.
We can use that information when figuring out what to place our net debit at when ABFS breaks the prior days high by a percentage of the ATR. Recall that we use the ATR to get us in a trade and out of a trade and ABFS has an ATR of $1.75. If we take 10% of that we have $.18 that we will add to $37.46 (prior dayâ€™s high) for a total of $37.64. ABFS is currently trading at $35.28 so we have about a $2 move in the stock before we would even get triggered.
Knowing what we do now with the trigger we can adjust our net debit bid accordingly. We have a net Delta of .33 and if the stock moves $2 that would give a $.66 gain to the spread of the spread which would also increase our net debit to $5.11. We can also assume that the bid/ask spread for each individual option will be similar and thus so to the bid/ask of the spread of the spread. The end result would be taking half of the spread of the spread difference and adding it to our bid. In our example we would have a net debit of $4.45 plus $.35 (half of the $.70 spread of the spread) for a total net debit of $4.80.
If you look at the risk/reward graph of a bull call spread you can see that we have both defined risk and reward. In this example we have a $10 spread between the $35 strike we bought and the $45 strike we sold. To figure out our maximum reward we simply subtract the net debit from the spread ($10 - $4.80 = $5.20). The maximum risk is whatever our net debit is and for our example it would be $4.80. In a debit spread we want to get at least a 1:1 risk:reward ratio. In our example we will risk $4.80 to make $5.20 which gives us a slightly better than 1:1 ratio.
There are a few scenarios we can have happen and they are pretty straight forward. The best scenario is to have the spread called away from us where ABFS goes above the $45 strike by expiration. This would represent the maximum gain in this trade and saves us from another round of commissions. Another scenario is that ABFS doesnâ€™t make the $45 strike but rather comes up and hits the resistance at $42 for a gain of roughly $6.30. Our option would be worth $7 and the option we sold would be worthless. Therefore, the
spread would be worth $7 and we paid $4.80 for it so we walk away with a profit of $2.20. The other scenario would be that ABFS decides to fall beyond the gap fill and we would sell the spread back to the market for a loss. That loss would be determined by a technical level in the charts as well as your risk tolerance.
Below is the worksheet for the bull call spread that is found at the Investview website under the options module. Remember, these are questions that you can ask yourself to increase the odds of success in your trade. Answer as many as possible to allow yourself to make an informed decision.
Pre-trade checklist: o o o o o o o o o
Is the trend mildly bullish? Is the short-term target reachable in 2-6 weeks? Is the average volume over past 90 days for the stock greater than 500K? Is there a call that is slightly Out-of-The-Money (OTM)? Would you be controlling more than 10% of the open interest? Is your net delta greater than .25? Can you get 5% - 10% return on your investment? Is the call option volatility high? Have you verified earnings date and checked news headlines?
During trade checklist: o o o o
Is your stop at a technical level on the candlestick chart? Is the sector your stock in mildly bullish as well? Are the major indices in agreement with your stocks direction? Have you achieved a 40% gain?
Post trade checklist: o o o o
Did you reach your target? If so, how far above the target did the stock close at expiration? If not, were you stopped out? If you were stopped out was it your original stop or an adjusted one?
Bear Put Spread
A bear put spread consists of buying a higher strike put and selling a lower strike put. Your belief is that the stock will go lower and you want to reduce your risk in the trade. You should be able to place the trade as a spread meaning it will have a bid and ask for the spread. Your broker should be able to buy your put and sell the OTM put in one transaction.
Your risk is reduced by whatever price you get for selling the OTM put. As a result, whenever you reduce your risk in trading you reduce your reward. Your reward is limited to the difference in your spread minus the cost of trade. As an example, if you bought the $50 strike and sold the $40 strike your spread is $10 ($50-$40). The total debit of the spread was $4 so you would subtract your debit from the spread ($10-$4=$6) and that is the maximum you can make on the trade. You also know the maximum you can lose on the trade as that is the net debit ($4) for the spread.
Maximum profit = the difference between the spread minus the net debit Maximum risk = the net debit Break-even point = the strike price of the put you purchased minus the net debit
Letâ€™s look at an example of a bear put spread and work through the details to better understand how it works. Below is a daily chart of Sunpower Corporation and it shows a stock that has been in a mild downtrend for some time.
We can see from the chart that there are potential targets for a 6-month low but there is also a chance that the stock could climb higher before moving lower, to fill the gap, so we need to protect ourselves. We can do that through the use of a spread. Letâ€™s look at a weekly chart of SPWR to see if we can more clearly define a target.
We can see the 6-month low again on the weekly chart, but more importantly we can see a nice, well defined channel that gives us a great target to shoot for. Using the bottom channel as our guide, and the grid, we can assume that we are looking at a target of about $40. We will be conservative and estimate a bit higher than it is and use $45 as our target. This will allow us to better define both the option we are going to buy and the option we are going to sell.
We can get both our target and our stop from the weekly chart above. The target is $45 and the stop is $73.50. With the stock currently trading at $64.82 we need to define our entry into this trade. To do so, letâ€™s look at a close-up of the daily chart.
The prior day’s low is $62.10 and we need to take a percentage of SPWR’s ATR, which is $4.50, and subtract that. If we take $0.45 from $62.10 we get a trigger of $61.65. That is where our put spread order will be triggered live in the market. We now have all the numbers to help us decide which options to use to construct this bear put spread. Below is the option chain for the September SPWR puts that we will use. Since SPWR is currently trading at $64.82 we know that the $65 strike is the ATM strike. We also know that our target is $45 so we can start by looking at the delta of that strike and we see that it is -.10. We know that we want at least a net delta of -.25 so we are looking for a put with a delta of at least -.35. The $60 strike will be close enough as that would make our net delta -.24 and we really can’t justify spending the extra money for the $65 put.
We now have our bear put spread ready to go as we look at buying the $60 put for $6.50 and then selling the $45 put for $1.65 which would give us a net debit of $4.85. We can see that the spread for the $45 put is $.40 and the spread on the $60 put is $.20 which would give us a $.60 spread on the spread of the spread. We want to keep that information and the net Delta of -.24 and figure out where to place our limit net debit order.
With $62.10 being our trigger and the stock currently trading at $64.82 we need a move down of $2.72. With the net Delta being -.24 we can adjust our bid by $.75 (.24 x 3) because the stock is set to drop about $3. Once again, take half of the spread of the spread ($.30 on our example) and add that to our bid plus the expected increase in the net Delta with the stock move. In all, we will need to increase our bid by $1.05. So, our total net debit will be $5.90 on this put spread. We also know that this is a $15 spread so our maximum gain for this spread is $9.10 and that would not quite be a 1:2 risk/reward. We like that and believe that SPWR will reach our target of $45 and allow us to collect the maximum gain. A couple of scenarios need to be addressed with this trade. The best scenario is that WYNN falls to our target of $45 and we make the maximum profit of $9.10. Another scenario is that WYNN falls, but not to $45 but rather the near-term support just above $52. In this case, our spread would be worth $8 (we paid roughly $5.90) so we would make a profit of around $2.10. The other scenario is that we get stopped out as WYNN closes above our stop of $73.50 and our spread would be worth $3.05 ( the stock loss times the delta) for a loss of $2.85. Below is the worksheet for the bear put spread that is found at the Investview website under the options module. Remember, these are questions that you can ask yourself to increase the odds of success in your trade. Answer as many as possible to allow yourself to make an informed decision.
Pre-trade checklist: o o o o o o o o o
Is the trend mildly bearish? Is the short-term target reachable in 6-8 weeks? Is the average volume over past 90 days for the stock greater than 500K? Is there a put you can sell that is Out-of-The-Money (OTM)? Would you be controlling more than 10% of the open interest? Is your net delta greater than -.25? Can you get 5% - 10% return on your investment? Is the put option volatility high? Have you verified earnings date and checked news headlines?
During trade checklist:
o o o o
Is your stop at a technical level on the candlestick chart? Is the sector your stock in mildly bearish as well? Are the major indices still in agreement with your stocks direction? Have you achieved a 40% gain?
Post trade checklist: o o o o
Did you reach your target? If so, how far below the target did the stock close at expiration? If not, were you stopped out? If you were stopped out was it your original stop or an adjusted one?
The strategies we just covered in this chapter are basic strategies to an option specialist. Keep in mind that you are not expected to fully comprehend them at this point. Rather, you are expected to use the tools given in this chapter to paper trade the strategies and see how they work. An option specialist will find a handful of strategies that they employ month in and month out. Whatever you do, do not get discouraged thinking all is lost. It is not lost, but rather right in your face and may be difficult to see.
Letâ€™s move forward at this point to better understand how the volatility in the markets, and in our options, can be used as a trading tool. Volatility, by far, is one of the most misunderstood and applied variables by beginning option traders. Therefore, an option specialist has an in-depth understanding of volatility and tools to actually make money from that understanding. The next chapter focuses on volatility and how it impacts options as well as a few strategies designed specifically for volatility.
Chapter Six Volatility as a Trading Tool Earlier in chapter two, we discussed the fact that options carry a higher level of volatility than their underlying stocks. This increased volatility leads to greater profit potential as well as increased risk. It will be critical to your success as an options specialist to not only be aware of the volatility of a given option contract, but also the different ways an option’s volatility is measured. Once you have an understanding of how to measure and evaluate an option’s volatility, you will be ready to learn trading strategies that are designed to take advantage of specific types of volatility. Options have a number of factors that can affect its price, such as price movement of the underlying stock, time, and supply and demand of the contract itself, to name just a few. Option specialists pay attention to these dynamics using measurements referred to as options Greeks. Earlier in this manual we discussed the Greeks and the effect each has on the pricing of the option using the BlackScholes pricing model. One of the key Greeks we focused on was the delta and how that tells us the amount of money we will make with every $1 move in the underlying stock. As effective as the Delta can be in identifying how much opportunity or risk there may be in a given option contract, it doesn’t provide any insight about the effect of increased supply and demand on a contract. This is an important consideration that option specialists are careful to account for, particularly when they are thinking about using option spread strategies. Option traders often neglect to think about the effect of supply and demand on the contracts they want to trade, because most of the movement an option contract makes is dependent on the movement of the underlying stock. It is important to remember that although options are dependent on the underlying stock’s movement, they are also separate and independently traded securities in their own right. They have their own market and exchanges just as stocks do. For this reason, an increase or decrease in the demand or supply of a given contract
can have a dramatic effect on that contract’s price – even beyond the effect of the underlying stock. Christmas shopping is a good example of how supply and demand can artificially inflate an item’s value. What happened a few years ago when Tickle Me Elmo dolls first hit stores? A simple stuffed toy that would normally run around $30 suddenly cost a lot more; when stores ran out of their supply and people were still clamoring for them, the price reached unimaginable levels. Online auction sites, newspapers ads and the like were offering dolls for hundreds of dollars – far more than anybody would be willing to pay under normal circumstances – and getting it. The same thing often happens to options; it can happen when a stock begins to make a significant move, or sometimes even on nothing more than speculation that the stock could start to make a move. Suppose for a moment that you are looking at a $25 stock, and that your analysis of the stock indicates that it may be about to start a new upward trend. You notice that the stock also offers options. You look at the calls with a $25 strike price for the next few months. Suppose that the $25 contract with a three month expiration is currently priced at $3.50. Daily volume on the option is pretty light, at around 50 contracts. A week later you look at the stock again, and sure enough, it has begun a sharp move to the upside – in fact, the stock is now at $30 only one week later. The three month call is now worth $9.50 – an increase of $6 per share on the option, while the stock only moved $5 in the last week. As you look at the option, you notice that today’s volume was over 1,000 contracts. What happened? Not only did the stock make a dramatic upside move in favor of the call contract, but interest and activity in the contract also picked up dramatically in the week since you last checked. It makes sense that as the stock went up in price, more traders would have become interested in buying the $25 call. If the interest level picks up dramatically or quickly, the option’s price will inflate even more than the effect of the stock’s price movement. Market makers can ask for a higher price for people who want to buy the call, knowing that interest is high. Identifying Changes in Volatility
Now that you are familiar with some of the basic mechanisms used to measure a stock and an optionâ€™s volatility, letâ€™s look at a practical, easy way to identify periods of increasing or decreasing volatility in a stock. Remember that any opportunity to place an option trade comes first from the price action of the underlying stock. It makes sense then that if you can identify periods of increasing or decreasing volatility in a stock, you should also be able to find options in that stock that can give you good opportunities to take advantage of those changes. To apply this method, we need to introduce you to a new technical indicator: the Bollinger Bands (BB).
This is an example of how the BBs move with the stock. The red lines are the upper and lower bands and represent 2 standard deviations away from the simple moving average (the blue line). In this example, and the default, the SMA used is a 20 period moving average.
You can use Bollinger Bands to identify periods of changing volatility in the stock’s movement. Bollinger Bands were designed to visually approximate the contraction and expansion of a rubber band. It makes sense that a rubber band stretched as far as it can go maintains that level of tension only so long; if the force imposing the tension is removed, the band snaps quickly back to its original shape. Stock movement often follows a similar premise. A stock developing a strong trend in either direction is similar to an expanding rubber band; tension on the stock’s trend increases the longer the trend lasts. If the force imposing the current trend (news, institutional buying, strong earnings, etc.) suddenly changes or is removed, the stock will often move in the opposite direction of the trend and experience a period of uncertainty as to the next move. This creates a mostly sideways pattern in the stock that can be compared to the lack of tension in the rubber band when you first release it. In simplest terms, a contraction of the upper and lower bands can indicate a good opportunity to buy an option contract: a call if the middle band is moving up and a put if it is moving down. Spread trading strategies such as straddles and strangles are also well suited to contractions, particularly if the middle band’s trend is sideways. An expansion of the upper and lower bands would indicate points to take profits in any of the previously mentioned strategies. Straddles
At this point you should be familiar with and accustomed to identifying a stock’s trend and trading in the direction of that trend, whether it is moving up or down. However, often overlooked or missed are opportunities to profit when a stock’s trend moves neither up nor down, but sideways. The opportunity in such situations lies in the fact that although a stock can maintain a sideways trend for an extended period of time, they will break out of a sideways pattern and begin to establish a new trend at some point. Often, these break-outs happen very quickly and dramatically, meaning that traders who are properly positioned can realize significant profits when the break out happens.
The difficulty in such situations is not only deciding when the breakout might occur, but also which direction it will break. You could simply guess and buy either a call or put and hope it breaks that way for you, but a sideways trend rarely gives any indication of what kind of directional move will follow. A typical straddle is constructed by buying call and put options on the same stock, with identical strike prices and expiration dates. The most neutral straddle trade will use the at-the-money (ATM) strike price for both the call the put. This puts the watchful trader in position to profit no matter which direction the stock breaks. The risk lies in the possibility that the stock may not break in the timeframe specified by the contractsâ€™ expiration dates. In addition, if the stock doesnâ€™t break far enough to reach your break-even points. Risk/Reward:
Maximum profit = infinite Maximum risk = the net debit Break-even point = strike price minus net debit (lower) or strike price plus net debit (upper)
Identifying Straddle Candidates In general, any stock that has established a recent sideways trend could be a candidate for a straddle trade; but in reality, the risk of picking any sidewaystrending stock is that the current trend could hold for a longer than expected period of time. The real key is not only in finding stocks with sideways trends, but also finding stocks in sideways trends that could have a catalyst in the near-term to propel them out of their current trends. The easiest catalyst to look is earnings. It is not uncommon for stocks to begin to vacillate in their price movement prior to an earnings announcement and establish mostly sideways patterns. Traders and stockholders often get nervous about a stock prior to an earnings release, and speculation about what the companyâ€™s earnings should be runs both to both positive and negative extremes. When the companyâ€™s announcement is finally released, either the buyers or sellers will have been proven right; the stock often will take its near-term direction from that news. This gives straddle traders the best opportunity to profit.
We can see that the stock is trading in a sideways trend for the past three months. We can also see that the Bollinger Bands are contracting and the moving average is just trending sideways. We have found a candidate for our straddle and need to look at the options.
There are options available for July, August, and September. Since the July options are the front-month and have less than two weeks to expiration, we will focus on either the August or September options. Look at the open interest in both months and we can see that the September options have more interest. Letâ€™s check the earnings on FPL as this may impact our decision even further. FPLâ€™s earnings are scheduled for the 31st of July so we should focus on the August options as they will be the most actively traded in the coming weeks as earnings approach. This is due, in part, to the speculation that precedes earnings and the uneducated options trader trying to pick a direction. Below are the option chains for the August calls from our brokerage followed by the puts.
With FPL trading at $67.79 the ATM strike would be the $65s. To purchase the $65 call we will pay $4.50 and to purchase the $65 put we will pay $1.40 so our net debit on this trade will be $5.90. This net debit is how far beyond the current price FPL needs to move in order for us to be at break-even. Letâ€™s draw those lines on the chart.
Keep in mind that this is at expiration meaning the options are beyond their life. We donâ€™t want to hold the options that long and we plan on getting out of the losing leg before expiration. One caveat with straddles is that you are going to pay more for either the put or the call. In this case we spent nearly 3.5 times more money for our calls. With that being said, we could consider this trade as a bullish one since we would only need to gain $1.40 in our call to cover the cost of the put. This topic is one of many traders and can be addressed later when we look at a strangle. Two things we have working for us on this trade is that earnings are approaching and that typically gives a catalyst to break outside the current trend. We also have the probability that the Implied Volatility will increase as earnings approach. Both of these will increase the odds of a successful straddle.
The images below are of the actual readings from our brokerage for the specific options we would buy. They indicate, when looking at the IV chart, that our options are a bit high on the IV (blue line) but we can see a peak of 38 back in January. Ideally, we want to buy options with low IV and sell it when itâ€™s high.
This straddle has a bullish tint to it based upon the outlay for our call versus that of our put. Additionaly, we have over twice the delta in our call which is not ideal either. In reality though, the straddle is a neutral strategy and we really donâ€™t care which direction FPL moves, we just want it to move. Straddles work best for
volatile stocks so be sure to look at the history of the stock for volatility. Gaps in the history of the charts are a good sign as well as big moves after previous consolidation periods. Straddles are not an easy strategy to find good candidates for so use the checklist below to help. Keep in mind that you are looking for volatile stocks that are in a calm (before the storm). Uses the Bollinger Bands that we talked about as well as the Beta of the stock you are trading to give you an idea.
Pre-trade checklist: o Is there pending news? o Has the stock been beyond either break-even point? o Is the average volume over past 90 days for the stock greater than 500K? o Would you be controlling more than 10% of the open interest? o Are the deltas between .25 and .35? o Can you get 5% - 10% return on your investment? o Is the option volatility high (buy low, sell high)? During trade checklist: o Is your option volatility increasing? o Do you have a stop in place? Post o o o o
trade checklist: Did you reach your break-even points? If so, how far above/below the target did the stock close at expiration? If not, were you stopped out? If you were stopped out was it your original stop or an adjusted one?
A long strangle is initiated with the simultaneous purchase of a put option and a call option at different strike prices but at the same expiration. The idea is that you can make money if the stock moves far enough in either direction. Stocks that have pending reports such as FDA announcements, law suits or earnings make the best candidates for long strangles. You truly donâ€™t care which direction the stock moves, you just want it to move. Risk/Reward:
Maximum profit = infinite Maximum risk = the net debit
Break-even point = strike price minus net debit (lower) or strike price plus net
debit (upper) Remember in our discussion on straddles we emphasized the need to sell the negative option back to the market as soon as the stock begins to establish a clear direction. In a strangle trade, by the time the stock passes the strike price of either the call or put option to create a profitable leg, the negative option will often be worthless. This makes it easier to manage the trade; rather than generating an additional commission by selling the negative option at a loss, you can simply let that option expire worthless. Since a greater level of momentum in the underlying stock is required for either leg to be profitable, it is also easier for the profit in the profitable leg to offset the cost of the losing leg. The largest risk in a strangle trade occurs if the stock doesnâ€™t move past either strike price. In this case, neither leg will show a profit. In addition, you will have a greater loss in one leg than the other, depending on which strike is closer to the stockâ€™s price at expiration. For this, it is advisable to maintain the same level of vigilance and attention that you would on a straddle. If the stock fails to gain enough momentum to move past either strike price, you should consider selling the options back to the market before expiration so as to minimize your loss. Letâ€™s look at an example of a strangle using the exact same stock and scenario as the straddle. We can see that the stock is trading in a sideways trend for the past three months. We can also see that the Bollinger Bands are contracting and the moving average is just trending sideways. We have found a candidate for our straddle and need to look at the options.
Below are the calls for the month of August followed by the puts for the month of August. We can structure a strangle using different strike prices.
If we want to remain neutral in this strategy then we need to commit the same amount to both the put and the call. In addition, we donâ€™t want to get a Delta higher than .35 (-.35). Doing this allows our options to not move too much before the breakout. If we look at the choices we have we can buy a $70 call for $1.65, with a Delta of .39 and buy a $65 put for $1.40, with a Delta of -.29 we would have a net debit of $3.05. Letâ€™s put that on the chart to see where our break-even levels are for this strangle.
You can see that the break-even levels have come in quite a bit. However, the put break-even looks more achievable because it is actually within the consolidation. As such, at least at first glance, the thought is that we would be better off with FPL going down. Not true! Look at where the stock is now and we are at even as to whether it goes up or down. Donâ€™t fool yourself! Below is the checklist for the strangle to help you remember what to look for in a candidate. Remember that both the straddle and the strangle are difficult trades to find and manage but they do have their place in the option specialistâ€™s arsenal.
Pre-trade checklist: o Is there pending news? o Has the stock ever been beyond either break-even point? o Is the average volume over past 90 days for the stock greater than 500K? o Would you be controlling more than 10% of the open interest? o Are the deltas between (+/-) .25 and .35? o Can you get 5% - 10% return on your investment? o Is the option volatility high (buy low, sell high)? During trade checklist: o Is your option volatility increasing? o Have you achieved a 40% gain? o Do you have a stop in place? o Post trade checklist: o Did you reach your break-even points? o If so, how far above/below the target did the stock close? o If not, were you stopped out? o If you were stopped out was it your original stop or an adjusted one? You have been introduced to some of the most profitable option strategies used by option specialists. The last few chapters have hopefully opened your eyes up to the wonderful world of option trading. Do not get discouraged if you donâ€™t understand everything that was discussed in this manual. You are not expected to understand everything, but rather use this manual, along with a practice account, to learn the strategies. Set some goals for yourself and use the tools you have to become an option specialist. The next chapter is a summary of what weâ€™ve covered in this manual as well as important information about money management. Remember, to be a successful trader you need to manage risk. Doing so allows you to learn what you are doing correctly and what you are doing wrong. Focus on replicating those things you are doing right and remove those things that are counterproductive.
Chapter Seven Money Management and Options Central to the success of your trading plan is the development of a system that will allow you to manage risk. This is as true of options trading as of any financial market. In previous chapters, you have learned important details about trading strategies such as covered calls, long calls and puts and spreading strategies. You also learned how to define your trading style and risk profile. This section will correlate the various strategies we have covered to your trading style and risk profile. We will also discuss position sizing and risk management principles as they relate to options trading. Determining where the various strategies you have learned fit in terms of their general objective and the amount of risk they usually entail will help you identify which specific strategies you should actually use. You have learned several strategies as well as how to use them profitably; however, most successful, profitable options traders only use one or two specific options strategies. The reason for this is practical as much as it is about keeping things simple. Keeping in mind all of the rules related to every option strategy you have learned or will learn is a big job; you probably have a lot of other demands on your time and attention. There is no such thing as a â€œjack of all tradesâ€? in trading; successful traders understand that they are most effective by specializing in a couple of specific strategies. Concentrating on the one or two specific strategies that best fit you will allow you to master the specific rules, techniques and dynamics that relate to those strategies and trade them to the greatest possible benefit. Weâ€™re not suggesting that once you decide what strategies fit you best initially, all other strategies become irrelevant. Just as trading rules evolve over time, so will your trading style, attitude about risk, and sophistication level. You may find that your needs change over time. Suppose that your initial trading goals and profile are built around growing your portfolio and building wealth so you can eventually quit your job and live on your investments. After a while, you have built the wealth you planned for and are ready to quit your job. Since you will now need to live on the investments you make, your objective has now changed from growth to income, which means that rather than buying calls and puts, you should begin to look at
writing covered calls and using spreads such as calendar spreads, bull call spreads and strangles. Having learned about them previously will make it easier for you to transition to these strategies. There are several ways most people think of themselves when it comes to the kind of trading they do or want to do. Generally speaking, most people think about trading in terms of either what they want to get out of it, or how much risk they are willing to take. When it comes to options, your answer to these questions will help guide you to specific options strategies. You have learned about these strategies already; the objective of this section is to align each strategy to a particular style or risk profile. Objective: Income There are a variety of ways to generate income using options, including spread trading and writing naked options. Both of these strategies are quite advanced, however, and can involve a high level of risk. For our purposes, we will deal with the two simplest, generally most conservative strategies for generating income: covered calls and calendar spreads. Covered Calls Covered calls are an effective method for generating consistent, significant income. The advantage of the covered call strategy is that the call option contracts you sell are completely backed by the shares of the stock that you own. If the stock rises higher than your strike price and you are called out, you simply deliver the stock and your obligation is met. In the meantime, you get the money you put into the stock back (with some appreciation if you have planned the trade correctly) and you keep the premium you were paid at the beginning of the trade. Remember, however that there are two principal drawbacks of covered calls: capital outlay and downside risk. In order to write a single covered call, you must own at least 100 shares of a companyâ€™s stock. If you are writing a call on a $40 stock, for example, you must have $4,000 available to dedicate to the stock for the period you have written the call for. If you intend to generate sufficient income from covered calls to live on, you must plan to allocate a large amount of your available capital into the stocks you will use. In addition, if the stock experiences a sudden drop in price, you are exposed to all of that downside risk
until you buy back the call option you sold. Brokers don’t allow traders to enter a stop loss order on a stock you have written a covered call on, so your downside exposure is somewhat greater. It is critical to make sure that you conduct a thorough fundamental analysis of the stocks you plan to use for covered calls as well as their volatility so as to manage that downside risk more effectively. Many inexperienced traders begin using covered calls to generate income and believe that since it is a conservative strategy, there is no need to follow up on the progress of the stock on a daily basis. The downside risk of covered calls makes this both a false assumption as well as a dangerous one. If you experience a sudden drop in price on a day you haven’t checked the stock, you will experience that entire drop and be left to wonder, “What happened here?” Don’t make the mistake of ignoring stocks you have written covered calls on. Check their charts and their current news on a daily basis to make sure that if something negative does happen, you will be able to react appropriately. Calendar Spreads Calendar Spreads are a variation on the covered calls strategy that many traders like to use. It allows you to combine the conservative, positive aspects of the covered call strategy with some of the strong downside management aspects of spread trading. It also requires a smaller capital outlay than the covered calls strategy. Spread trading refers to trading multiple options contracts on a single stock at the same time. There are several types of spreads that options traders use; a calendar spread is the simplest to understand and execute while still providing an attractive net return on investment. Identifying stocks with attractive potential as a calendar spread trade follows the same logic as the covered call strategy. A calendar spread is a bullish trade; this means that you should look for conservative, stable stocks with flat to up trendlines. The difference is that where you have to own the stock in a covered call setup, in a calendar spread you buy a long-term call contract rather than the stock itself. After the LEAPS contract is purchased, you sell a short-term call option (usually no longer than two months from expiration) to create the spread. Technically, a calendar spread creates a naked call position for the contract you sold. This means that for your broker’s purposes, you will have to have adequate margin or cash in your account to cover the cost of buying the stock if you were
called out of the short-term call contract. In literal terms, however, the margin risk of a calendar spread is minimized by the long-term contract. If the stock rises above the strike price of the call option you sold, you will be called out, but all you have to do is exercise your long-term option to deliver the stock. This does mean that you will have to have enough cash or margin available in your account to purchase the stock at the strike price of the long-term contract. If you have planned the trade correctly, however, you should still have a net profit from the trade. In every other sense, a calendar spread is identical in nature to a covered call, so the same level of attention and vigilance should be given to any calendar spread trade you have entered. Objective: Growth Many investors perceive the need to build wealth, or grow their investment portfolios, as an aggressive approach to the market that necessarily involves high levels of risk. While many strategies do fit this description, there are a number of other approaches to options trading you can take that will allow you take advantage of high growth potential in options trading while minimizing risk at the same time. Of course, higher risk translates to greater profit potential, so besides thinking about how much growth you need to achieve in your investments, you must also find a balance with how much risk you are willing to take. Calls and Puts Buying calls and puts is the most straightforward type of options strategy there is. If you are bullish enough about a stock to want to buy it, a call option allows you to take advantage of the stockâ€™s upside potential without having to put as much capital into the trade. If you think a stock is like to go down in price, you can buy a put option to profit from that downside move without having to rely on margin or tie up large amounts of your capital to close out the trade. The highly leveraged nature of options contracts means that if you guess correctly about the timing and direction of a stock move, you can achieve significantly higher profits than you would by trading the stock itself. This can make trading calls and puts a significant part of an overall growth strategy.
Of course, call and put options trades aren’t necessarily that simple. Short-term options contracts include a high degree of time risk, meaning that if you don’t identify correctly the timing of the move, you can lose significant amounts of your capital in time decay. Also, remember that leverage doesn’t just work on the upside; if you are wrong about the direction, the option contract you have will lose value dramatically faster than if you were to trade the stock. Even if you are a very conservative investor, this doesn’t mean that options won’t work, but rather that these types of aggressive options trades should make up a very small portion of your total investment capital. Protective Puts If your objective is growth, protective puts provide the most conservative approach to growth you can find. This is a straightforward strategy – you simply buy a put option on a stock you already own. The put option provides downside protection if the stock drops in price. You can compare it easily to buying an insurance policy on your car or house. This strategy is also known as a hedge, since it gives you the ability to minimize your risk while still keeping you in position to realize significant profit if the stock increases in value. The downside protection offered by the put generally eliminates the need to maintain a stop loss on the stock, but this luxury doesn’t mean you don’t need to pay attention to the stock. Remember that your put has a finite life; if the stock has dropped and your put is profitable, you should be prepared to sell the put before expiration, take the profit, and purchase another put with a later expiration date to maintain your protection. Also, in order to provide as much protection as possible, you should purchase one put contract for every one hundred shares of the stock you own, which is called being fully hedged. If you own a disproportionate number of puts versus the shares of the stock, the profit in the puts is less likely to sufficiently offset your loss in the stock. Keep in mind that no hedge provides absolute, 100% protection against loss; this strategy is designed only to minimize your loss as much as possible. Straddles Straddles provide traders with a more conservative way to profit from sudden, dramatic changes in a stock’s price than buying the stock outright or using long calls or puts separately. If a stock is currently in a mostly sideways trend or
trading range, a breakout above or below the range or trend is likely. Since predicting which way the stock will break is a 50/50 proposition at best, many options traders use straddles to take advantage of the breakout without worrying or betting that it will move in one direction or the other. One of the easiest ways to look for stocks that could work for this kind of trade is to pay attention to scheduled earnings announcements, since these often act as catalysts for significant changes in a stockâ€™s price. A simple straddle buys a call option and a put option at the same strike price with identical expiration dates. This requires a greater allocation of trading capital than a simple long call or long put, but positions the trader effectively as long a break out occurs before expiration. The risk of this trade lies in the possibility the stock could remain at the same price it was at when the option contracts were purchased; in this event, both options would expire worthless and the trader would lose all of the money invested. Managing a straddle trade requires the trader to pay close attention to the stock on a daily basis. As soon as the stock begins to define a breakout in one direction, the profit in the positive leg will be offset to a certain extent by the loss in the negative leg. For this reason, it is advisable to sell the losing leg as soon as you can see the stock define its new direction. This will minimize the loss on the negative side, and allow you to maximize the gain on the positive side. Strangles Strangles are designed for the same environments and stock patterns as a straddle trade. Stocks in mostly sideways trends with low volatility but the possibility for a significant change in price are the best opportunities to apply a strangle trade. This strategy generally is considered more risky than a straddle because it involves buying out-of-the-money call and put options with equal expiration dates. The lower cost involved with these contracts and the distance the stock must move to create a profit in either of the legs of a straddle mean that you donâ€™t have to plan to sell the negative leg as the stock defines its breakout; by the time you have a profitable leg, the negative leg is more likely to have next to no value at all. This fact makes managing a strangle trade relatively simple as long the stock moves past one of the strike prices you have purchased, but it also underscores the risk of this trade. If the stock doesnâ€™t move far enough in one direction or another, both
contracts could expire worthless and you would lose all of the money involved in the trade. The advantage of a strangle is that if the stock does make a substantial enough move to create a profit on one side of the trade, you will often realize a very significant profit. Stocks that move several dollars in a short period often maintain their momentum for a sufficiently long period of time to create a profit that is more than enough to offset the loss in the losing leg and then some. Theoretically, the upside potential on either of the trade is unlimited, while your maximum loss is restricted to the premiums paid for each contract. Options Strategies and Risk As you have learned, different options strategies provide varying levels of risk. Besides thinking about your objective, you must also consider where each of the options strategies you have learned fits within the level of risk you are willing to take. Risk and objective are often tied to each other; for example, if your primary objective is to produce an income off of your investments, you likely have an accompanying need to preserve the capital you have. This means that many of the more aggressive options strategies such as long calls and puts or selling naked options may not be appropriate for the largest portions of your portfolio, since these kinds of trades tend to place a higher level of risk on your investment capital. Donâ€™t discount the emotional component of risk, however, no matter what your need is. If your primary objective is to grow your investment capital, but from a personal standpoint, the idea of buying short-term call options on a volatile stock makes you sweat and lose sleep, then you should follow a more conservative approach to growing your portfolio. The following table summarizes the general risk profile of the strategies discussed in this course.
Although it is important to make sure that you avoid strategies that would put you in risky trades you canâ€™t tolerate, it is also important to remember that you can often combine the strategies above into a mix that gives both the long-term advantages of a growth objective as well as a measure of the stability associated with using conservative income-producing strategies. This can be a good way to diversify your overall portfolio and spread the risk in your trades in more than a single area. Many conservative investors who rely on their investment capital to produce income still allocate a small percentage of their portfolio to more aggressive, growth-oriented trades. This can be a reasonable approach to take so long as those aggressive trades are limited to a small enough portion of a portfolio to make losing trades manageable. At the same time, even aggressive traders who are seeking to maximize profits as much as possible recognize the value of adding an income component to their portfolio using covered calls or calendar spreads. Managing Risk in Options Remember to consider your options strategy, objectives and risk in the context of your overall investment portfolio. Making sure that you are using stop losses, analyzing risk:reward ratios on individual trades, and limiting the size of the capital you dedicate to a trade are techniques you should already be familiar with; these techniques are as critical to successful options trading as they are to stock trading. One of the guidelines of effective money management is to make sure that any loss you incur in an individual trade is no more than 3% of your total investment capital. Letâ€™s discuss each area and how you can use each to manage your options trades effectively.
Stop Losses By now, placing a stop loss on a stock trade should be an automatic action in every one of your stock trades. If it is, then the idea of using a stop loss on every one of your options trades also makes perfect sense. However, the volatile nature of options contracts can make using stop losses on options a little trickier. One common technique for setting a stop loss at the beginning of a stock trade is to identify a price just below the current support threshold. If the stock breaks your support level, then your stop loss is activated and you sell the stock. Options traders often confused when trying to associate this stock price with a corresponding options contract price. The InvestView favors simplicity on options trades whenever possible, so we will outline a couple of simple approaches to stop losses that will work reasonably well. Since option contracts are inherently more volatile than their underlying stock, one approach many traders use is to place their stop loss approximately 30-50% below the price where they bought the contract. This may sound like a large loss to take on a single trade; remember that the leveraged nature of options means that it is necessary to use wider stops on options trades that you would on stock trades. Placing a stop loss on a stock trade just below current support usually means getting out of the stock if it drops anywhere from 5-10% in price. A 5-10% change in the price of a stock will usually translate to a change in price of around 30-50% in most options contracts, which is why this can be a good general guideline to use. Check with your broker to determine if they allow stop losses on options trades; if they do, you can treat your options trades in nearly the same manner as you would your stock trades. If your broker doesnâ€™t provide this capability, then you will be forced to use a mental stop loss. The other approach you can use is also straightforward, but in most cases requires a higher level of discipline and vigilance. Rather than setting a stop loss on the options contract you just bought, you can apply a stop loss price to the underlying stock. For example, if you bought a call option on XYZ Inc. when the stock was at $30, you might identify a support level for the stock around $28. You could use a stop price of $27 for your options trade. Simply put, if the stock breaks its support zone at $28 and drops to $27, you would be willing to say the stock isnâ€™t going to move in the direction you want, so you would go ahead and sell the contract
and hold on to whatever amount of money is left. Brokers donâ€™t offer the ability to trigger a sell order on an options contract based on a stock move, so this type of stop loss is usually a mental exercise. This is why this approach requires greater discipline than using an automated stop loss through your broker; you have to remember to check the stock on a daily basis, not just the option, and keep track of your stop loss price on your own. Another type of stop loss that is common in stock trading is a trailing stop loss. Trailing stop losses are an effective means to maximize profits in a strongly trending stock; however, the short-term nature of most options contracts makes the idea of using a trailing stop loss nearly irrelevant. This is critical to money management because successful options traders know they need to take profits when the underlying stock reaches their target price; time decay usually prevents options traders from trying to stay in a trade for a longer period of time to take maximum advantage of a trend. The rule you should use for trailing stop losses is simple:
Do not use a trailing stop loss in a short-term options trade. The exception to this rule is when you have purchased long-term contracts or any options contracts that extend three months or more. In these cases, you can often use a trailing stop to protect option profits when the stock reaches your target price if you think the stock will continue to show strength. The difference is that the extended amount of time in an options contract that extends for several months gives you the ability to stay in the stock without having to worry about time decay to the same extent you do in short-term options. Reward:Risk Ratios You have already learned how to analyze reward:risk ratios as they apply to stock trades. The beauty of this skill is that it applies to every kind of trade you can make in the stock or options market. There are no additional techniques that you need to apply to an options trade in analyzing its reward:risk ratio than what you are already familiar with doing. The difference between the current price of a stock and your target price identifies your total projected reward, while the difference between the current price of a stock and its current support (for buying options) or resistance (for selling options) level identifies your total
projected risk. A stock that gives you a 2:1 ratio or better is worth pursuing as a trade, both for stock or options trades. You can also do the same kind of historical analysis of reward:risk ratios by using your options trading history as a tool to identify weak spots in your trading system and make adjustments or refinements. Simply taking the sum total of your gains over a determined period of time and dividing the total by the number of winning trades will give you an average profit, while taking the sum total of your losses over the same period of time and dividing it by the number of losing trade will give you an average loss. If your reward:risk ratio doesn’t equate to 2:1 or better you need to refine your techniques and/or analysis; if the ratio is 2:1 or greater, you’re right on. Position Sizing Position sizing is a critical part of the money management portion of your trading system. On each option trade you make, make sure that you take the time to determine:
What percentage of your total investment capital you will allocate to options trading. What percentage of the options-specific portion of your capital you will allocate to a single options trade.
Remember that the principal purpose of position sizing is to limit the exposure you have in any given trade to significant loss. For example, if you are only allocating 10% of $50,000 to a single stock trade, and in that trade, your use of stop losses limits your potential loss to no more than 10%, then you are only placing a grand total of $500, or 1% of your capital at risk. You can apply position sizing your options trades in a similar manner. Suppose that out of your $50,000 investment capital, you have decided to allocate only a small portion of it to options trades; a conservative allocation would be 10%, or $5,000. Now suppose that out of the $5,000, you determine that you will place no more than 10%, or $500, in a single options trade. If you follow the stop loss guidelines we outlined earlier that suggest placing a stop loss between 30-50% of the cost of the trade, then you are limiting your loss in any single options trade to no more than $150-250. This means that even if you are absolutely wrong on an
options trade, you are still only risking a maximum of 5% of your options allocation, and a mere .5% of your total capital. This would give you the ability to absorb multiple bad trades without dramatically affecting your ability to continue to trade. The numbers listed here are only examples; we don’t recommend any specific numbers for position sizing. You need to take the time to consider how much loss you are willing to absorb in any single stock or options trade and base your position sizing rules on that preference. If you aren’t sure what numbers to use, begin with a conservative approach and experiment with paper trades. You can then modify your allocation percentages on a trade by trade basis to determine what works best for you. Many beginning investors jump into options trading because the leveraged nature of options contracts offers the tantalizing prospect of huge profits if the underlying stock moves even a little bit. Although this concept is true, it often leads traders to make lethal mistakes in their trades. Perhaps the most common mistake is that such traders will ignore position sizing and put large portions of their capital into a single trade. Trading options based on the potential for huge profits on a single trade will ultimately lead you to these kinds of mistakes, which will expose you massive losses when you hit a losing streak. This is why we emphasize the need to apply position sizing on every trade you make, be it a stock or options trade. Even if you are only allocating a small percentage of your capital to options trades as we suggested in our example, when you are right about the direction of the underlying stock, you will still realize significant profits. Let’s suppose that in our $500 example trade, you purchase a call option on a $30 stock. Sure enough, the stock goes up as you anticipated, to $34. This is a $4 move, or about 13%, which would be a great profit if you owned the stock. For your option, the story is even better – your option contract may very likely double in value, making your small, $500 position worth $1,000. Most options trades are very short-term in nature, ranging in length from days to only a couple of weeks. Repeating the process on a regular basis won’t make you rich overnight, but it will ultimately give you substantial profits over time that will add measurably to the results you achieve with the larger portion of your portfolio.
Remember: options trading works best in the context of a regular, consistent, and conservative trading system over time.
On a piece of paper, identify your trading objective, and the level of risk you are willing to take to achieve that objective. From the strategy matrix given earlier in this chapter, which strategies best suit your profile? Evaluate the stocks in your watchlist for the options strategy that would best apply to each. Make a note of the strategy you would use for each one. On each potential trade, determine the reward: risk ratio of the setup for the stock. Remember, the reward:risk of the option trade will be the same. Is the trade justified? Determine how much capital would be required to set up your options trade. How much risk are you exposed to? What is the potential loss as a percentage of your total trading capital? Based on the position sizing information you gathered, which strategies would suit the capital you have to trade with best? Which strategies would expose you to more risk than you should accept? Write these on your paper. Post your notes on the wall next to your computer as a reference to use as you begin your options trading.
You have some tremendous tools at your disposal now in your quest to become an option specialist. The road ahead is an exciting one but will require discipline and fortitude on your part. You have access to a coach, the worksheets, and the newsletters as well as the scans in the Investview Options Module. Use them! Don’t try to go this alone as it is a lonely journey if you do. Share your experiences with others, both bad and good, and be honest to yourself. When you are ready, the advanced options class is waiting and provides even more strategies that build upon those in this class. Some of the strategies you will learn in the advanced options class are the Bear Call Spread, Bull Put Spread, Iron Condor, Butterfly, Back Spreads and Ratio Spreads. You will also learn how to change an option position from bullish in nature to bearish and vice-versa. The life of an option specialist is an envious one and you have found the gate. All the knowledge in the world is useless unless you apply it and grow.
Glossary A Abandonment When a trader allows an option to expire unexercised. AGI (Adjusted Gross Income) A key number used by many different section of the tax code to determine the eligibility of the taxpayer for deductions and credits. As a general rule, you want â€œabove the lineâ€? expenses, such as business expenses, which are used to reduce your AGI. AMEX (American Stock Exchange) Located in downtown Manhattan, this stock exchange consists primarily of index options and shares of small and medium-sized companies. Active Account Refers to a brokerage account in which many transactions occur. Brokerage firms may charge a fee for an account that does not generate an adequate level of activity. Aggregate Exercise Price The total exercise value of an option contract. It is found by multiplying the strike price by the number of shares represented by the contract. For example, if you hold five $50 calls, the aggregate exercise price is 5 x 50 x 100 = $25,000. This is the amount you would have to pay if you decided to exercise all five contracts. Whenever an option is adjusted (through splits are acquisitions, for example), the aggregate exercise price remains the same. For instance, if the above $50 call splits 2:1, then you would hold ten $25 contracts for an aggregate exercise price of 10 x $25 x 100 = $25,000. Alan Greenspan
Chairman of the Federal Reserve Bank. The market reacts very strongly to the occasional comments and remarks he makes about the economy and monetary policy. All-or-None (AON) A type of order restriction that designates that the trader does not want any partial fill. Technically, any buy or sell order is an order to buy or sell up to the number of shares or contracts specified in the order. If a trader wants only the entire order filled or nothing at all, then an AON restriction should be placed. Be aware that AON orders greatly affect how the order is traded. It is possible to not get filled with an AON restriction even though the security traded at or through the price. It is not a good idea to use AON on option orders less than 20 contracts, because each option quote is good for at least that many. American Option A style of option that allows the holder (buyer) to exercise any time prior to expiration. All equity options are American style, as is the OEX index. Generally, call options should not be exercised early (except to capture a dividend or other rare cases), and put options should be exercised early once the put is sufficiently in-the-money (where delta = 1). See also European Option. American Stock Exchange (see AMEX) Analyst An employee of a brokerage, fund management house, or other financial institution who studies companies and makes buy-and-sell recommendations on stocks of these companies. Most analysts specialize in a specific industry. Arbitrage Any trade that generates a guaranteed profit for no cash outlay. The classic case is the simultaneous purchase and sale of the same security in different markets, such as buy IBM for $100 on the New York Stock Exchange and simultaneously sell it on the Pacific Stock Exchange for $101.25. Because so many traders have access to the quotes, this type of arbitrage rarely occurs. Traders who look for arbitrage situations are called arbitrageurs or arbs, and serve important economic functions in the markets because they help to keep prices fair.
Announcement Date The date on which news concerning a given company is announced to the public. It is used in event studies to evaluate the economic impact of events of interest. Ask Price This is the lowest price a market maker will accept to sell a stock. The quoted offer at which an investor can buy shares of stock; also called the offer price. Asset Any possession that has value in an exchange. Assignment When the short option position is notified of the long position's intent to exercise. The long position "exercises" and the short position is "assigned." The long position has the right to exercise; if the trader chooses to exercise, the short position must oblige. At-the-Money A term used to describe an option with a strike price equal to the market price of the stock. Because it is rare to see a stock trade exactly at one of the strike prices, the term is loosely used to mean the strike nearest the current stock price. Authorized Shares Number of shares authorized for issuance by a firmâ€™s corporate charter. Automatic Exercise The process where the Options Clearing Corporation (OCC) exercises an in-themoney call or put without instructions. Generally, equity options are automatically exercised if they are 3/4 of a point or more in-the-money, while index options are exercised it they are in-the-money by one cent or more. If a trader does not wish to have the in-the-money option exercised, he should either sell it in the open market or submit instructions to the broker not to exercise. Away from the Market
A limit order to buy below the current market price (the ask) or to sell above the current market price (the bid). These orders are held as either day or good 'til canceled orders and may not be filled if the market does not reach these limits. B Backspread A type of ratio spread having unlimited profit potential. For example, if a trader is short ten $45 calls and long twenty $50 calls, he is long a call backspread. Similarly, short ten $50 puts and long twenty $45 puts is a long a put backspread. Basis In simple terms, your cost of the asset. If you paid $10/share for stock and $1/share commission, your basis would be $11/share. Bear (Bearish) An investor who believes a stock or index will fall. The term gets its name from the way a bear attacks; it raises it paws and swipes down, simulating a high to low motion. If you think stocks are moving from high to low, you are bearish. Bear Market Any market in which prices exhibit a declining trend for a prolonged period, usually falling by 20% or more. Bear Spread Any spread that requires the underlying stock to fall in order to be profitable. The basic bear spread, for example, would be to buy a $50 put and sell a $45 put, or buy a $50 call and sell a $45 call (with all other factors the same). Any time the trader is buying the high strike and selling the low strike, with all other factors constant, it is a bear spread. Benchmark High The most recent zone of resistance above the current price of the stock on an upward trend. Benchmark Low
The most recent zone of support below the current price of the stock on a downward trend. Beta A measurement of the volatility associated with a stock relative to the S&P 500. A beta of 1.0 means the stockâ€™s volatility is equal to that of the S&P 500. Bid Price The highest price a market maker is willing to pay to buy a security. The price an investor will pay to sell shares of stock. Bid-Ask Spread The difference between the prices buyers are willing to pay and what sellers are asking for. Big Money A term used to refer to institutional money as it flows in and out of the stock market. Black Monday Refers to October 19, 1987, when the Dow Jones Industrial Average fell 508 points after sharp drops the previous week. Black-Scholes Option Pricing Model A theoretical option-pricing model developed by Fisher Black and Myron Scholes. It produces the theoretical value of an American call option with the following five inputs: stock price, exercise price, risk-free interest rate, volatility, and time. It is arguably the single most important piece of research in modern finance theory. Myron Scholes was awarded a Nobel Prize in 1997 for his contributions. Blue-Chip Company A large and creditworthy company which is renowned for the quality and wide acceptance of its products and services, and for its ability to make money and pay dividends. Bond
Debt issued for a period of more than one year. When investors buy bounds, they are lending money. The seller of the bond agrees to repay the principal amount of the loan at a specified time. Breakout A rise in the price of a security above a resistance zone (commonly its previous high price) or a drop below a zone of support (commonly the former lowest price). It can be used as a buy or sell indicator. Broker An individual who is paid a commission for executing customer orders; an agent specializing in stocks, bonds, commodities, or options, and must be registered with the exchange where the securities are held. Bull An investor who thinks the market will rise. Bull Market Any market in which prices are in an upward trend. Bull Spread Any spread that requires the underlying to rise in order to be profitable. A basic bull spread, for example, would be to buy a $50 call and sell a $55 call, or to buy a $50 put and sell a $55 put. Any time the trader is buying the low strike and selling the high strike, with all other factors constant, it is a bull spread. Bullish Refers to the attitude of an investor as being optimistic; an optimistic outlook. Butterfly Spread A spread consisting of at least three different commissions where the trader buys a low strike, sells two middle strikes, and buys a high strike, all equally spaced and on the same underlying. For example, buy one $50 call, sell two $55 calls, and buy one $60 call. The trade can also be done with puts. In addition, synthetic versions of each piece can be used, making more than three commissions.
Another view of the butterfly spread is that it is a bull spread matched with a bear spread either with calls or puts. Butterfly spreads are used primarily by market makers to take advantage of minor price discrepancies between spreads. Buy-Write A trade where the investor buys stock and simultaneously sells a call against it. It is a covered-call position but the buy-write is a way to enter the trade. Both the stock and call are executed at the same time, thereby eliminating market movement risk called execution risk. See also Sell-Write. Buy To purchase an asset, usually taking a long position. Buy-and-Hold A passive investment strategy with no active buying and selling of stocks. Buy Limit Order A conditional trading order that indicates a security may be purchased only at the designated price or lower. Buy on Margin Borrowing to buy additional shares of stock, and using those same shares as collateral. Buy Order An order to a broker to purchase a specific quantity of a security. Buy Stop Order An order to buy that is not to be executed until the market prices rises to the stop price. Once the security breaks through that price, the order is then treated as a market order. Buyerâ€™s Market A market in which the supply exceeds the demand, creating lower prices. C
Calendar Spread See Horizontal Spread. Call Option A contract between two people that gives the owner the right, but not the obligation, to buy stock at a specified price over a given time period. The seller of the call has an obligation to sell the stock if the long put position decides to buy. Capital Money available to invest. Capital Gain When a stock is sold for a profit, the difference between the net sales price of the securities and their net cost results in your total profit, which you then report to the IRS as a capital gain and pay capital gains taxes on. Capital Gains Tax The tax levied on profits from the sale of capital assets. A long-term capital gain, which is achieved once an asset is held for at least 12 months, is taxed at a maximum rate of 20% (for taxpayers in the 28% tax bracket) and 10% (for taxpayers in the 15% tax bracket). Assets held for less than 12 months are taxed at regular income tax levels, and, since January 1, 2000, assets held for at least 5 years are taxed at 18% and 8%. Capital Loss When a stock is sold below cost (sold at a loss), the difference between the net cost of a security and the net sales price. Cash Flow Represents earnings before depreciation, amortization, and non-cash charges; sometimes called cash earnings. This indicates the ability to pay dividends. Cash Market (Spot Market) The market for the underlying stock (or index). For example, some traders may refer to Intel shares of stock as the "cash market" when talking about Intel options. Because options can be used to defer a purchase or sale, the underlying
shares are called the "cash market" or "spot" market (because this is where the asset can be purchased "on the spot"). Cash Settlement A type of option settlement usually used by index options. These options do not deliver or receive shares in the underlying index. Instead, they are settled for the cash value between the closing of the index (subject to specific guidelines) and the strike price multiplied by the contract size. For example, if a particular index closes at $4,050 and a trader holds ten $4,000 strike calls, that trader will receive $50 x 10 x 100 = $50,000 cash the following business day. The trader receives shares of the index and cannot exercise the call. CBOE An acronym for the Chicago Board Options Exchange. This is the largest options exchange in the world. Ceiling The highest price, interest rate, or other numerical factor allowable in a financial transaction. Chart patterns The pattern made by a stock on its stock graph as it fluctuates over a given period of time. These patterns provide traders with information about support and resistance, breakouts, and so on. Clearing House See Options Clearing Corporation. Closing Purchase A transaction where an option seller buys the same contract to close. A closing transaction relieves the seller from the potential obligation under the original sale. For example, a trader sells one XYZ March $50 call to open. The trader may be forced to sell 100 shares of XYZ at a price of $50 if the long position exercises. At a later time, the trader decides he does not want to have this obligation, so he
can buy one XYZ March $50 call to close. The trader's profits or losses depend on the opening selling price and closing purchase price. See also Closing Sale, Opening Purchase, Opening Sale. Closing Sale A transaction where an option buyer sells the same contract to close. A closing transaction removes the rights from the original purchase. For example, a trader buys one XYZ March $50 call to open. This trader may purchase 100 shares of XYZ by expiration in March for $50. At a later time, the trader may decide to sell this right to someone else, so he could sell one XYZ March $50 to close. The trader's profits or losses depend on the opening purchase price and closing selling price. See also Closing Purchase, Opening Purchase, Opening Sale. Close The period at the end of the trading session; sometimes used to refer to the closing price of a stock. Closing Price The price of the last transaction of a particular stock completed during a dayâ€™s trading session on an exchange. Closing Quote The last bid and offer prices of a particular stock at the close of a dayâ€™s trading session on an exchange. Collateral An asset that can be repossessed if a borrower defaults. Collar A strategy where an investor sells calls against a long stock position to finance the purchase of protective puts. From a profit and loss standpoint, it is effectively a bull spread and has limited upside potential and limited downside risk. For example, an investor who owns stock at $100, sells a $105 call, and purchases a $95 put is utilizing a collar strategy. The investor will give up all gains in the stock above $105
but will not take any losses below $95. Also called funnels, range-forwards, cylinders, and split-price conversions. Combination Also known as a combo, this is not a uniquely defined term. Most in the equities market use it to mean a strangle - a strategy where the investor buys a call and a put at different strike prices on the same underlying. For example, a long $50 call and a long $45 put would be a long combo. It has the same basic intention as a straddle with less potential for gains and losses. Commission The fee paid to a broker to execute a trade, based on number of shares, bonds, options, contracts, or their dollar value. Commodity A fixed physical substance that investors buy or sell, usually through futures contracts. Commodities are basic goods and products, such as food, steel, metal, and so on. Common Stock Traditionally, units of ownership that do not give guaranteed payments or dividends to their owners, and are usually limited in their voting power. In return for accepting these restrictions, owners of common stock normally receive all growth over the amount paid to preferred shareholders. Condor A spread involving at least four commissions. The condor trader has similar intentions to the butterfly, except the middle two strikes are split. For example, buy one $50 call, sell one $55 call, sell one $60 call, and buy one $65 call. The condor is a lower-risk, lower-return strategy compared to the butterfly. The condor is really two laddered butterfly spreads. Confirmation The comparison of technical signals and indicators to ensure that the majority of them are pointing in the same direction; information that validates your opinion of a buying or selling opportunity.
Coupon Rate Interest rate on a bond the issuer promises to pay to the holder until maturity, expressed as an annual percentage of face value. The term derives from the small detachable segment of a bond certificate which, when presented to the bondâ€™s issuer, entitles the holder to the interest due on that date. Covered Call (Covered Write) The sale of a call option against a long stock position. The short call is "covered," because the investor will always be able to deliver the shares regardless of how high the underlying moves. See also Naked or Uncovered Positions. CPI (Consumer Price Index) Measure of change in consumer prices, as determined by a monthly survey of the U.S. Bureau of Labor Statistics. Traders use this as a way to track inflation. Also known as the cost of living index. CRB Index (Commodities Research Bureau) An index of 21 of the most influential commodity categories, such as oil, gas, steel, etc. Credit Spread Any purchase and sale of an option that results in a credit to the account. For example, if you buy a $50 call and sell a $45 call, the net will be a credit paid to your account, assuming the two options are traded simultaneously. This is because the lower strike call will always be more valuable and therefore carry a higher price. Likewise, you can buy a $50 put and sell a $55 put simultaneously, which will result in a net credit to your account. With puts, the higher strike will always be more valuable and carry a higher price. With any credit spread, the initial credit is always yours to keep regardless of what happens to the underlying stock. The trade is not risk-free; however, limited losses will occur if the stock lands in a particular range. See also Debit Spread. D Daily Price Limit
The level at which many commodity, futures, and options markets are allowed to rise or fall in a day. Exchanges usually impose a daily price limit on each contract. Day Order A request to buy or sell stock that is good only for the day the order is placed. If the buy or sell request is not filled before the close of the market, the order is cancelled. Most stock buy and sell orders are day orders unless otherwise specified by the investor. Day Trading Establishing and liquidating the same position or positions within one day’s trading. Debt Market The market in which bonds are issued and bought and sold between investors. Debt-to-Equity Ratio Total liabilities divided by shareholder’s equity. This shows to what extent owner’s equity can cushion creditor’s claims in the event of liquidation. Debit Spread Any purchase and sale of an option that results in a debit to the account. For example, if you buy a $50 call and sell a $55 call, the net will be a debit to your account, assuming the two options are traded simultaneously. This is because the lower strike call will always be more valuable and therefore carry a higher price. Likewise, you can buy a $50 put and sell a $45 put simultaneously, which will result in a net debit to your account. With puts, the higher strike will always be more valuable and carry a higher price. With debit spreads, the stock must move in a particular direction to show a profit. See also Credit Spread. Delta One of the "Greeks" denoting an option's sensitivity to the underlying price. Deltas on calls will always range between 0 and 1 and between 0 and -1 for puts. (Delta can sometimes exceed these ranges but only in unusual circumstances and then only for a short while.) If a $50 call option is priced at $5 with delta of 1/2, the option will be worth approximately $5.50 if the underlying moves up one full point (the option
gained 1/2-point to the stock's 1 point). Deltas constantly change and are highly dependent on the strike price, time to expiration, and volatility of the underlying. Delta Neutral A trading strategy typically used by market makers where the total deltas of all positions add to zero (or at least very close to it). Because the underlying stock or index moves, traders must continually adjust their positions to remain delta neutral. Retail commissions often make this strategy too costly to use. Delayed Quote A stock or bond quote that shows bid and ask prices 15 to 20 minutes after a trade takes place. Depressed Market Market in which supply overwhelms demand, leading to weak and lower prices. Derivative Security Any financial asset whose value is determined by the value of another security known as the underlying security. Options and futures are probably the most wellknown derivatives, but there are many others including Collateralized Mortgage Obligations (CMOs), swaps, swaptions, options on futures, and a host of others. Many bonds are derivative securities because they have embedded call or put features. Diagonal Spread A spread where the investor is long a strike at one month and short a strike at another month, with both options being calls or puts and on the same underlying. If the trade results in a net debit (credit), it is a long (short) diagonal spread. For example, if a trader buys a March $50 call and sells a January $60 call, he would be holding a diagonal spread. Quotes are listed in the newspaper with months across the top and strikes down the side. You will see the quotes for a diagonal spread appear on the diagonal of the quote matrix - hence the name. Discount Broker
A brokerage house featuring relatively low commission rates in comparison to a full-service broker. Diversification Dividing investment capital among a variety of securities with different risks, rewards, and correlations in order to minimize risk. Dividend A portion of a companyâ€™s profit paid to common and preferred shareholders. Domestic Market A nationâ€™s internal market for issuing and trading securities or entities domiciled within that nation. Dow Jones Industrial Average (Dow) The best know U.S. stock index. A price-weighted average consisting of 30 actively trade blue-chip stocks, primarily industrial, including stocks traded on the New York Stock Exchange and NASDAQ. It is also a barometer of how shares of the largest U.S. companies are performing. Downtick A move down in a particular stock. Downtrend The stage in which a stock begins making lower highs and lower lows. Downturn The transition point between a rising, expanding economy to a falling, contracting one. Drawdown The total amount of money your trading system will lose during a losing trade or losing streak. Average drawdown can be calculated by adding all of your losing trades over a given period of time and dividing the total by the number of losing trades. This is a way to establish the amount of risk you have taken historically for the reward you have received. E
Earnings Net income for a company during a specified period of time. Earnings Surprise Positive or negative differences from the consensus forecast of earnings by institutions. Effective Date In an interest rate swap, the date the swap begins accruing interest. Entrance/Entry Threshold An entry price to buy stock at a zone of support. EPS (Earning Per Share) Net income for a company during a specified period of time expressed as a per share value. Net income divided by shares outstanding. Equities Market The various exchanges that make up the stock market. Exchange A location where buyers and sellers can exchange securities. This can be a trading floor, such as the New York Stock Exchange, or an electronic, computerized exchange, such as the NASDAQ. Exit Threshold An exit price to sell stock at a zone of resistance. Expected Gains In a money management system, your reward multiplied by your chances of winning over time. Export Goods and products produced in the U.S. and sold in foreign countries. Exponential Moving Average A moving average, calculated over any period of time, where the most recent price information is weighed more heavily than later information.
Ex-Dividend The day on which a stock trades without the right to the dividend. Say XYZ is trading at $100 and pays a $1 dividend with the ex-date being tomorrow. If you buy the stock today (or bought any time prior), you will be entitled to the upcoming $1 dividend. If you wait until tomorrow, the stock will trade for $99 (because the stock price will be reduced by the amount of the dividend), but you will not be entitled to the upcoming $1 dividend. Exercise The procedure where a trader notifies the seller of his intent to buy the stock (if a call) or sell the stock (if a put). The trader wishing to exercise an option simply notifies the brokerage firm, which in turn notifies the Options Clearing Corporation (OCC). The OCC then pairs a short position through random assignment. See also Assignment. Exercise Price e as strike price. It is the price where the buyer and seller of the option agree to transact stock. For example, if a trader has a $50 call, he holds a $50 exercise price and can purchase the stock at anytime for $50. The short position must sell for $50. Likewise, the holder of a $50 put has an exercise price of $50 and may sell the stock for $50 at any time. The seller of the put must purchase the stock for $50. With all else constant, lower call strikes will always be more expensive than higher ones, with the reverse being true for puts. Expiration Technically, option expiration (for equities) is always the Saturday following the third Friday of the month. If a trader has an October call option, it can no longer be exercised after that point. But for trading purposes, the last day to buy or sell an option will be the third Friday of the month. Equity options can be traded until 4:02 EST and 4:15 EST for index options. European Option
A style of option that allows the holder (buyer) to exercise only at expiration. Most index options are European-style with the exception of OEX. See American Option. Extrinsic Value Same as time value. An option's price can be separated into two components: time value (extrinsic) and intrinsic value. The intrinsic value is the amount by which the option is in-the-money, and the extrinsic value is the remaining amount. The following equation may help: option premium - intrinsic value = time value. See also Intrinsic Value, In-the-Money. F Fair Value The theoretical value of an asset. Fakeout The event that occurs when a stock appears poised to break through a zone of support or resistance but fails to do so. A false trading signal that can be minimized through the use of filtering techniques. Federal Reserve Bank One of the 12 banks that, with their branches, make up the Federal Reserve System. These banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The role of each Federal Reserve Bank is to monitor the commercial and savings banks in its region to ensure that they follow Federal Reserve Board regulations and to provide those banks access to emergency funds. The reserve banks act as depositories for member banks in their regions, providing money transfer and other services. Each of the banks is owned by the member banks in its district. Fed Funds Rate The rate banks charge to each other to cover Federal Reserve requirements. These are usually very short term loans, often overnight.
Fed Funds Discount Rate The rate at which banks can borrow money from the Federal Reserve Bank. Usually a relatively slow-changing rate, it is adjusted up or down in increments as the Fed deems necessary to boost the economy or guard against inflation. The stock market reacts dramatically to changes in this rate. Filtering (see Price Filter, Time Filter, Volume Filter) A method used to determine whether a market is breaking or holding support or resistance zones. Financial Analysis An analysis of a companyâ€™s financial statement, usually done by financial analysts. Financial Analysts Professionals who analyze financial statements, interview corporate executives, and attend trade shows of companies in order to write reports recommending either purchasing, selling, or holding various stocks. Also called securities analysts and investment analysts. Fiscal Quarter The three-month period of time the company uses to track their quarterly performance. All quarterly statements and financial reports are tied to this time period. Although this quarter often follows standard calendar quarters, it just as often does not. The quarter period a company follows is dictated by its fiscal year. Fiscal Year The twelve-month period of time the company uses to track their yearly performance. All year-end statements and financial reports are tied to this time period. Although many companyâ€™s fiscal years follow the standard calendar year (January â€“ December) it is just as common that they do not. A fiscal year can begin and end in any twelvemonth period on the calendar. Fixed Percentage A money management technique to dictate how much of the investment capital an investor has will be used in a single trade. Encourages more conservative position sizing which helps to minimize risk. Flight to Quality
Moving capital to the safest possible investment to protect oneself from loss during an unsettling period in the market. This movement can manifest itself in any of the various financial markets; for example, unexpected volatility and risk in the stock market often results in investors selling stocks and buying more government bonds. Float Shares outstanding minus insider holdings. The float consists of all shares that are available for trade in the stock market at any given time. This number can help identify how liquid a stock is as well as how much control of the stock insiders maintain. Fluctuation A price or interest rate change. Forecasting Making projections about future performance on the basis of historical and current conditions data. Full-Service Broker A broker who provides clients an all-inclusive selection of services such as advice on security selection and financial planning. Fully Invested Used to describe an investor whose assets are totally committed to investments, typically stock. Fundamental Analysis Security analysis that seeks to detect mis-valued securities through an analysis of a firmâ€™s business prospects and historical performance, focusing on earnings, dividend prospects, expectations for future interest rates, and risk evaluation of the firm. Futures A term used to designate all contracts covering the sale of financial instruments or physical commodities for future delivery on a commodity exchange. Futures Contract
An agreement to buy or sell a set number of shares of a specific stock in a designated future month at a price agreed upon today by the buyer and seller. The contract is often traded on the futures market. A futures contract differs from option as an option is the right to buy or sell, while a futures contract is the promise to actually make the transaction. G Gain A profit on a securities transaction recognized by selling a security for more than security originally cost. The gain is the difference between the cost and the sale. Gamma One of many "Greeks" used in options. It denotes the sensitivity of an option's delta with respect to the underlying stock. It can be viewed as the delta of the delta. Long call and put positions have positive gamma, while the short positions have negative gamma. It measures the speed component of the option and therefore its risk. High gamma positions are riskier relative to low gamma with all other factors the same. Good 'Til Canceled (GTC) An order time limit that specifies to leave the order open until it is either filled or canceled by the investor. The New York Stock Exchange allows for a maximum time limit of six months, but brokerage firms have the liberty to make the restrictions tighter. Check with your brokerage firm for the specific time frame designated by their GTC orders. See also Day Order, Fill or Kill, Immediate or Cancel. Greeks There are five main Greek letters used to specify an option's price sensitivity: 1) Delta (sensitivity in relation to movements of the underlying stock), 2) Gamma (sensitivity in relation to speed of movement of the underlying), 3) Vega (sensitivity in relation to volatility), 4) Theta (sensitivity in relation to time) 5) Rho (sensitivity in relation to interest rates). Gross Profit
Sales minus the cost of goods sold. Gross Profit Margin The gross profit divided by sales, which is equal to each sales dollar left over after paying for the cost of goods sold. Growth Opportunity Opportunity to invest in profitable projects. H Hedge A transaction that reduces the risk of an investment. Hedging A strategy designed to reduce investment risk using call options, put options, short-selling, or futures contracts. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss; it help lock in profits. Held Order An order that must be executed without hesitation or if the stock can be bought or sold at that price in sufficient quantity. High-Tech Stock Stocks of companies operating in high-technology fields. Intel, Microsoft, IBM, Yahoo! and Amazon.com are example of high-tech stocks. Hold To maintain ownership of a stock over a long period of time; also a recommendation of an analyst who is not positive enough on a stock to recommend a buy, but not negative enough on the stock to recommend a sell. Horizontal Spread A spread where the trader buys and sells options of the same type - either calls or puts - on the same underlying with the same strike, but with different times to expiration. For example, if a trader buys a March $50 and sells a January $50, that is a horizontal spread. If the trade results in a debit, it is called a long
horizontal, and a short if a credit is received. Also called a time or calendar spread. I IRA (Individual Retirement Account) Tax deferred accounts one can contribute to as long there is earned income; the individual maximum annual contribution is $2,000, although spouses can also make contributions even if they do receive earned income. Contributions are deductible so as the taxpayer does not earn more than $51,000 and is not covered by a pension plan. Implied Volatility The volatility necessary to put into the Black-Scholes Option Pricing Model to produce the current quote on the option. It is the forward volatility of the underlying stock that is implied by the market price. In-the-Money A call option with a strike below or a put option with a strike above the current stock price are said to be in-the-money. This is also the amount of intrinsic value of an option - the amount that would be received if exercised immediately. For example, if the stock is $103.50, a $100 call is $3.50 in-the-money. If the trader exercised the call immediately, he would receive stock worth $103.50 and pay only $100 for a net gain of $3.50. Any amount above this $3.50 figure in the option's premium is called time or extrinsic value. See also Out-of-the-Money, Extrinsic Value. Intrinsic Value An option's intrinsic value is the amount by which it is in-the-money. See also Inthe-Money, Extrinsic Value. Independent Financial Market A financial market that trades a specific type of financial instrument. The stock market, bond market, currency market, and commodity market are all examples of
independent financial markets, because although each can impact the other, they don’t necessarily depend on each other to operate on their own. Index Statistical composite that measures changes in the economy or in financial markets, often expressed in percentage changes from a base year or from the previous month. Indices measure the ups and downs of stocks, bonds, and some commodities markets, in terms of market prices and weighting of companies in the index. Indicator A technical or fundamental measurement securities analysts use to forecast the market’s direction, such as investment advisory sentiment, stock trading volume, interest rates direction, and corporate insiders’ buying or selling. Individual Investor Average, typical investors who trade their own money, rather than doing it for institutions. Even wealthy, very successful investors who trade their own accounts are considered individual investors. Industry A subcategory of market organization below the sector level. Industry Groups A subcategory of market organization below the Industry level. Inflation Rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market – too much money chasing too few goods. Moderate inflation is a common result of economic growth, while prices rising at more than 100% per year are considered hyperinflation and reflective of a lack of confidence in the dollar. Interest Rates Cost of borrowing money, expressed as a rate per period of time, usually one year, in which case it is called an annual rate of interest. Intermarket Analysis
The process of analyzing each of the independent financial markets to determine their impact on the stock market. Intermediate Trend A trend period of six to nine months. Changes in the Intermediate Trend are generally taken as market corrections. Insider Information Material information about a company that has not yet been made public. Insiders Directors and senior officers of a corporation; those who have access to inside information about a company; someone who owns more than 10% of the voting shares of a company. Institutional Investors Money invested in the market by mutual funds, investment banks, insurance companies, brokerage houses, and major corporation. Large dollar volume transactions that can dramatically impact the price of a stock in a short period of time. Investment Income The revenue from a portfolio of invested assets. Investment Manager The individual who manages a portfolio of investments; also called a portfolio manager or money manager. Investments The study of financial securities, such as stocks and bonds, from the investorâ€™s viewpoint. Investment Strategy A strategy an investor uses when deciding how to allocate capital among several options, including stocks, bonds, cash equivalents, commodities, and real estate. Investor
The owner of a financial asset; one who is looking to earn money in the stock market through a “buy and hold” strategy. Most earnings are either long-term capital gains, dividends, or interest. Import Goods and services brought into a country from sources outside its borders. Iron Butterfly A butterfly spread constructed by a bull spread with calls and a bear spread with puts with all options representing the same underlying and expiration date. It can also be viewed as a long straddle paired with a short strangle. A long iron butterfly is equivalent to a short butterfly. K Kappa See Vega. Keogh Plan A type of pension plan in which taxes are deferred. Available to those who are self-employed. L Large-Cap Stock A stock with a high level of market capitalization, usually at least $5 billion in market value. Leader A stock or group of stocks first to move in a market upsurge or downturn. LEAPS® An acronym for Long Term Equity Anticipation Securities. LEAPS are just longerterm options with expirations up to three years. Because of the time involved, there are many strategies available with LEAPS that cannot be done with regular options.
Leverage This rising or falling at a proportionally greater amount than comparable investments; a given stock price change that may result in a great increase or decrease in the value of the investment. Liabilities Claims on the assets of a company or individual â€“ excluding ownership equity. Characteristics: 1) It represents a transfer or assets or service at a specified or determinable date. 2) The firm or individual has little or no discretion to avoid the transfer. 3) The event causing the obligation has already occurred. Limit Order An order to buy stock at or below a specified price, or to sell stock at or above a specified price. A conditional trading order designed to avoid the danger of adverse unexpected price changes. Listed Stocks Stocks traded on an exchange. Long-Term In accounting terms, one year or longer. Long Term Capital Gains Gains from the purchase or sale of capital assets that are held for longer than 12 months. Long-Term Investor A person who makes investments for a period of at least five years in order to finance his or her long-term goals. Lower Band The bottom range of a technical oscillator such as MACD or Stochastics. M MACD
A hybrid technical analysis tool which combines the characteristics of an oscillator with trend tracking to identify buying and selling signals. Majority Shareholder A shareholder who is part of a group that controls more than half of the outstanding shares of a corporation. Margin Allows investors to buy securities by borrowing money from a broker; the difference between the market value a stock and the loan a broker makes. Margin Account An account that can be leveraged, in which stocks can be purchased for a combination of cash and a loan. The load is collateralized by the stock; if the value of the stock drops sufficiently, the owner must either put in more cash, or sell a portion of the stock. Market Analysis An analysis of technical, corporate, and market data used to predict movements in the market. Margin Call A demand for additional funds because of adverse price movement in a stock bought on margin; maintenance margin requirements; security deposit maintenance. Market Capitalization The total dollar value of a companyâ€™s equity. Calculated by multiplying the current price of the stock by the shares outstanding. Market Ceiling The most immediate zone of resistance in a stock. Market Floor The most immediate zone of support in a stock. Market Guide A report produced by Multex.com to compile recent and current financial statement data such as earnings, revenues, etc. for the entire stock market.
Market Index A measure of the market consisting of weighted values of the components that make up a certain list of companies. A tracking of the performance of certain stocks by weighting them according to their prices and the number outstanding shares using a particular formula. Market Opening The start of a formal trading day on an exchange. Market Order An order to buy or sell a stated amount of a security at the most advantageous price obtainable after the order is presented in the trading crowd. Special restrictions cannot be specified (all or none or good till cancelled orders) on market orders. Market Prices The amount of money a willing buyer pays to acquire stock from a willing seller. Market Research A technical analysis of factors such as volume, price trends, and market breadth that are used to predict price movement. Market Return The return on the market portfolio. Market Risk Risk that cannot be diversified away. Market Share The percentage of total industry sales that a particular company controls. Market Value The price at which a security is trading and could presumably be purchased or sold; what investors believe a stock is worth, calculated by multiplying the number of shares outstanding by the current market price of the stock. Mature To cease to exist; to expire.
Merger An acquisition in which all assets and liabilities are absorbed by the buyer; any combination of two companies. Midcap A stock with a capitalization of usually between $1 billion and $5 billion. Momentum The amount of acceleration of an economic, price, or volume movement. Money Management A complete, holistic set of trading rules and specifications that defines how you should make your stock trades. Establishes the balance you need to maintain between reward and risk to be successful in your trading over time. Moving Average The mean price of a stock calculated at any time over a past period of fixed length to help define trend direction and support and resistance zones. Moving Average Crossover The point when moving averages reflecting different time periods (such as a 20day MA and a 50-day MA) intersect and cross. Depending on the direction of the trend, these crossovers can be seen as critical breakthrough points to the upside as well the downside. Many oscillators use these crossover points to identify specific buying or selling signals. N NASDAQ The National Association of Securities Dealers Automatic Quotation System. A nationwide computer network for buying and selling NASDAQ-listed stocks. Naked (Uncovered) A short position not covered by an offsetting position. A trader who sells calls to open is short the call. If the underlying stock is not in the account, that call is naked (uncovered). Naked positions are considered to be the most risky because
they have unlimited liability (or nearly unlimited for puts) to the trader. Naked positions require margin deposits to ensure performance by the trader. Narrow Market An inactive market, which displays large fluctuations in prices due to a low volume of trading. Narrowing the Spread Reducing the difference between the bid and ask prices of a security. Net The gain or loss on a security sale as measured by the selling price of a security less the adjusted cost of acquisition. New York Stock Exchange (NYSE) The most well-known stock exchange in the world. Also called the Big Board or the Exchange. News Daily events reported on news programs and the Internet which can often have a sudden and dramatic effect on the price of a stock. NYSE Composite Index Composite index covering price movements of all common stocks listed on the New York Stock Exchange. It is based on the close of the market on December 31, 1965, at a level of 50.00 and is weighted according to the number of shares listed for each issue. The composite index is supplemented by separate indexes for four industry groups; industrial, transportation, utility and finance. O Offer Price Indicates a willingness to sell at a given price. Open Having either buy or sell interest at the indicated price level and side. Open Interest
The net long and short positions for any option contract. If a trader "buys to open" and another "sells to open," then open interest will increase by the number of contracts. This is because both traders are opening. If one "buys to open" and the other "sells to close," then open interest will remain unchanged. Finally, if one "buys to close" and another "sells to close," then open interest will decrease by the amount of the contracts. Open Position A long or short position whose value will change with a change in prices. Opening The beginning of the trading session officially designated by an exchange during which all transactions are considered made â€œat the openingâ€?. Opening Price The range of prices at which first bids and offers are made on an exchange. Options Clearing Corporation (OCC) The organization that acts as a buyer to every seller and a seller to every buyer, thereby guaranteeing the performance of the exchange-traded contracts. Order Instruction to a broker/dealer to buy, sell, deliver, or receive securities or commodities that commits the issuer to the terms specified. Oscillator A tool used to confirm trend direction and short-term buying and selling signals. Oscillators are generally designed to measure momentum and overbought/oversold conditions. Out-of-the-Money A call option with a strike above and a put option with a strike below the current stock price. Also, an option with no intrinsic value is said to be out-of-the-money. For example, if the stock is $100, a $105 call and a $95 put are out-of-the-money. See also In-the-Money, Extrinsic Value.
Over the Counter (OTC) A market in which securities transactions are conducted through a telephone and computer network connecting dealers in stocks and bonds, rather than on the floor of an exchange. The NASDAQ is an OTC market. Also, a stock that is not listed and traded on an organized exchange (bulletin board stocks, for example) are traded over the counter. Overbought A condition in which a stock is considered to have risen as much as it is likely to in the short term, forecasting a short-term pullback. Oversold A condition in which a stock is considered to have dropped as low as it is likely to in the short term, forecasting a short-term increase in price. P Par Value The face value of a bond. A bond selling at par is worth the same dollar amount it was issued for or at which it will be redeemed at maturity. Paper Gain/Loss Unrealized capital gain/loss on securities held in a portfolio based on a comparison of the current market price to the original cost. Paper Trading Placing stock trades in paper format rather than with actual dollars to gain experience in using research and timing techniques without putting investment at risk. Parity An option trading with only intrinsic value; the time value is zero. For example, with the stock at $104.50, the $100 call trading at $4.50 is trading at parity. See also In-the-Money, Extrinsic Value. P/E Ratio The price to earnings ratio, which is calculated by dividing the current stock price by trailing annual earnings per share or expected annual earnings per share.
Peak The high point at the end of an economic expansion until the start of a contraction. PEG Ratio A derivation of the P/E ratio and expected growth rates. It is calculated by dividing the current P/E ratio by the expected EPS. Portfolio Manager A professional who assumes responsibility for the securities portfolio of an individual or institutional investor. In return for a fee, the manager manages the portfolio and chooses which types are most appropriate over time. Position A market commitment. The number of shares bought or sold for which no offsetting transaction has been entered into. The buyer of a security is said to have a long position, and the seller of a security is said to have a short position. Position Sizing The process of determining what portion of an investorâ€™s capital should be placed in a single position. This is an important component of risk management in an effective trading system. Preferred Shares Shares that give investors a fixed dividend from the companyâ€™s earnings and entitle them to be paid before common shareholders. Premium The amount paid for an option. The option's premium can be further broken down into intrinsic value and time value. Price Divergence A condition in which technical indicators such as Stochastics and MACD begin to move in the opposite direction of the price of the stock. Rather than confirming a buying signal, this is a warning sign in an up trending stock. Price Filter
A method for identifying breakthroughs of support and resistance zones. Price filtering refers to waiting for a stock to break through a specific price that has been identified as support or resistance before initiating a buy order on the stock. Price Spread See Vertical Spread. Primary Market Where a newly issued security is first offered. All subsequent trading of this security occurs in the secondary market. Primary Trend The longest term trend, lasting nine months to two years. This trend is most directly impacted by the fundamental strength of the broad economy. Prime Rate The interest rate banks charge to their most creditworthy customers, and which acts as a baseline for loans to less creditworthy customers. Profit Revenue earned minus the cost and the commission. Total amount made on the transaction. Profit Forecast A prediction of future profits of a company that could affect investment decisions. Profit Margin An indicator of profitability. The ratio of earnings available to stockholders to net sales. Determined by dividing net income by revenue for the same 12-month period. Also known as net profit margin. Profit Taking Action taken by short-term securities traders to cash in on gains created by a sharp market rise, which pushes prices down temporarily but implies an upward market trend. Public Offering
A stock offering to the investment public, after compliance with registration requirements of the SEC, usually by an investment banker or a syndicate made up of several investment bankers, at a price agreed upon between the issuer and the investment bankers. Public Ownership The portion of a companyâ€™s stock that is held by the public. Publicly Held Describes a company whose stock is held by the public. Publicly Traded Assets Assets that can be traded in a public market such as the stock market. Purchase Order A written order to buy specified goods at a stipulated price. Put Option A contract between two people that gives the owner the right, but not the obligation, to sell stock at a specified price over a given time period. The seller of the put has an obligation to buy the stock if the long put position decides to sell. Q Quarterly Occurring every three months. Quoted Price The price at which the last trade of a particular security or commodity took place. R Rally (Recovery) An upward movement in the price of a stock or the broad market. Range The high and low prices recorded during a given period of time.
Ratio Spread Any spread having unequal long and short positions. Specifically, if the trader has unlimited risk, it is a ratio spread. If the trader has unlimited profit potential, it is a backspread. Real Time A stock or bond quote that is current with the current buy or sell price of the stock or bond. Realized Return The return that is actually earned over a given time period. Recession A temporary downturn in economic activity, usually indicated by two consecutive quarters of a falling gross domestic product. Relative Strength The rate at which a stock falls relative to other stocks groups in a falling market or rises relative to other stocks in a risking market. Analysts reason that a stock that holds value on the downside will be strong performer on the upside and vice versa. This logic can also be applied to industry group and sector comparisons. Resistance A price level above which it is supposedly difficult for a security or market to rise. A price ceiling at which technical analysts and traders note persistent selling of the security or market. Return The change in the value of a portfolio over a period of time, including any distributions made from the portfolio during that period. Return on Equity (ROE) An indicator of profitability determined by dividing net income for the past 12 months by stockholder equity and shown as a percentage. ROE is used to measure how a company is using its money. Return on Investment (ROI)
Book income as a proportion of net book value. Revenue Total dollars brought into a company through sales, stated on a quarterly and annual basis. Reversal A change in the direction or trend of a stock. Reward: Risk Ratio The potential reward in a given trade or set of trades over time divided by the amount of risk taken. If a trade appears to have $2 of upside potential against $1 of downside potential, then the reward: risk ratio is 2:1. A critical component of risk and money management. Rho One of the "Greeks" representing the sensitivity of an option's price for a small change in interest rates (usually considered to be a 1% change in rates). Risk The risk that the issuer cash flow will not be adequate to meet its financial obligations. Additional risk a companyâ€™s shareholder bears when the firm uses debt and equity. Risk Factor A set of common factors that impact returns (e.g., market return, interest rates, inflation, etc.). Risk Management (see also Money Management) The process of identifying and evaluating risks and selecting and managing techniques to minimize risk. Roth IRA A type of IRA account that allows contributors to invest up to $2,000 per year, and for assets to grow completely tax-free, and to withdraw the principal and earnings tax-free under certain conditions. This differs from a traditional IRA, however, in that yearly contributions are not tax deductible. S
Scaling In A conservative approach to position sizing an money management that places smaller amounts of money in a position at the beginning of the trade, then increases the size of the position as the stock extends into an upward trend. SEC Securities and Exchange Commission. A federal agency that regulates the U.S. financial markets, as well as overseeing the securities industry and promoting full disclosure in order to protect the investing public against malpractice in the securities market. Sales Forecast A key input to a firmâ€™s financial planning process based on historical experience, statistical analysis, and consideration of various macroeconomic factors. S&P 500 Composite Index An index of 500 widely held common stocks that measures the general day-to-day performance of the market. Sector Used to characterize a group of securities that are similar with respect to maturity, type, rating, industry, and coupon. Sector Rotation The flow of institutional money into various sectors of the stock market. Securities Stocks and their derivatives, bonds, and commodities. Any financial instrument that can be publicly traded. Sell Limit Order Conditional trading order that indicates a security may be sold at the designated price or higher. Sell Off The sale of securities under pressure. Sell Order
An order that may take many different forms by an investor to a broker to sell stock, bond, option, future, mutual fund, or other holding. Sell-Write A trade where the investor shorts stock and simultaneously sells a put against it. It is a covered-put position but the sell-write is a way to enter the trade. Both the stock and put are executed at the same time, thereby eliminating market movement risk called execution risk. See also Buy-Write. Sellerâ€™s Market A market in which demand exceeds supply. As a result, the seller can often the dictate the price and terms of the sale. Selling Short Selling a stock not actually owned. If an investor thinks the price of a stock is going down, the investor could borrow the stock from a broker and sell it. Eventually, the investor must buy the stock back on the open market to close the position and repay the obligation to the broker. Sentiment The general attitude or feeling about a stock or market. Most accurately reflected by tracking buying and selling volume. Shareholder A person or entity that owns shares or equity in a corporation. Shareholder Equity Total assets minus total liabilities of a corporation. Shares Certificates or book entries representing ownership in a corporation or similar entity. Shares Outstanding Shares of a corporation, authorized in the corporate charter, which have been issues and are outstanding.
Short One who has sold a contract to establish a market position and has not yet close out the position through an offsetting purchase. Short Position Occurs when a person sells stocks he or she does not yet own. Shares must be borrowed from the broker before the sale to make â€œgood deliveryâ€? to the buyer. Eventually, the shares must be bought back to close out the transaction. This is done when an investor believes the stock price will drop. Short-Term Any investments with a maturity of one year or less. Short-Term Gain/Loss A profit or loss realized from the sale of securities held for less than a year. This is taxed at normal income tax rates if the net total is positive. Short-Term Trend A trend that lasts two to four weeks. Changes in the short-term trend generally come about from random news events such analyst ratings and downgrades and profit forecasts. Sideways Trend (see Trendless) A horizontal price movement within a narrow price range over an extended period of time, creating the appearance of a relatively straight line on a stockâ€™s price graph. Simple Moving Average A moving average that is calculated by adding the closing prices over a given period of time, then dividing the sum by the number of days in the period. Each day in the calculation is given the same weight. This contrasts with an exponential moving average which places a heavier weighting on the most recent days. Slump A temporary fall in performance, often describing consistently falling security prices for several weeks or months. Small-Cap
A stock with a small capitalization, meaning a total equity value of less than $500 million. Smart Money Experienced, sophisticated investors who use advanced techniques to track sector rotation and institutional money flow as a guide for stock trades. Speculation Purchasing risky investments that present the possibility of large profits, but also pose a high-than-average possibility of loss. Split When a company splits its outstanding shares into more shares. The investorâ€™s equity in the company remains the same, and the share price of the owned is onehalf the price of the stock on the day prior to the split. Spread Any position consisting of a long and short position. If the spread is on the same underlying stock, it is an intra-market spread. If it is over different securities, it is an inter-market spread. For example, long $50 call and short $55 call is a vertical spread. See also Horizontal Spread, Time Spread, Vertical Spread, Diagonal Spread. Stage I Trend The highly speculative early period of an upward trend. The immediate trend at this time is flat or sideways. Stage II Trend The period of an upward trend immediately after a breakout from support or resistance zones. The period of time where investors buy into a stock hoping the early price surge will continue. Stage III Trend The final upward thrust of an upward trend when everybody that wants to be in the stock now is. This is usually the beginning of the end of the upward trend. Stage IV Trend
The final period of the upward trend where the stock begins to test support zones and fails to break resistance zones, resulting in a sideways movement of the stock. Stochastics An oscillator that measures overbought and oversold conditions in a stock over time. Stock Ownership of a corporation indicated by shares, which represent a piece of the corporationâ€™s assets and earnings. Stockbroker A person registered with the CFTC who is employed by and solicits business for a commission house or futures commission merchant. Stock Buyback A corporationâ€™s purchase of its own outstanding stock, usually in order to raise the companyâ€™s earnings per share. Stock Certificate A document representing the number of shares of a corporation owned by a shareholder. Stock Dividend The payment of a corporate divided in the form of stock rather than case; often used to conserve cash needed to operate the business. Stock dividends are not taxed until sold. Stock exchanges Formal organizations approved and regulated by the SEC that are made up of members who use the facilities exchange certain common stocks. Stock Index An index such as the Dow Jones Industrial Average that tracks the performance of a basket of stocks. Stock Market Also called the equities market.
Stock Split Occurs when a firm issues new shares of stock and in turn lowers the current market price of the stock to a level that is proportionate to pre-split prices. Stock Ticker A letter designation assigned to securities and mutual funds traded on U.S. financial exchanges. Stop-Limit Order A stop order designating a price limit. Unlike the stop order, which becomes a market order once the stop is reached, the stop-limit order becomes a limit order. Stop Loss Order An order to sell a stock when the price falls to a specified level. Stop Order An order to buy or sell at the market when a definite price is reached, either above (on a buy) or below (on a sell) the price that prevailed when the order was given. Stopped Out A purchase or sale executed under a stop order at the stop price specified by the customer. Strengthening Trend An upward or downward trend that becomes steeper as buying or selling activity increases in the stock. This usually serves to extend the current trend even higher in the short term.
Straddle A strategy using a long call and long put (or short call and short put) with both options having the same exercise price and expiration. The long straddle position is hoping for a large move in either direction, while the short straddle is hoping for the market to sit fairly flat.
Strangle (Combo) See Combination. Success Rate The rate at which winning trades make money. This is correlated with drawdown rates to identify reward: risk profiles and appropriate position sizes in specific trades. Support (see Price Floor) Price zone at which a security tends to stop falling because demand begins to outweigh supply. Symbol Letters used to identify companies on the exchanges. T Target Price The price an investor hopes a stock will reach in a certain time period. Technical Analysis Security analysis that seeks to detect and interpret patterns in past security prices. Technical Analysts Analysts who use mechanical rules to detect changes in the supply of and demand for a stock in order to capitalize on the expected change. Technical Indicators Information that confirms or supports trading signals. Oscillators such as MACD and Stochastics are examples of effective technical indicators. Theoretical Value The fair value of an option based on a known pricing method such as the BlackScholes Option Pricing Model. If an option trades higher (lower) than its theoretical value, traders will become sellers (buyers) with all else constant.
Theta One of the "Greeks" that measures an option's price sensitivity in relation to time. Usually it is expressed as the amount of money an option will lose if one day passes with all other factors the same. Tick Refers to the minimum change in price a security can have either up or down. Time Filter A method for identifying breakthroughs of support and resistance zones. Once a stock has broken a support or resistance zone, waiting 1-3 days to see if the stock holds the new higher price can provide confirmation of the move. Time Order An order that becomes a market or limited price order, or is cancelled at a specific time. Time Decay A property of options that states some or all of an option's value will erode with the passage of time, and are consequently known as wasting assets. Time attacks shorter-term options much harder than longer-term. All else equal, an option seller will prefer to sell shorter-term options, while option buyers will prefer to buy longer-term options. Time Spread See Horizontal Spread. Time Value The amount of an option's price not accounted for by intrinsic value. If an option is out-of-the-money, its premium will consist entirely of time value. For example, say there is a $55 call trading at $3 with the stock at $50. This option is out-of-themoney, so the entire $3 is time premium. If the stock were at $57, then the $55 call would be in-the-money by $2; the intrinsic value would be $2 and the time premium would be $1.
Total Cost The price paid for a security, plus the commission and any accrued interest owed to the seller (as with a bond). Total Dollar Return The dollar return on a nondollar investment, including the sum of any dividend/interest income, capital gains or losses, and currency gains or losses on the investment. Total Return In performance measurement, the actual rate of return realized over an evaluation period. Total Revenue Total sales and other revenue for the period shown. Total Volume The total number of shares or contracts traded on national and regional exchanges in a stock, bond, commodity, future, or option on a certain day. Trade An oral (or electronic) transaction involving one party buying a security from another party. Once a trade is consummated, it is considered final. Settlement occurs 1-5 business days later. Traders Individuals who take positions in stock investments with the objective of making profits. Traders take proprietary positions in which they seek to profit from the directional movement of prices or spread positions that can be held for either the long term or short term. Trading The buying and selling of securities. Trading Costs Costs of buying and selling securities, including commissions, slippage and the bid/ ask spread.
Trading Pattern The long-range direction of a securityâ€™s price, charter by drawing a line connecting the highest prices the security has reached and another line connecting the lowest prices at which the security has traded over the same period. Trading Range The difference between the high and low prices traded during a period of time. Trading Rules A set of predetermined, customized rules that must be followed on each and every trade you place. Trading Signal An indication of a buying or selling opportunity. Trading System A holistic view of the trading process that encapsulates trading rules, fundamental, technical and intermarket analysis, and money management techniques to increase the odds of success over time. Trading Volume The number of shares transacted every day. Because there is a seller for every buyer, trading volume is half of the number of shares traded. Trailing Stop A stop loss order that trails the progress of an upward trending stock. It helps to preserve profit while also providing downside protection. Transaction The delivery of a security by a seller, and its acceptance by the buyer. Treasury Securities Short and long-term bonds issued by the Treasury Department and backed by the full faith of the U.S. government. Treasury yields are commonly used to track fluctuations in interest rates. Trend The general direction of the market
Trendless (see Sideways Trend) A horizontal price movement within a narrow price range over an extended period of time, creating the appearance of a relatively straight line on a stockâ€™s price graph. Trendline A technical chart line that depicts the past movement of a security, and that is used to help predict future price movements. Triple Witching Any day where futures, index options, and equity options all expire. Usually this is the third Friday in the end month of each quarter (March, June, September, December). It is of interest to traders, because market makers must buy and sell the underlying stocks to unwind (get out of) their positions. This usually causes great volatility in the market. U Uncovered Position See Naked. Underperform When a security appreciates at a slower pace than the overall performance of the market. Undervalued A stock price perceived to be too low, as indicated by a particular valuation model. For instance, a companyâ€™s stock price may be considered cheap if the company price earnings ratio is much lower than the industry average. Unissued Stock Shares authorized in a corporationâ€™s charter, but not issued. Unmargined Account A cash account held at a brokerage firm.
Unwind Unwind refers to the specific strategy of "undoing" a buy-write position where the investor would sell the stock and buy the call to close. Unwind can be used loosely to mean the reversing of any position. Up Market indication that securities, or the market in general, is doing well in volume trading. Up Tick A plus tick; a price movement in the upward direction. A trade occurring at a price higher than the previous trade. Upgrading Raising the quality rating of a security because of new optimism about the prospects due to tangible/intangible factors. This can increase investor confidence and push the price of the security up. Upside Potential The amount by which analysts or investors expect the price of a security may increase. Upswing An upward turn in a securityâ€™s price after a period of falling prices. Uptrend Upward direction in the price of a stock, bond, or commodity future contract or overall market. Upper Band The top range of a technical oscillator such as MACD or Stochastics. V Validation The comparison of technical signals and indicators to ensure that the majority of them are pointing in the same direction; information that confirms your opinion of a buying or selling opportunity.
Valleys The low point at the end of an economic contraction until the start of an expansion. Valuation A determination of the value of a companyâ€™s stock based on earning and the market value of assets. Variable An element in a model; variables change through time and are not constant. Vega One of the "Greeks" (although not technically a Greek letter) denoting an option's price sensitivity for a small change in volatility (usually a 1% change in volatility). Vega is sometimes denoted by the Greek letter, Kappa. Vertical Spread A spread where a trader buys options of the same type - either calls or puts - at different strikes with all else the same. For example, if a trader buys a $50 call and sells a $55 call, he would have a vertical spread. Also called a time or calendar spread. See also Bull Spread, Bear Spread. Volatility A measure of risk based on the standard deviation of the asset return. A variable that appears in option pricing formulas where it denotes the volatility of the underlying asset return from now to the expiration of the option. Volume The daily number of shares of a security that change hands between a buyer and a seller. Volume Filter A method for identifying breakouts through support and resistance zones. Volume Filtering refers to waiting for an increase in buying or selling volume to support the breakout you are observing. W
Wall Street Generic term for the security industry firms that buy, sell, and underwrite securities. Watchlist A list of securities selected for special attention as potential investments. Weak Market A market with few buyers and many sellers, and a declining trend in prices. Well-Diversified Portfolio A portfolio that includes a variety of securities in order to approximate the overall market risk. The unsystematic risk of each security is diversified throughout the portfolio. Whipsaw A highly volatile environment in which a stock experiences severe fluctuations on both the upside and downside. Traders will sometimes get stopped out of these trades only to see the stock continue to rally higher after they have exited the trade. Write/Writing Selling an option to open. Any time a trader sells an option to open, he is said to have "written" the contract. A call writer is one who has sold calls against stock (covered call position) and is also called a covered-write. Writing is the same as shorting. Y Year-End Dividend A special dividend declared at the end of a fiscal year that usually represents higher than expected company profits. Year-to-Date (YTD) The period beginning at the start of the calendar year up to the current date.
Yield The percentage rate of return paid on a stock in the form of dividends. Z Zone A price level of support or resistance for a stock. Looking for breakouts through support and resistance zones provides opportunities to buy stocks at the early stage of new rallies.