OPTIONSTRADING

TheSimplifiedBeginner’sGuidetoOptionsTrading

SecondEdition

Contents

ACCESSYOURFREEDIGITALASSETSINTRODUCTION|1|OPTIONBASICS

WhatareOptions?WhatareStocks?OptionsintheStockMarketTheBrokerTheMarketMakerTheOptionsClearingCorporationOptionsIndustryCouncilWhyWereOptionsSuchaHit?Optionsvs.Stocks

|2|TRADINGFUNDAMENTALSCallsandPuts—What’sinaName?BuyingaCallOptiononExxonSellingaCallOptiononDisney™BuyingaPutOptiononGeneralElectric™SellingaPutOptiononMcDonalds™

|3|ASOUNDSTRATEGYFORABEGINNERSellingtheCoveredCallDumpingDuPontIntheMoney(ITM)orOutoftheMoney(OTM)DisclaimerAvoidtheseBeginnerMistakesPracticeMakesPerfect

|4|KEYINFLUENCERSONOPTIONSPRICESWhyYouShouldCareAboutHowOptionsArePricedTheMoneynessFactorTimeValue&TimeDecayVolatilityInterestRates&Dividends

|5|WINATOPTIONSBYSPEAKINGGREEKDeltaGammaThetaVegaRho

|6|POPULAROPTIONSSTRATEGIESStraddlingaStockUsingOptionsTheStrangleABull(orBear)SpreadRollingPositions

CONCLUSIONGLOSSARYABOUTCLYDEBANK

Termsdisplayedinbolditaliccanbefounddefinedintheglossary

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Introduction

WhyThisBookWasWrittenHunting for a good beginner-level book on options trading can be a very

frustratingendeavor.Manyof thebooks thatare labeled“introduction to...”or“...for beginners” arewritten byhigh-level brokers or academicswhohave anannoyinghabitoftalkingovertheirreaders’headsanddivingheadfirstintoWallStreetjargonwithouttakingthetimetoproperlyexplainthebasics.On the flip side, since options trading is such a fertile niche for new ideas,

every John Doe and his brother has written a book on options trading, and,unfortunately, an enthusiastic options trader doesn’t necessarily make a goodwriter.Advicefromthesewriterscanbenotonlyconfusingbutalsomisleadingandtheresultsoffollowingsaidadvicecanbealarmingifnotdisastrous.This book, however, was written with the goal of maximizing clarity and

readability,allwhileprovidinganextensivelookatthefundamentalsofoptionstrading. You should be more than ready to make your first few trades afterreadingthisbook.

|1|OptionBasics

Throughoutthisbook,we’llbetalkingaboutstockoptions.However,thereareother types of options which you may delve into at a later time. Here’s adefinitionofeachfromthefolksatoptionstrading.org.

Stock Options : The underlying asset for these contracts is shares in aspecificpubliclylistedcompany.IndexOptions:Theseareverysimilartostockoptions,butratherthantheunderlyingsecuritybeingstocksinaspecificcompanyitisanindex–suchastheS&P500.Forex/CurrencyOptions:Contractsofthistypegranttheownertherighttobuyorsellaspecificcurrencyatanagreedrate.Futures Options : The underlying security for this type is a specifiedfuturescontract.Afuturesoptionessentiallygivestheownertherighttoenterintothatspecifiedfuturescontract.CommodityOptions :Theunderlyingassetforacontractofthistypecanbeeitheraphysicalcommodityoracommodityfuturescontract.BasketOptions :A basket contract is based on the underlying asset of agroupofsecuritieswhichcouldbemadeupofstocks,currencies,commoditiesorotherfinancialinstruments.

Butlet’skeepitsimplefornow.Considerthisscenarioasawaytounderstandthebasicpremiseofstockoptionstrading.Iknowa fashiondesignerwho is aneccentricgenius.Shemakes incredible

dresses thatyou just can’t find anywhere else.There’snothing like them!Shemakesthemallbyhand,andshedoesalltheworkherself.Theonlydrawbackisthatsheonlymakesthesedressesinthesummer,andsheonlymakesabout10ofthemeachyear.It’s themiddleofwinter,andI’vemadeadeal tobuyoneof thisdesigner’s

summer dresses for a price of $100. I’ve guaranteed the purchase using acontract.ThecontractstatesthatIhavetherighttopurchaseadressat$100atanytimebeforethethirdFridayofSeptember.Tosecuremyoptiontobuythedress,Ipaidafee,orpremium,of$50.Note : This $50 is not a deposit or down payment. It will not be deducted from the $100 I willeventuallypaytoownadress.The$50premiumismerelythepriceofmyrighttobuythedressfor$100beforethethirdFridayinSeptember.InJuly,Idecidetoexercisemyoptiontobuyadress.Permycontract,Ipay

$100forthedress.OnthesamedayIdecidetogotothedesigner’sEtsypageandtakealookattheotherdressesshe’sselling.Theyareallpricedat$200.Idecide,ratherthankeepingthedress,tosellittoanotherpartyfor$200.SinceIpaid only $100 plus the premium payment of $50, I profited $50 from mypurchaseofanoption.

WhatareOptions?

Optionsarecontracts.Theyentitleapartytopurchaseorsellaspecificasset(stock,realestate,merchandise)foraspecificpricewithinacertainwindowoftime.Theyalsoobligeaseparatepartytosellorpurchasethespecificasset.Forinstance, in the example above, just asmy option contract guaranteedme therighttobuythedressfor$100,thedressmakerwasobligedtosellthedressfor$100.Ineveryoptioncontractthereisabuyerandaseller.Oneparty,eitherthebuyerortheseller,hasanobligationtoparticipateinaparticulartransactionperthedictatesoftheoptionscontract.Theotherparty,eitherthebuyerortheseller,has the option to participate in a particular transaction per the dictates of theoptionscontract.Intheexampleabove,Ipaid$50fortheoptiontobuyadressfor$100beforethethirdFridayinSeptember.JustbecauseIownedthisoptiondoesnotmeanthatIwasobligedtoexecuteit.Iwastheownerorbuyeroftheoption.Thedressmaker,whowasobligatedtosellmethedress,wasthewriterorselleroftheoption.

WhatareStocks?

If you’re thinking about delving into theworld of options, you’re probablyalready familiarwith stocks. But, just as a refresher – a stock is a piece of acompany.Whenacompanydecidestobea“public”company,itissuessharesofstock for purchase by the general public. The more “stocks” or pieces youpurchase,themoreofthecompanyyouown,though,inmostcases,unlessyouownthousandsofshares,yourpieceisprettysmall.Nowthatyouaretechnicallyaco-ownerofthiscompany,youareawardeda

portionoftheprofits.If thecompanyisperformingatitsbest,yourstockgoesup inpriceandyouseeaprofit,usuallypaid toyou in the formofdividends,which are sums of money paid out to investors on a regular basis (usuallyquarterly).But if thecompanyisn’tperformingwellforonereasonoranother,youassumealoss.Inthiscase,thedividendsyoureceiveareloweror,insomecases,youdon’treceiveanyatall.In order to trade options, youDONOT need to own stock in the company

withwhichyouare trading.However, if you’re thewriter/sellerof theoption,thenowningthestockwilllessenyourrisk.Thesearecalled“covered”optionsandwe’lltalkabouttheminalaterchapter.

OptionsintheStockMarketThough option contracts have been around in some form since the days of

ancientGreece1, itwasn’t until 1973 that the trading of stock options becameformally institutionalized in theChicago Board Options Exchange (CBOE).Prior to theCBOE, the general publicwas highlymistrustful of trading stockoptions.Contractsweredifficulttoenforce,andevenbrokershadadifficulttimeaccuratelypricingoptions.TheCBOEsawtoitthatstockoptioncontractswereall standardized and that a clearing corporationwas formed (OptionsClearingCorporationorOCC)thatwouldberesponsibleforensuringthatcontractswereenforced. There was still a lot of doubt about whether options trading wouldcatchonwith thegeneral public, but after a fewyears in business, theCBOEwasbuzzingwithtradingactivity.Sincethattime,optionstradinghasbecomeapersistentfacetofmajorsecuritiesexchangesacrosstheglobe.

Currently,thereareatotalofsixoptionsexchangesintheUnitedStates.Theyall have excellent websites where new and experienced traders can gathergeneral informationaboutoptions tradingaswellasmorespecific informationonthelistingstheyhandle.Thesesitesaregoodtoolsandshouldbeperusedasyoubeginyouroptionsjourney.

AmericanStockExchange(AMEX)www.amex.comBostonOptionsExchange(BOX)www.bostonoptions.comChicagoBoardOptionsExchange(CBOE)www.cboe.comInternationalSecuritiesExchange(ISE)www.ise.comNewYorkStockExchange(NYSE/ARCA)www.nyse.comPhiladelphiaStockExchange(PHLX)www.phlx.com

Now,withsixmarkets,theprocessofoptionstradingseemscomplicatedrightoffthebat.However,somekeyparticipantsinyouroptionstradingventurewillhelpyounavigatethesemarketsandbetterunderstandtheentireprocess.

TheBrokerIfyoualreadyhaveastockbroker,chancesarethatheorshecanalsohandle

optionstradingforyou.However,somebrokersspecificallydealinoptions.Aswithstocks,yousimplyinstructthemastowhatkindoftransactionyou’dliketocarryout,andtheydothelegworkandchargeyouacommissiontoputthetradeinmotion.You can ask them to buy new contracts, sell contracts you alreadyown, or write new contracts to sell. You can also provide them with certainordersaboutbuyingandsellingatparticularprices.Inall, theycanmanageallaspectsofyouroptionsportfolio.Asyouentertheworldofoptionstrading,lookforafull-servicebrokerrather

than adiscountbroker.The lattermerely takesorders and executes them.Theformer is more expensive commission-wise but should take the time to meetwith you personally and get to know your financial circumstances andinvestmentgoals.Onceyoufeelyouaresufficientlyexperiencedinthefieldofoptionstrading

andhavebecomequitehands-oninyourtrading,youmaydecidetogowiththeless-expensiveoptionofadiscountbroker.

TheMarketMakerThemarketmakerisn’tapersonyou’llevermeetorevensee.Rather,theterm

referstoabroker-dealerfirmthattakesontheriskofholdingmultiplesharesofaparticularsecuritysothattradinginthatsecuritycanhappen.Inotherwords,themarketmakerdoesexactlyasthenamesuggests–providesamarketforyouroptions order. They are there to keep the markets running smoothly and toensureacertainamountofliquidity.Toaccomplishthat,theystepiniftherearenopublicorderstomatcharequiredtradebymaintainingasizeableanddiverseportfolioofoptionscontracts.For example, supposeyouwant tobuyoptionscontracts forGoogle,butno

onefromthegeneralpublicissellingatthemoment.Themarketmakerstepsinandsellsyouthoseoptionsfromitsownportfolio.Ifnot formarketmakers, therewouldbe far fewer transactionsoccurring, it

might be difficult to buy or sell, and the options availablewould be severelylimited.

TheOptionsClearingCorporationTheOptions Clearing Corporation (OCC) is the firm that guarantees that

options sellers meet their obligations and complete their transactions. As aclearinghouse,itliterallymovesbillionsofdollarsaday,whichmakesitoneofthelargestequityderivativesclearingorganizationsintheworld.Youwon’teverneed tocontact them,most likely,but it’sgood toknowthey’re there tomaketradesrunsmoothly.

OptionsIndustryCouncilThisisaninvestoreducationpartnershipformedbythesixoptionsexchanges

mentioned previously. For those new to the options market, the OIC is a

wonderful tool and itswebsite provides a plethora of information about listedstockoptions.Checkitoutatwww.optionscentral.com.

WhyWereOptionsSuchaHit?

As you see, options trading has gained a lot of attention over the past fewdecades.There’snodefinitiveexplanationforitsresoundingsuccess.Justasinanyotherproductorpursuit,therewasnowaytobesureofthatsuccesspriortotestingthemarket.Partoftheappealofoptionstrading,nodoubt,isthepotentialto realize fasterand largerprofits than in the traditional stockmarket.Optionsalso provide a way for investors to participate in the stock market with lessinvestment. That’s because you don’t have to own shares of a stock to tradeoptionsassociatedwiththatstock.Ifaninvestorisfamiliarwithacertainstockandbelievesshecanpredictitsmovement,thenpurchasinganoptionallowsthatinvestor a chance to capitalize on that stock’s behavior without having topurchasethestockoutright.

Optionsvs.StocksNot everyonewho “plays” the stockmarket is interested in trading options.

Dependingon your financial portfolio aswell as your goals, your brokermayadviseagainstitduetotherisk.Sowhetherornotyougetinvolveddependsonjusthowwillingyouaretotakeachancewithyourcash.Indeed, the stockmarket is simpler to navigate than the optionsmarket. In

general,youonlyhavetoworryaboutonething–whetherthestockisgoingupor down.With options, as you’ll see in future chapters, you have to get threethingsright–thedirectionit’smoving,thetiming,andthemagnitude.Instocktransactions,lossestendtobesmaller–yourarelylose100%ofyourinvestmentasyoumightwithoptions.Furthermore,ifastockisinalosingposition,youcanusuallyjustwaititoutuntilitgetsbacktofairmarketvalue.Optionscanbescary,buttheydohavetheiradvantages.Investinginoptions

allows you to tie up a lot less of your cash on hand, as you’ll see when wediscuss strategies in a later chapter. Hence, options have greater leveragingpower.Thepotentialforhigherreturnsiscertainlypresentaswell,particularlywith less cash outlay. Finally, options are a very flexible investment tool andcreatemoreinvestmentalternatives,idealforthosewhowantadiverseportfolio.Ofcourse,neitherstocksnoroptionscarrywiththemanysortofguarantee.It’s

yourjob,alongwithyourbroker,todeterminewhatkindofrisksyouareabletotakeandifyoucanlivewiththepotentialconsequences.That’swhybookslikethis,whichoutlinethebasicsandexplainthestrategies,areessential.1Sincere,Michael.UnderstandingOptions.NewYork:McGrawHill,2014.Electronicbook.

|2|TradingFundamentals

Forthereaderwhoiscompletelynewtotheworldofoptionstrading,patienceisindeedavirtueasyounavigatetheoftenconfusingworldofstockoptions.Keepthefaiththatyouwilleventuallygainanunderstandingofhowoptionsworkandofhowthedifferenttypesofoptionsandthedifferentstrategiescomeintoplay.Thisbookmakesitaseasyaspossibleforyou.Tradingoptionsmayappear,ataglance,tobecomplicated,butit’sreallynot

sobadonceyougraspsomeof the fundamentalconceptsand jargon involved.Youmayhavetorereadcertainpassagesofthisbookagainandagainandmayhavetoresorttosomepencil-and-papercalculationstofigureitallout,butwithsome practice and a little “virtual” trading, you’ll eventually be comfortableenoughtogiveitashot.This chapter provides youwith some proverbial nuts-and-bolts and reviews

thetwomaintypesofoptionstrading:theputoptionandthecalloption.

Calls&Puts—What’sinaName?Perhapstheeasiesttypeofoptiontounderstandisthecalloption.It’scalleda

call because the buyer/ownermay “call” for the sale of the stock at any timepriortotheexpirationdate.InthedressexamplefromChapter1,Ipurchaseda“call” option on a designer dress and exercised the option by “calling in”myrighttomakethepurchasefor$100,eventhoughthesamedressesweresellingonEtsyfor$200.Thepersonwhosells thecall,alsoknownasthewriterofthecall,agreesto

sellthestock(underlyingasset)attheagreed-uponpriceatanypointbeforetheexpirationdate.Note :Aquickwordabout expirationdates inoptions trading—thewriter/seller of the call orputoptionalways specifiesanexpirationdate.Usually this isdone justby stating themonth,and it isassumedthattheoptionwillexpireonthethirdFridayoftheexpirationmonth.Forexample,youcan

purchaseanoptioncontractinMarchwithaMayexpiration.Unlessotherwisespecified,thecontractwillexpireonthethirdFridayofMay.Aninvestorwouldchoosetobuyacallwhentheybelievethattheunderlying

assetwill seean increase inpriceover a certainperiodof time.Callshaveanexpirationdateand,assuch,theassetcanbepurchasedatanytimepriortooronthatdate.Expirationdates are important. Inorder for thebuyer/ownerof anoption to

profitfromit,thestockinquestionmustperforminacertainway(itmusteithergoupordown)withinacertainperiodoftime.Thelongerthetimeperiodbeforeexpiration, the greater chance, theoretically, that the stockwill perform in thedesired way. Therefore—the most important principle of options trading is—timeismoney.Themoretimeexistsinanoptionscontractbetweenthepointatwhichtheoptionissecuredandthepointatwhichtheoptionexpires,themorevaluablethecontractwillbe.The ideaof “timeasmoney,” specifically in reference tooptions trading, is

emphasized thoroughly in Edward Olmstead’s bookOptions for the BeginnerandBeyond.Olmsteadsaysthat,“Thisphrase[timeismoney]shouldalwaysbeinthebackofyourmindasyoudealwithoptions.2”

Note:Othertradersandtradingreferencepublications,suchasOptionsMadeEasybyGuyCohen,havecoinedthetermtimevaluetorefertotheaddedvalueofanoptioninlightofhowmuchtimeisleftbeforethecontractexpires3.Note:ItmayalsobeprudenttonoteherethatthereareAmerican-styleoptionsandEuropean-styleoptions. This book focuses on American-style options. The difference between the two is thatAmerican-styleoptionsmaybeexercisedatanypointpriortotheexpirationdate,whereasEuropean-styleoptionsmustbeexercisedontheexpirationdate,ifatall.

Theoppositeofacalloption isaputoption,and, like thecalloption,aputoptionhasabuyer/ownerandaseller/writer.Aputoptionissonamedbecausetheownerhastherightto“put”hisstockbackintothemarketatanagreed-uponpriceatanytimewithinanagreed-upontimeframe.Thewriterofaputoptionsimplyagreestopurchasesaidstockattheagreed-uponpriceatanytimewithinthe agreed-upon time frame.An investorwould buy a put option if theywereexpectingtheunderlyingassettofallinprice.So there you have it, the basics of option trading. From these fundamental

concepts come literally countless scenarios and opportunities for profitabletrading.Let’scultivateyourunderstandingofthedynamicsofoptionstradingbygoingthroughafewspecificexamplesofeachtypeoftrade.

BuyingaCallOptiononExxonLet’ssayyou’reabout tobuyacalloptiononExxonMobil™.Now,before

you do so, it’s important to understand why you’ve decided to make thisparticularmove.HowmuchisExxonMobilsellingforrightnow?Atthisverymoment,let’ssayExxonissellingfor$80.Ok,youthinkthestockisgoingtogoup significantly in thenext twomonths, soyou’regoing topurchasea calloptionfor100sharesofExxonMobileatastrikeprice (seeGlossary)of$85,and you’re going to set your expirationmonth forMarch, twomonths away.Thismeans thatyou’rebuying the right topurchase100sharesof thestockat$85atanytimebetweennow(January)andthethirdweekinMarch.Thetraderjargonforyourcalloptionpositionis:longoneXOMMar85call.

Note:Remember,expirationdatesareassumedtobethe3rdFridayoftheexpirationmonthunlessotherwise specified. Also, XOM are the call letters for Exxon Mobile. Don’t worry if you don’tunderstandallcomponentsofthejargonjustyet.Thatwillcomeintime.Note:Thestrikepricesandthecostoftheoptionsintheseexamplesarefictitious.Youcanviewanup-to-dateoptionsschedulebyvisitingyourbrokerage’swebsite,orbyaccessingthewebsitesoftheOIC, CBOE, Google, or Yahoo4. Here’s an example of what a typical option listing (sometimesreferredtoasan“optionchain”)lookslikeonYahooFinance.Asyoucansee,yousetan$85strikepriceforFebruary19th2015(twomonthsawayfromthetimeofthequery)and,asyoucansee,thecall option is selling for about a dollar per share5. As for the other columns, their importance isdiscussedlateroninthisbook.

2Olmstead,Edward.OptionsfortheBeginnerandBeyond.UpperSaddleRiver,NJ:FTPrenticeHall.2006.Print.3Cohen,Guy.OptionsMadeEasy.London:FTPrenticeHall,2005.Print.

So,ifyou’rebrandnewtooptionstrading, thenyoumaybewonderingwhyyou’re reserving the right tobuyExxon stockat aprice ($85per share) that’smore expensive than its current value of $80 per share. You’re doing thisbecauseyou’rebetting thatExxon isgoing togoup invalueby theexpirationdate(thirdFridayinMarch).Let’ssayyou(oryourbroker)findawriterforthisoptionwho’swilling to sell it toyou for$1per share (alloptioncontractsarequotedonapersharebasis).Sinceyouwantacalloptionon100shares,you’regoingtopayatotalof$100toownthisoptioncontract.Fromhere,therearemanypossibleoutcomes:

Scenario1:ThethirdFridayofMarcharrives,andthestockstillhasyettoclimbabove$85.Youroptionisessentiallyworthless,andyou’reout$100.

Scenario 2: It’s February and you’re midway through your contract. ExxonMobilehasclimbed to$90andyoucall inyouroption tobuy100sharesat$85.You’vemade$500minusthe$100youpaidtoowntheoption—$400intotalprofit.Believeitornot,underthesecircumstances,callinginyouroptionisnotlikelytobethemostprofitablemove.

Scenario 3: Again, it’s February and you’re midway through your contract.ExxonMobilehasclimbedto$90andyoudecidetosellyouroptioncontracttoanotherparty.Youroptioncontractnowhaswhat’scommonlyreferredtoasanintrinsicvalue.

Note:TheintrinsicvalueoftheoptionisderivedfromthefactthattheoptionguaranteestheownertherighttopurchaseExxonat$85pershare.Meanwhile,Exxonissellingfor$90pershareontheopenmarket.Thecalloptionthushasanintrinsicvalueof$5.

Sinceyouroptionnowhasanintrinsicvalue,it’sismorevaluablethanitwaswhen you first purchased it (whenExxon stockwas selling for $80).With anintrinsicvalueof$5, the sameoption thatyoubought for$1per share isnowlikelytosellfor$6or$7pershare.

Note:Thepersharepriceoftheoptionisalmostalwaysmorethanitsintrinsicvalue.Why?Becausetimeismoney.ThenewownerofyourcalloptionisgoingtobebettingthattheExxonstockisgoingtoclimbevenhigherbeforetheoptionexpiresinMarch.She’sbuyingnotjusttherighttobuythestockat$85andreapherimmediate$5profit,butshe’salsobuyingtherighttowaitandseeifthestockgoeshigher,potentiallymakingher$85callmoreprofitable.Timeismoney.

So,ifyouhaveanoptioncontractworth$6persharethatyouboughtfor$1ashareandyousellit,howmuchprofitdoyoumake?Thetotalcostforoptioningthe100shareswas$100.Nowyou’resellingatatotalsalepriceof$600.Yourprofitisaneven$500.Comparethistothe$400intotalprofityou’dhaveendedupwithhadyoucalledinthestockperscenario2.

Scenario 4: Let’s say, again, that it’s mid-February. Exxon hasn’t climbed invaluebutinsteadhoveredaroundthe$80mark.Perhapssomenewfactorhasledyoutobelievethatit’sunlikelythatthestockisgoingtoclimbhigherthan$85asyou’doriginallyexpected.Youcanalwayssellyourcalloption,asis,eventhoughithasnointrinsicvalueandwon’tbeworthasmuchasyoupaidforitnowthathalfthecontracttimehaspassed.Nonetheless,itisfeasiblethatyoucouldcutyourlossessome,perhapsbyfindingabuyerwhowillpurchasethecalloptionfor50centspershare.You’dget$50foryouroptioncontractafterpaying$100,andyou’dtakea50%loss.

SellingaCallOptiononDisney™Let’s takea lookatapossiblescenario inwhichyouwant tosellorwritea

calloption.Whenyouwriteacalloptionyou’reguaranteeinganotherpartythepurchase of a particular stock at a particular price at particular point in time.You’renotrequiredtoownthestockinordertowriteacalloptionforthatstock.Thisisknownasnakedcallwriting,andit’squiterisky.Let’s say that youown stock inDisney andyouwant towrite a call option

contractfor100sharesofthestock.SinceyouownDisneystock,thisisknownascoveredcallwriting.Disneyiscurrentlytradingat$110pershare.However,after years of holding the stock, you’re not very optimistic about Disney’sacquisitionoftheYouTubecontentcreationcompanyMakersStudio.OntopofthatyouknowtheircurrentCEOis looking toretireby theendof thequarter,and you’re not thrilled about his replacement prospects. You’re looking tolightenyourloadonDisney.Selling/writingacalloptionforthestockcanhelpyou both get rid of Disney and possibly make some extra money in the

meantime.It’sJuneandyouwriteacalloptionwitha$120strikepriceandanexpiration

monthofNovember.Theposition is technicallycalled:shortoneDISnov120call.DISisthetickersymbolforDisney.Becauseyou’regivingtheowner/buyerof the call option over four months Jun-Nov to wait for the Disney stock toclimb,youroptionmaysellatanicehighprice.Let’ssayyou’reabletoselltheoptionat$5pershareor$500total.Youimmediatelyreceivethe$500butareobliged to sell 100 shares ofDisney at $120 per share at any time before thethirdFridayinNovember.

Scenario1:Thestockstaysbelow$120and,naturally,nooneevercallsitin.Noone is going to voluntarily purchase 100 Disney shares at $120 when theycould buy it for less. You’ve alreadymade $500 by selling the option andyou’refreetowriteanothercalloptionifyou’restilllookingtodumpDisneyinthemostprofitableway.

Scenario2:It’sOctober,thetrailerforthenextStarWarsinstallmentisreleased,andit looksawhole lotbetter thananyonehadanticipated.Suddenlyyou’renotsosurethatyouwanttogetridofyourDisneystock.Thestockistradingat$122,twodollarsabovethestrikeprice,anditmaybedestinedtogoevenhigher.Thecalloptionyouwrotealreadyhasanintrinsicvalueof$2andwillprobablysellformorethanthat,alotmoreconsideringthattheoptionsoldfor$5per sharewith no intrinsic value at all.But then again, you also have toconsiderthatthere’slesstimeleftinthecontract.It’sduetoexpireonthethirdFridayofNovember.Let’ssay that thecalloption thatyousoldcannowbereboughtfor$8ashare.Sinceit’s$3moreexpensivepersharethanwhatyousolditfororiginally,ifyoudecidetobuyitback(becauseyoudon’twanttobeforcedtosellyourDisneystock),it’sgoingtocost$800,givingyouanetloss of $300. But, if Disney keeps climbing, you’ll end up better than youwouldhavehadyousoldthestockattheendofthecallcontract.

Note :Evenif thestockgoesabove$120early in thecontract,youwill likelyneverhavethestockcalledawayuntiltheNovemberexpirationdateisveryclose.Why?Becauseifthestockjumpsup fastandearly, thennotonly is youroption likely tohavemore intrinsic value,butthere’salsogoingtobeplentyoftimeleftonthecontract(timevalue).Thesetwofactorswillmake thecalloption spike inprice,and thecurrentownerof theoptionwill stand to realizemoreprofit through selling theoption thanbycalling it in.Ultimately though, if theprice isclimbing,someonewilleventuallycallawayyourstockbeforetheexpirationdate.Ontheflipside,ifthestockdoesnotincreaseinvalue--let’ssayitdropsto$105---then,ofcourse,nooneisgoingtobuythestockatthe$120callprice.You’llhavesimplymade$500bysellingthecalloption,and,ifyouwant,youcanturnaroundandwriteanothercalloptioncontract.Thisisagoodapproachtouseifyouultimatelydowanttopartwayswithit.

Scenario3:Let’ssaythatyouwererightaboutthewholesuccessionissuewithDisney.They’renotgoingtobeabletoassuretheirinvestorsthatthey’vegottherightleadershipinplaceforthenextgeneration.Twomonthsintothecall

contract,thepriceofDisneyfallsto$100ashare.Itdoesn’tseemlikelythatthe $120 call option that you sold is ever going to be exercised, and,meanwhile, the value of that option has decreased tremendously since thecurrentpriceofthestockislowerandthere’sonlyhalfasmuchtimeleftonthecontract.Atthispoint,ifyouwantto,youcanbuybackthecalloptionforpenniesonthedollarandturnaquickprofit.Youshouldonlydothis,though,ifyoubelievethatthere’sstillachancethatthestockmayreboundbackupto$120,atwhichpointyoucaneithersellitagain,ordonothingandjustkeepyourstock.There’s reallyno limit to the scenarios andpossibilities.Whendealingwith

options,therearealwaysalotofoptions.

BuyingaPutOptiononGeneralElectric™Remember,buyingaputoptionisbuyingtherighttoputyoursharesbackon

themarket at a certain price—the strike price—within a given period of time.Usually, put options are bought when the purchaser believes that a stock healreadyowns isdestined todecline invalue,andhe’swilling topaymoney toguarantee thathehas the right to sell the stockat the strikeprice foracertainperiodoftime.It’sAprilandyou’vegotsomeGEstockworth$29ashare.Youcomeacross

someinformationthatcouldbeeithergoodnewsorbadnewsforGE,you’renotsurewhich.Youdon’twant to sell off your stock, but youdon’twant to loseyourshirt,soyoudecidetobuyaputoptionthatguaranteesyourrighttounload100 shares ofGE at $30 per share. The contract expirationmonth is June, soyourposition isnamed:LongoneGEJun30put.Thestockcurrentlysellsfor$29pershare,butyouboughttheputoptionat$3pershare,sothe$1pershareyouwouldhavegainedfromsellingimmediately(theintrinsicvalue)isoffsetbythepriceoftheoption.Note:Youdon’tevenhavetoownGEoranystocktobuyaputoption.Buyingaputoptionwithoutowningthestockisknownasbuyinganakedput.Ifthestockgoesdownasyouanticipated,you’llusuallybeabletoreselltheputoptionatahigherprice.Inotherwords,whenGEwastradingat$29youpaid$300($3pershare)toownacontract,whichentitlesyoutosell100sharesofGEat$30per

share.Thatputoptionisgoingtobeaheckofalotmorevaluablethan$300ifGEplungesto$27pershare,assuming there’sstill some time lefton thecontract,as thebuyerpurchasing theputoptionwillbepayingalittlemorethantheintrinsicvalueinhopesthatthestockwillcontinueitsdeclineinvalue.Ifthebuyer,forinstance,iswillingtopay$4persharefortheputoption,thenyouwillnetaprofitof$100.Itwon’tmatterwhetherornotyouactuallyeverownedthestockornot,allyoudidwasbuy (and then sell) anoption toput that particular stock in thehandsof abuyer for$30pershare.

In the event that the stock never falls as expected but remains at $29 and the contract is nearexpiration,thepriceoftheoptionwillfallcloserandclosertoitsintrinsicvalueof$1,atwhichpointyoucansellitofffor$100andtakea$200loss.Again,youdon’tnecessarilyhavetohavepossessionofanyrealGEstocktoexecutethesetransactions.

Fg.7:EventhoughtheintrinsicvalueoftheoptionisthesameinOctoberandJanuary($1),thevalueoftheoptionissignificantlylessinJanuarybecauseithaslesstimevalue(lesstimeremainingbeforeitexpiresinFebruary).Asoptionsapproachtheirexpirationdates,theirpricesgetcloserandclosertotheirintrinsicvalues.

SellingaPutOptiononMcDonalds™Inthisexample,we’regoingtoswitchthingsupbyenvisioningthesaleofa

putoptionwithinthecontextofashortsell.Shortsellingiswhenyoubetagainsttheperformanceofaparticular stockorgroupof stocks.Thepracticeof shortsellinggarneredmuchattention in theaftermathof the2008 financial crisis intheUnitedStates.Here’showitworks:Let’s sayMcDonald’s is currently selling for $120 per share, but you think

thatthefactthattheystartedsellingbreakfastalldayisultimatelygoingtodipinto theirprofitmarginsand thevalueof thestockwill soongodown.You’rebettingagainstMcDonald’s.So you borrow – yes, borrow – 100 shares ofMcDonald’s. Your broker is

goingtochargeyouaheftyfeefor this transaction,sobesureyouknowwhatyou’re doing. When you borrow shares, what you are doing is temporarilycontrollingsharesinacertaincompanywithanagreementtoreturnthestockatacertaintime.Sosomeoneouttherewhoowns100sharesofMcDonald’sstockhasallowedyoutotakethose100sharestemporarilyonthesoleconditionthatyou agree to return the 100 shares ofMcDonald’s to the original owner after,let’ssay,twomonths.Onceyouhave theMcDonald’s stock, you can, of course, dowhatever you

wantwithit.Ifyouweretoshortthestock,thenyouwouldimmediatelysellitallatitscurrentpriceof$120pershare.Youwouldnowhave$12,000incash.IfyouwerecorrectandMcDonald’stakesadipto,let’ssayto$110pershare,then you would simply buy back the 100 shares of McDonald’s stock for$11,000andyouwouldthenhavethe100sharesofMcDonald’sreadytoreturnto the lender.Youwouldhavemade$1,000onyour short sellminusany feesyoupaidtoborrowthestock.Assumingyouweren’tchargedover$1,000,itwasaprofitableshortsell.Now,here’swhere selling a put optionmaybe awisemove.Let’s say that

midway through your short selling of McDonald’s stock, they release a newbreakfastitem,ahighproteinMcMuffinorsomeothergimmickthatyouthinkisgoingtobesuccessfulandultimatelypreventMcDonald’sstockfromdroppingas lowasyou’doriginally thought.Let’s say the stock is tradingat$110,youstill have some time before you have to return the 100McDonald’s shares tolender,andbecauseofthisnewitem,youdon’tthinkthestockisgoingtodropmuch lower.Soyoudecide tosellaputoptionat$105,wherebyyouagree tobuy100sharesofMcDonald’sstockat$105persharebythetimeyourcontractexpires,let’ssay,byAugust.Toputitintojargonyourpositionis:shortoneAug105put.Let’ssay theputoptionsells for$6pershare.Youimmediatelyhave$600incashjustforsellingtheoption,butyouhavetheobligationtobuy100sharesofMcDonald’sstockfor$105pershareatafuturedate;thesesame100shares will eventually be returned to the party fromwhom you borrowed thestock.Soifyou’rewrongabouttheProteinMcMuffinanditturnsouttobeabigflopanddrivesthepricedownto$95ashare,thenyou’regoingtobeforcedtobuybackyour100sharesat theabove-marketpriceof$105,becauseyousoldthe put option.Nonetheless, since, in this scenario, you originally shorted thestockat$120,you’llstilllikelymakeaprofitattheendoftheday.Ontheflipside,ifyouwerecorrectandtheProteinMcMuffinstabilizedthe

McDonald’sstockanditdidn’tdroptoofarbelow$105, thenyou’vemadeanextra$600inprofitbysellingtheputoption.How?Simple,youstillbuyback100 shares ofMcDonald’s at $105 (a total price of $10,500),which is $1,500lessthanitsvaluewhenyoufirstborrowedandsoldit($12,000),plusyou’vegotyour$600inprofitforsellingtheputoption,atotalprofitof$2,100minusanybrokerage and other fees paid for borrowing the stock and for selling the putoption.Ultimately, in theMcDonald’s scenario, there is profitability in both of the

considered outcomes, but only because it assumes that the short sell wassuccessful.Theonlyquestionbecamewhethersellingtheputoptionwouldaddtoordetractfromtheprofitgainedontheassumedlysuccessfulshortsell.Asaplayer of the market, you should know that the short sell itself is incrediblyrisky, as once you sell off the shares after you borrow them, the price could

skyrocket, forcing you to buyback the shares youborrowedwith infinite losspotential.Becareful.Atthispointyoushouldhaveabasicgraspof themechanics, terminologies,

strategies, and risk factors involved in options trading. If you feel totally lost,then read through this chapter again beforemoving on. As JimmyCliff says,“Youcangetitifyoureallywant.”2Olmstead,Edward.OptionsfortheBeginnerandBeyond.UpperSaddleRiver,NJ:FTPrenticeHall.2006.Print.3Cohen,Guy.OptionsMadeEasy.London:FTPrenticeHall,2005.Print.4Sincere,Michael.UnderstandingOptions.NewYork:McGrawHill,2014.Electronicbook.5YahooFinance.finance.yahoo.com.accessed12/16/2015.

|3|ASoundStrategyforaBeginner

One of the fundamental challenges of teaching options trading to beginners isthattherearemanypitfalls,andifyoujustgointothemarketgunsblazing,youwill likely come up short. Many gurus and authors have thus turned theirattentions to the search for good, simple, conservative trading strategies forbeginner-leveltraders.Ideally,youwillusethesesimplestrategiestogetafeelfor options trading and to steadily learn more and more about the details,metrics,andmorecomplexstrategiesthatmaycomeintoplayifyoucontinuetotrade.

SellingtheCoveredCallSeveral authors and experts, among them Michael Sincere, author of

UnderstandingOptions,hasarguedthatthesellingofthecoveredcallisoneofthe bestways to christen your options trading journey6. Similar sentiment hasbeen echoed by stocktrader.com in their published list of 6 Great OptionsStrategies for Beginners. The covered call is at the top of their list7. It is theopinionofthisauthorthatthegurusaren’tpromotingcoveredcallsforbeginnersbecausetheyrepresentasomehowuniquelysimpleformofoptionstrading,butinstead,becausetheyareahighlypalatablewayofintroducingoptionsintoyourgeneraltradingaffairs.Here’swhy:asyoumayrecallfromChapter2,whenyousellacall(anycall),

you’reguaranteeinganotherpartytherighttopurchaseastockatanagreed-uponprice–thestrikeprice—beforeanagreed-uponperiodoftimehasexpired.Whatmakesthesaleofthecall“covered”isyourownershipofthestock—knownasthe “underlying asset”—for which you are selling the call. In the example inChapter2,yousoldacalloptionforDisneystock,andyoudidsobecauseyou

ownedDisney and selling yourDisney Stockwas already part of your largerstrategy.Foroptionsbeginners,getyourfeetwetbychoosingastockthatyoualready

own (100 shares, preferably) andare looking tounload.Hence, a covered callcanprovideyouanopportunitytomakesomemoneybeforeyoueventuallyselloff the stock. In the fictitious Disney example from Chapter 2, you sold acoveredcalloption for100sharesofDisneyata$120strikeprice—shortoneDISNov120call—for$5per share, agrand totalof$500.Now, for the first-timeoptionstrader,theworstcasescenarioisthatthepriceofDisneyskyrocketsandyoumissouton abig return from thenormal saleof the stock, asyou’reforcedtosellitoffat$120persharetotheownerofthecall.Thatsaid,you’realreadygoingintothetransactionwithanintentiontounloadtheDisneystockatapricethatyou,atleastatthetime,thinkisreasonable.Therefore,ifyousticktocovered calls for your first several option trades, you’ll be able to directly setlimits foryour losses,meanwhile, you’ll learnmore aboutoptions trading andwillbeabletomorecomfortablyintegrateoptionsintoyouroverallinvestmentstrategy.Ideally,sellingcoveredcallsonstocksyouwanttosellanywaywillculminate

inacashinflux.Whenyousellacoveredcallyouwill,ofcourse,getpaidforit.Thispaymentisknownasa“premium.”IntheDisneyexample,thepremiumforsellingthecalloptionwas$500.Iftheoptionisneverexercised,thenthesellerpocketsthepremium,keepsthestock,andisfreetoputanothercoveredcalloutonto themarketandpocketanotherpremium.Thiscanbeagreatway tokeepyour stocks generating income for you, even as you’re preparing to partwayswiththem.

DumpingDuPontLet’ssayyou’rebrandnewtooptionsandreadytosellyourDuPont™Stock

(DFT).Meanwhile, you’d like to make somemoney on your way out of thestockandmaybetryyourhandatoptions trading.Let’sfirst takea lookat theoptionschain:

Asyou can see, there’s a dropdownmenu just below thequotedprice thatallows you to select an expiration date for your call option. Since you’reaccessing the options chain on December 16, 2015, go ahead and pull upavailablecontractswithanexpirationdateofApril15,2016,aboutfourmonthsaway.Yourobjectiveissellacalloptioncontract(100shares)foryourDuPontshares.Howdoyouuseinformationfoundintheoptionchaintodetermineyoursaleprice?If you don’t already know what bid prices and ask prices are, then it’s

definitelytimeto learn.Thesepricesdeterminehowmuchit’sgoingtocost tobuyorsellyouroptions.Sinceyou’reselling,thebidpriceforaparticularoptionrepresents what’s immediately available to you. Look at the chart in Fg. 8.Specifically take a look at the April 15th option contract with the $35 strikeprice.Asyoucansee,there’sanaskpriceof$.70andabidpriceof$.25.Thismeansthatsomepartyispreparedtoimmediatelypay25centspersharetoownthiscalloptioncontract.Thereisalsoapartywillingtosellthiscalloptionfor$.70pershare.Whatdoesthistellyou?Well,forstarters,that’sabitofawidespread for such an inexpensive option—we’ll talkmore about that later. But,longstoryshort,ifyouwanttoguaranteeyoursaleofthecalloption,thenyoucandosobyacceptingthebidpriceof$.25andsellingyourcoveredcall(100shares worth) for a total of $25. Seems a little skimpy, huh? If you’re juststarting in options trading, and especially if you’re looking at smaller spreads(the difference between the bid and the ask prices), then youmaywant to goaheadand sell your coveredcall at thebidprice to ensure thatyou’re trade isfilled. Ifyou’realreadyfamiliarwithexploiting thewiggle roombetweenbidsandaskprices,thenyoumaywanttojumprightinwithalimitorder,inwhichyouagreetopurchaseacertainfinancialasset(stocks,options,etc.)atorbelowacertainprice.Forexample,youcould instructyourbroker to“selloneAprilDFTcallat$.50orbetter.8”Ifyou’vebeenwondering,whatthe“one”meansinoption lingo, it refers to the buying or selling of “one” options contract (100shares).IfyouselltwoAprilDFTcallat$.50orbetter,thenyou’resellingtwocontracts (200 shares), and you’ll be paid $100 for the trade rather than $50,

assumingyourlimitorderisfilled.Ifyou’restillhavingtroublegettingyourheadaroundtheconceptofasksand

bids,thenimagineyourbrokerageasanimportbusiness,likePier1,thatshipsallofitsproductsfromSouthEastAsia.There’saparticularcosttothebusinessfor each product because of the transportation expense and the cost ofmanufacturing the product. There’s also a particular retail price. The importbusiness owner is not going to want to sell you one of her products at cost,because shewon’tmakeanyprofitwhatsoever.She’dprefer thatyou just payretailprice,butthatdoesn’tmeanthatshe’dbeunwillingtounloadtheproductif youwere interested in paying somewhere between the product cost and theretail price. Bottom line, flexibility is available, but there’s no guarantee thatyournegotiationswillbefruitful.

IntheMoney(ITM)orOutoftheMoney(OTM)NoticeinyourattemptstosellyourcoveredcallforDFTthatyou’repaying

particularattentiontothebottommostcallcontract,theonewiththestrikepriceof$35.Youmayalsonoticethelittlebluemarker thatYahoobusinessusestodenotecontractsthatarecurrentlyInTheMoney(ITM).IfanoptionisITM,itmeans that exercising the option immediately will yield a profit. That is, ofcourse, ifyoudon’t take intoaccount thecostofacquiring theoption tobeginwith.InFg.8thetopmostcallcontractisITMandthebottommost,theoneyou’re

lookingatwiththestrikepriceof$35,isOTM.The$30DFTcallcontracthasastrike price ($30), which is less than the value of the stock. Therefore, if theownerofsaidoptionimmediatelycalledinthestockat$30,she’dbemakingaprofitof$2.18pershare.Thatsaid,apricewaspaidtoobtaintheoption.Ifthatpricewasmorethan$2.18pershare,thentherewasactuallynonetprofitmade,eventhoughthecalloptionwasITM.Therefore,ifanoptionisITM,it’sgoingtoincreaseinprice,andiftheoptionisOTM,thentheoptionwilllowerinprice.Now,it’simportanttounderstandthattheparametersofOTMandITMchangewiththetypeofoptionbeingconsidered.Let’stakealookattheputoptionson

themarketforApril15thforDuPont.SeeFg.9below.

Notice that the baby blue “ITM” highlight is used to denote the put optionwith thestrikepriceof$35.This isbecauseforputoptions,whichrepresentaguaranteedrightto“put”orsellstockbacktothemarket,thestrikepricemustbehigherthanthestockvalueinorderforaprofit toberealized.InFg.9, theput option that’s ITM has a strike price of $35 and bid-ask spread of $4.10-$4.70.Thepershareprofitrealizedfromimmediatelyexercisingthisputoptionis$2.82($35-$32.18),which,ofcourse,isoffsetbythepriceofpurchasingtheoption.Inorderforanyoption(ITMorOTM)tobetrulyprofitableforabuyer,thestockprice(and/ortheoptionprice)mustalwaysmoveintherightdirectionwithin theallotted time.Inotherwords, thedirectprofitobtainedbycallinginthestockorputtingitonthemarketmustbegreaterthanthepriceyoupaidtoobtaintheoption.

Note : When the current price of the stock is the same as the strike price, then the option isconsidered tobe“At theMoney.”It iscommon foranoption tobereferred toas“At theMoney”evenifit’soffbyafewcentsupordown.Also,inhisbook,UnderstandingOptions,MichaelSincerepoints out an important rule of thumb for traders—don’t ever make the mistake of confusing anoption’sbeingITMforitsprofitability.Aswasalreadyexplainedinthissection,ITMandOTMdon’tinandofthemselveshaveaninfluenceonnetprofitability.Theonlythingthesetermsexplainistherelationshipbetweenthestockpriceandtheoption’sstrikeprice9.

Whenyou’rejuststartingoutwithoptionstradingandsellingacoveredcall,it’sbetter ifyouchooseacontractwitha strikeprice that’s slightlyoutof themoney.Yourthinkingshouldbesomethingakintothefollowing:‘I’vegot100shares ofDKT, currently valued at $32.18, that I’m looking to unload. I’d behappytosellitoffat$35ashare,soI’mgoingtoletthestockworkformeinthemeantime—I’mgoingtosellacalloptionwitha$35strikeprice.I’llmakesomemoneyintheshortterm,andI’llonlyhavetosellmystockifitgoesupto$35 or higher by the end of the expiration period. If the call option expireswithout ever being redeemed, then I’ll just issue a new one and continue togeneratemoremoneyfromthepremiumsreceived.I’llkeeptrackofhowmuchmoneymystockhasgenerated,as this isgoing to lowermycostbasis for thestock,andideally,makemyoverallinvolvementwithDFTamoreprofitableandsuccessfulendeavor.’

DisclaimerKeep in mind that when we advocate selling the covered call option as a

conservativeplayforabeginner,we’redoingsobecausethestrategyiseasytounderstand and can be easily fit into a greater investment strategy.We’re notimplyingthatthisstrategyismorelikelythanotherstoturnaprofitorminimizerisk. In his book, Options for the Beginner and Beyond, author and trader,EdwardOlmstead, provides a reality check for the covered call trade strategyandissuesthefollowingcaveats:

Olmsteadadvisesmonitoringthevalueoftheunderlyingasset,thestock,morecloselythanthevalueoftheoption.Justbecauseyou’vesoldacoveredoptiononthestockdoesnotobligeyoutokeepitifitfallstoolow10.

Note : Olmsteadmakes a good point, and it’s especially relevant for beginner-level optionstraders.Ifyou’retheownerof100sharesofastock,evenifyouwanttosellit,andareusingthestocktosellcoveredcalloptions,thenyou’restilllikelytobemoreaffectedoverallbytheperformanceofthestockratherthanbytheperformanceoftheoption,evenduringthetimeinwhich the option is active. Don’t let your covered call options distract you from your big-picturestrategy.

Olmsteadalsowarnsagainstgettingtoogreedyandimpulsivelybuyingbackyourcalloptionintheeventthatthestockshootsup,“Avoidbuyingbacktheoptionforalossunlessyouhaveagoodreasontodoso.”Ifthestockgoesup,youstillmadeaprofit.Maybeit’snotaslargeasitmighthavebeenhadyounotsoldtheoption,butit’sstillanetprofitinyouroverallinvestmentstrategy.Behappywithitandmoveon11.

AvoidTheseBeginnerMistakesEveryone makes mistakes with their investments, whether you’re trading

stocksandoptions,buyinggoldandsilver,orpurchasingrealestate.Agoodpre-investingeducation,canhelpyouavoidsomeofthecommonpitfallsthatclaimbeginningoptionsinvestorsandsendthemrunningforthehills.Considerthese:

Plantowork&workyourplanYou should always enter options deals with a plan, most specifically an exitplan.Manyofusmakeadefinitiveexitplanonlytogetcaughtupinthemomentand change it. Choose your upside and downside exit points in advance andadheretothosedecisions.Don’twaitaroundbecauseyouthinkastockisgoingto soar through the roof and you’llmake evenmore. The converse is true aswell.Don’tditchyourexitstrategyinhopesthatastockwillcomeupandyou’llrecoupmore of your losses. It’s easy to let your emotions get the best of youduring trading, especiallywith yourmoney at risk, but you need to put thoseemotions aside as best you can. That doesn’tmean, of course, that you can’treassessyourplanatall.Youjustdon’twanttodoitinthemiddleofatrade.

Don’tbuyitbecauseit’scheapDoyouknowsomeonewhoheads to the supermarketwith stacksof coupons,buying everything with these cents-off offers whether they need the items ornot?Well,sometradersoperatethatway,too.Brokerswarnnewoptionstraders

about the temptation to buy deeply out-of-the-money options just becausethey’recheap.Thisisespeciallytrueofthoseworkingwithlimitedfunds.Ifanoptionisveryfarout-of-the-money,ithasalongwaytomovebeforeitbecomesprofitable.Hence,it’softenabetterideatostartwithoptionsthatcostmoreandaremorein-the-moneyandhaveanexpirationdatethat’sfurtherout.Ultimately,therewardmaynotbeaslarge,buttheriskwillcertainlybelower.

RememberthatlossesareafactoflifeYoucan’tavoidlossesaltogetherwhenyou’redealingwithoptions trading,sodon’tfearlosses.Losseshappen,butyoujustneedtolearnhowtokeepthemassmallaspossible. Inevitablyyou’ll suffera fewsizeableonesaswell,butyoucan’tletthatscareyouawayfromthemarket.Don’tjustthinkaboutyourtradesinthecontextofwhetherornottheymakemoneyforyourportfolio,butthinkofwhethertheyareinlinewithyourownrulesfortrading.Thatinitselfconstitutessuccess.Thenacceptthefactthatyoucan’tcontrolthemarket.

BedisciplinedinyourtradingThink about these things before youmake any trade: 1)What is a reasonableamount ofmoney for this trade? 2)What entry and exit signals do I need toidentify?3)WhatisthemaximumriskI’mwillingtoassumeforthistrade?and4)Whyisitimportantformetoexecuteeachorderaccordingtoplan?(SeePlantoWorkandWorkYourPlan.)Theseareallpartofbeingadisciplinedoptionstrader.Discipline also occurs as a result of researching each trade before youtake theplunge.Inshort,youmust learnall the thingsyouneedtodoto tradesuccessfully.You’rereadingthisbook,soyou’reofftoagoodstart!

PracticeMakesPerfectAsyoulearntheparticularsofputsandcalls,ITM,OTM,andeverythingelse

associated with the options trading world, youmight want to create a virtualportfolio.Many beginning investors do this with stocks, and it tends to work

wellwithoptions, too.Anything thatmakesyou feelmorecomfortablebeforeyou put your money on the line is a good thing, and with virtual or “paper”trading,youarefreetomakemistakesandlearnfromthem.Paper trading allowsyou to readyyourself for the tasks involved inoptions

trading.You’ll learn toanalyze theoptionsavailableandorganizeyour recordkeeping,andyou’llobservehowthemarketrespondstocertainfactorsandhowyoushouldrespond.You’llbeforcedtofacecertainsituationsthatcouldbenail-biting if your money were truly on the line, but if you do it on paper andsucceed,you’llbemoreconfidentwhenit’stherealthing.Someexpertsdiscouragepapertradingbecausetheybelieveit’sjusttooeasy

onthepsyche.Optionstradingcanbeatruerollercoasterride,andbytakingtherideonpaperwithoutatruerisk,youcannotprepareyourselfemotionallyforthelossesyoumightencounterasyoutrade.Othersnotethatpapertradingdoesnothelpwiththeunderstandingoftradeexecution.Allofthatsaid,however,ifyouwanttopracticefirst,youcanpapertrade“on

paper”orevendoitelectronically.TheCBOE,forexample,offersafreevirtualtradetoolonitswebsite(www.cboe.org),whichallowsyoutotestanewstrategybeforeputtingitintoaction.Usetheirdetailedvirtualtradescreenstogetafeelforrealoptionstrading.Theyevenofferlivechatsupportwhenyouneedit.It’sawin-win situation for anyonewho’s not quite ready to start tradingwith herinvestmentfunds.Ifyoudothis,it’simportanttocreaterealisticscenariosasyoutrade.Ifyou’re

not going to be investing $3million, then don’t paper trade with $3million!Onlyuseamountsthatyou’regoingtobeabletoaffordwhenit’stimetodothereal thing. Similarly, don’tmake aggressivemoves that youwouldn’tmake ifthiswereyouractualmoney.ThemoreyourelateyourpapertradingstrategiestoYOURreality,thebetteryou’lldoafteryouexitthevirtualworld.Severalinvestmentfirmsoffervirtualtradingsites,othersdonot.Afewofthe

better paper trading sites are listed below. Each is a little different and somehavelimitsastowhatyoucanvirtuallyinvest.Inmostcases,youneedtoopenanaccount(filloutaregistrationform)tousethem.

www.thinkorswim.com–OperatedbyTDAmeritradewww.optionsxpress.com–OperatedbyCharlesSchwabwww.tradestation.comwww.optionshouse.com

6Sincere,Michael.UnderstandingOptions.NewYork:McGrawHill,2014.Electronicbook.7Wolfinger,Mark.6GreatOptionsStrategiesforBeginners.March27,2009.StockTrader.Com.Dateaccessed:12/16/158Fontanills,GeorgeA.TheOptionsCourse,SecondEdition.HighProfitandLowStressTradingMethods.Hoboken,NJ.JohnWiley&SonsInc.2005.Print.9Sincere,Michael.UnderstandingOptions.NewYork:McGrawHill,2014.Electronicbook.10Olmstead,Edward.OptionsfortheBeginnerandBeyond.UpperSaddleRiver,NJ:FTPrenticeHall.2006.Print.11Sincere,Michael.UnderstandingOptions.NewYork:McGrawHill,2014.Electronicbook.

|4|KeyInfluencersonOptionsPrices

Thepriceofagivenoptionatanypointintimeisinfluencedbyseveralfactors.In this chapter, you’ll learn about the most important factors that affect howmuchyouwillpayforanoption(orhowmuchyouwillreceiveforsellingone).

WhyYouShouldCareAboutHowOptionsArePricedYoumaybe thinking that options trading is essentially a bet that a stock is

goingtoeitherriseordecreaseinvalue,whichwillinturnmakeagivenoptionvaluableorworthless.Whyshouldyoucareaboutotherfactors?Whilethepriceoftheunderlyingasset(thestock)iscertainlyahugefactorin

determining the value of an option, it’s most assuredly not the only one.Remember,mostoftheoptionsyouendupowningyouwillresell,notexecute.Thegoal is essentially the same as it iswith anyother portfolio strategy: youwanttobuylowandsellhigh,andinordertocarryoutthisstrategyintelligently,youneed toknowallof the intricacies thatgo intodetermining thepriceforagivenoption.

Note:Takealookatsomeoftheextremelycheap,nearlyworthlesscalloptionsforFordMotorCo.inFg.10.Inalllikelihood,anyonebuyinganoptionsofaroutofthemoneyandwithonlyonemonthuntilexpirationdoesn’ttrulybelievethatthestockisgoingtoclimbupby$10.Theyaremostlikelyhopingthatthestockclimbsupbyamodestamount,maybe$3,andthattheirlong-shotcalloptioncanbesoldbackintothemarketforslightlymorethanwhattheypaidforit.Thisistherightwaytothinkaboutoptions,asbuyableandsellablecommoditiesthataredifferentfromstocksonlyinsofarastheycomewithanexpirationdate.

Perhaps George Fontanills puts it best, “The primary reason [forunderstanding thekey influencers of optionspricing] is that understanding thekeypriceinfluencesisthesimplestmethodtoestablishrealisticexpectationsforhowanoptionpositionislikelytobehaveunderavarietyofconditions.12”

TheMoneynessFactorChapter3talkedabouttheconceptofbeinginthemoney(ITM)oroutofthe

money(OTM).Thedifferencebetweenanoption’ssetstrikepriceandthepriceoftheunderlyingassetorstockisknownasthemoneynessfactor,andFontanillsarguesthatmoneynessisthemostcriticaldeterminantofanoption’sprice.Youcan see themoneyness factor atwork in virtually any option chain. Take, forinstance,anoptionchainforTycoInternational.InFg. 12 a series of call options are listed for Tyco International (TYC),

complete with the current bid and ask prices. The per share price of TYC is$32.22,and the strikeprices for thecalloptions range from$29 to$37.Sincethesearecalloptions,anystrikepricebelowthecurrentpriceissaidtobeITM.Asyouaresuretoseeinmostanyoptionchain,optionsbecomelessexpensivethelessinthemoneyandthemoreoutofthemoneytheybecome.

Note : Fg. 12 features call options. For put options, the strike price must be higher than theunderlyingassetpricetobeconsideredITM.

TimeValue&TimeDecayThesecondmostcriticalfactorthatinfluencesanoption’spriceisthetimeof

expiration on the contract. As was stated in Chapter 2 and emphasizedcontinuallybywriterandtrader,EdwardOlmstead,“timeismoney.”Thetimefactorisalsothemostimportantdistinctionbetweenowningastockandowningan option. Because options lose their value over time, they are consideredwasting assets. The phenomenon of an option losing value over time iscommonlyreferredtoastimedecay.InOlmstead’sbook,OptionsfortheBeginnerandBeyond,heoffersareally

interestingwaytothinkabouttimevalue–intermsofhype.Olmsteadcomparesthe expensive option contract with lots of time left until expiration to a hot,flash-in-the-pan Christmas toy whose hype drives its price up, but only on atemporary basis. Also, rather than “moneyness,” Olmstead uses the termintrinsicvalueandhisexplanationoftimevalue(orhypedvalue)inrelationtointrinsicvalueisquiteuseful.Hesuggeststhatthehypedvalueofanoptioncanbe seen clearly as what’s left over after the option’s intrinsic value has beentakenintoaccount13.Let’s take Olmstead’s theory and apply it to a specific case study. For

instance,let’ssayyou’vegot100sharesofAlphabetInc.valuedat$758.09pershare (GOOG),which isgoing tocostyouabout$75,809.Youcanbuyacalloptionwitha$750strikepriceforabout$10.60pershare.Thisoptionisinthemoney(ITM),anditsintrinsicvaluecanbecalculatedbysubtractingthestrikeprice($750)fromthepriceoftheassetitself($758.09),whichleavesyouwith$8.09fortheintrinsicvalue.That’sabout$2.50lessthanthepriceoftheoption.Therefore, asHolmsteadmight say, the leftover$2.50 is the “hypedvalue”ortime value of the option. As it turns out, you’re looking at a call option thatexpires in only 3 days, so that explains the relatively small hype value/timevalue.

Let’slookatthatsameoption,butwithamoresubstantialdurationremainingonthecontract.Let’sdoacontractoffiveweeksratherthanthreedaysandseewhathappens.Itturnsoutthatthesameoptionisnowgoingtocostyou$26pershare.Theintrinsicvaluehasn’tchanged,it’sstill$8.09or($758.09-$750),butthat’s because you’re looking at an optionwith 5weeks (35 days) left in thecontract,asopposedto3days.Subtractingtheintrinsicvalueof$8.09fromthepriceofthenewoption,$26,leavesyouwith$17.91in“hypedvalue.”

Note : It may be interesting to note that the 35-day hyped value for the option is only 7.2 timesgreaterthanthe3-dayhypedvalue,eventhough35daysis11.7timeslongerthan3days.

Note:ItmayalsobeinterestingtonotethatonlystocksthatareITMaresaidtohaveintrinsicvalue.Therefore,ifyou’reconsideringpurchasinganoptionthat’snotinthemoney,youcanrestassuredthatthebulkofwhatyou’repayingforisconsidered“timevalue.14”

Now let’s take that last example inwhich you calculated a time value/hypevalueof$17.91andtakealookattheputoptionforthesamestock(GOOG)atthesamestrikeprice($750)andforthesame35-dayperiod.It’snoaccidentthatyoufindthatputoptionpricedat$17.87,essentiallythesamepriceasthetimevalue of the call option. This is no coincidence. The reasons are rathercomplicatedandperhapsbeyondthescopeofthisbeginner-leveltext,butwhat’simportant to accept is that time value/hype value should always be consistentbetweencallsandputswhenyou’redealingwithboththesameunderlyingassetandthesamestrikeprice.

Note :For theputoptiondiscussedabove, the$17.87priceisentirelydrivenbytimevalue,as theoptionhasnointrinsicvalue.$750islowerthanthepriceoftheasset,thereforetheputoption,unlikethecalloption,isoutofthemoney.

VolatilityVolatility refers to the propensity of a certain financial instrument to

significantlyfluctuateinvalueovertime.When you think rationally aboutwhatmakes an option profitable, youwill

cometotheconclusionthattheremustalwaysbesomesignificantmovementinthepriceoftheoption,drivenbymovementinthepriceoftheunderlyingassetthat outpaces the time-decay, which devalues the option. Therefore, if you

purchaseanoptionthat’snotinclinedtofluctuatemuchinprice,thenthere’samuch slimmer chance that your optionwill end up big in themoney.On theotherhand,ifyouroptionisvolatileandsubjecttowideswingsinpricing,thenyou’vegotachancetomakeabigprofit.Thewayvolatility isevaluatedandusedin tradingoptions isoneof thekey

distinctionsbetweentradinginoptionsandtradinginconventionalstocks.Withaconventionalstock,highvolatilitymeansthatnotonlycanyouprofitbig,butyoucanalsolosebig.Whenyouownanoption,it’seithergoingtobeexercisedorit’snot.If thingsgoreallybadlyandthenumbersmoveagainstyouroptionwithextremeprejudice,theendresultisthattheoptionwillexpirewithouteverbeing exercised. The same end result will occur if your option finishes itscontract just barely out of the money. Therefore, according to this logic, theability of volatility to hurt you is limited, whereas its ability to help you isunlimited.While it’s good to understand the nature of the playing field you’re dealing

with when trading options, it does get a little more complicated when youconsiderthefactthatyouroptionscanbesoldbeforetheexpirationdatetohelpyouturnaprofitorlimitaloss.Iftheoptiondramaticallyplummetsinprice,andyousellitoffformuchlessthanwhatyoupaidforit,thenyoumayfindyourselfwishing you’d bought a less volatile option. Generally, though, volatility isgoing to increase the premiumof an option, because there is a greater chancethatonanygivendayduring thecontract, theunderlyingassetwill jumpdeepintothemoneyandtheoptionownerwillhavemorechancestoeithersellofftheoptionataprofit,ortoexercisetheoptionforaprofit.There are several ways to evaluate volatility. In options trading, historical

volatility and implied volatility are commonly utilized metrics. Historicalvolatilityreferstotheobservedbehaviorofagivenfinancialinstrumentintermsofpricefluctuation in thepast. Impliedvolatility,oftenreferred toas“IV”,bycontrast, is an assessment of the asset’s potential for future volatility andconsidered by some to be the quintessential metric determining an optionschanceofbecomingprofitable.Implied volatility is generally expressed in percentages. In his book, The

Options Course, Harvard MBA graduate, George Fontanills claims that anyimpliedvolatilitylowerthan20percentisconsideredlow15.Let’sseeifwecanwitnesstheinfluenceofimpliedvolatilityintherealmarketplace.InFg.13,lookatthe$70calloption,wayatthebottomofthelist.It’snearly

$5 out of the money and will sell for about 57 cents per share (somewherebetween $.55 and $.59). The implied volatility, which can be found in thecolumnatthefarrighthandside,is28.71percent.

Now,let’s takea lookat themorevolatileWWEcalloptionswith thesameexpirationdate:

Ifyou lookat theverybottomof theofyouroptionchainyou’ll findacalloptionwitha$22strikepricethatcanbehadforatleast20centspershareifnotcheaper.LikeyourTimeWarner, thisoption isa totalof$5outof themoneyanditsIVratingisnearlydoublethatofTimeWarnerat56.64%.So,withsuchahighvolatilityrate,whyistheWWEoption$5outofthemoneyalmosthalfthe price of the TimeWarner option, also $5 out of themoney? The answer:scaling.WWEstockisworth$17.33pershare,whereasTimeWarnerisworth$65a

share.ForthecheaperWWEstock,$5OTMisamuchmoresignificanthurdleto overcome for the option to ever be profitable, even with a higher impliedvolatility.Thelessonhereisthatthevolatilityisscalabletothepriceofastock,henceit’sexpressedasapercentagevalue.IfyoulookatWWE’sperformanceoverthelastyear(Fg.15),you’llnotice

thattheonlydiscerniblespikeinthevalueofthestockclearedthe$22threshold.Therefore,inorderforthat$22calloptiontobeprofitable,you’dneedthestocktoreturntothatlevelbyJanuary15th,oratleastgetcloseenoughtoitbeforetheexpirationdateinordertoresellthisoptionataprofit.Itdoesn’tlookverylikely—hence,buyingthecallwouldonlycostyou20bucks.

Let’slookatthesame1-yeargraphforTimeWarner:

UnlikeWWE,TWXhasspentplentyoftimeoverthelastyeartradingabovethe $70 strike price. It looks like thingswere a bit dicey through the fall, butthere’sstillbeenmovementabove$70.ThislookslikeamorepromisingoptionthantheWWEpurchase,and,ofcourse,it’salittlemoreexpensive.Butbeforeyoupaythe$57tobuytheoption,youshouldprobablytrytogetareadonwhatcausedTWXtoplummetduringthelatesummerandearlyfall,andwhetherornotthere’sadecentchanceforabouncebackwithinthenextmonth.

Let’s takea lookatastock that tradesatasimilarpricepointasTWX.The58.comInc.stock(WUBA)iscurrentlytradingatnear$70.Whenyoulocatethe$75 call option forWUBA—that’s $5out of themoney (see the bottommostcalloptionlistinginFg.16)—you’llnoticethattheimpliedvolatilitypercentageisgreaterthanitwaswiththeTWXstock,nearly41%,comparedto29%.ThepriceoftheWUBAoptionissignificantlymoreexpensive,about$1.35persharecompared to TWX’s 57 cents. That’s a hefty price differential for a similarpositiononasimilarstock.PerhapstherearemoreforcesatworkdrivingupthepriceoftheWUBAJan75call.Let’stakealookatthestock’sperformancethisyear.

TherearetwothingsthatstandoutblatantlyinWUBAsperformanceoverthelast 12months (within the contextof thepotential purchaseof the Jan75 calloption).Itlookslikethestocktradedatover$75lastspringforsometime,thendroppedoff.Butitalsoappearsthatthestockisbeginningtoascendinvalue,somaybeit’sduetokeepascending.It’stheopinionofthisauthorthattheextraheftypricefortheWUBAcallis

mainlyduetotheapparentascendingtrend.WUBAlookstobeonthewayup,whereasfewerpeopleareinclinedtobelievethatTWXisgoingtoreboundanytime soon. Not to mention the fact that WUBA has greater overall impliedvolatility.Just for kicks and insight, let’s do a similar comparison between these two

similarstocksontheotherendoftheoptionspectrum.Let’slookataputoptionforTWXthat’slikewise$5outofthemoney:

In the image above you can see that there is similar pricing and similarimpliedvolatilitybetween theputand thecalloptions,each$5OTM.Theputoptionisslightlylessexpensive,mostlikelybecause,asshowninthegraphonFg.16,TWXdoesn’thaveanimmediatehistoryofsinkingbelow$60,whereasit’sspentawholelotoftimeupwardsof$70.Options traders largely rely on the strategy of searching for discrepancies

between a stock’s historical volatility and its implied volatility. If an optionstrader can spot an option with an implied volatility that’s too low given itshistoricalvolatility, then thatoption issaid tobecheapandmayprove tobeagooddeal.Ifthehistoricalvolatilityindicatesthatanoption’simpliedvolatilityis too high, then the option is thought to be expensive and should be sold ifpossible.Tradersarealsolookingformismatchesbetweentheimpliedvolatilityofanoptionandthevolatilityofitsunderlyingasset.Iftheassetismorevolatilethan the options with which IV credits it, then you’ve got an option worthbuying.IftheassetismorestablethanisreflectedbytheIV,sellitaway16.Impliedvolatility is aconcept thatyouunderstandmore themoreoftenyou

useit.AsMichaelSinceresays,“Todemonstratehowdifficultitistodefine,I’dlikeyoutoansweraquestion.Canyoudefinegravity?”Sinceregoesontooffera very psychologically-focused explanation of implied volatility: “It’s theurgency, or expectation, that the stock pricemight undergo a big change thatdrives traders to bid-up the options (forcing both the premium and impliedvolatilityhigher).17”

Fg.20:Anothermacro-trendinoptionvolatilityisthetendencyofoptionstobecomemorevolatileastheybecomemoresoinoroutofthemoney--thisisknownasthevolatilitysmileorgrin.

InterestRates&DividendsThough interest rates and dividends aren’t as important as the other factors

influencingoptionspricing,theystillmustbeacknowledged.Wheninterestrates(thecostofborrowingmoney)goup, thepriceofcallsgenerally increaseandputsdecrease.Theoppositeistruewheninterestratesgodown.Whendividendsof theunderlying asset increase, thepriceof calls decrease

andthepriceofputs increase.Whendividendsdecrease, theoppositeoccurs18.Wewon’tgetintothespecificmechanismsoftheserathernegligiblefactorsinthistext.The next chapter drills down even further on option evaluation metrics by

offeringinformationaboutthe“Greeks.”12Fontanills,GeorgeA.TheOptionsCourse,SecondEdition.HighProfitandLowStressTradingMethods.Hoboken,NJ.JohnWiley&SonsInc.2005.Print.16Fontanills,GeorgeA.TheOptionsCourse,SecondEdition.HighProfitandLowStressTradingMethods.Hoboken,NJ.JohnWiley&SonsInc.2005.Print.18http://www.investopedia.com/university/options-pricing/option-price-influence.asp13Olmstead,Edward.OptionsfortheBeginnerandBeyond.UpperSaddleRiver,NJ:FTPrenticeHall.2006.Print.15Fontanills,GeorgeA.TheOptionsCourse,SecondEdition.HighProfitandLowStressTradingMethods.Hoboken,NJ.JohnWiley&SonsInc.2005.Print.17Sincere,Michael.UnderstandingOptions.NewYork:McGrawHill,2014.Electronicbook.14Vine,Simon.Options:TradingStrategyandRiskManagement.Hoboken,NJ.JohnWiley&SonsInc.2005.Print

|5|WinatOptionsBySpeakingGreek

Itwouldn’t be a book on options tradingwithout the inevitable foray into theworldoftheGreeks.TheGreeksrefertoseveralkeymetricsdenotedbyaGreekletter, only a small handful—delta, gamma, theta, vega, and rho—are in thevocabularyofthetypicaloptionstrader,withdeltabeingthemostuseful.

DeltaPart ofwhatmakes delta useful is that it’s quite easy to understand.Aswe

explainedinChapter2,ifyoubuyanoptionandsuddenlytheunderlyingstockspikes in the right direction, it’s more advantageous (and usually moreprofitable) to resell the option than execute the option.What the deltametricdoesistellyouhowmuchthepriceofyouroptionisexpectedtomovewhentheunderlyingstockmovesbyasinglepoint.Thoughthedataprovidedfromdeltaisn’tironclad,itcanprovetobeanextremelyusefulreferencepointwhentryingtogaugethepotentialprofitabilityofanoption.Deltas are alwaysgoing tohave an absolutevaluebetween0 and1, though

traders often drop the decimal place—saying the option has a 50 delta, asopposed to a .5 delta. Calls always have a positive delta and puts, a negativedelta.Usuallythedeltaisgiven,especiallyonbrokeragesitesorexchangewebsites

thatspecializeinoptionstrading,butit’salsoeasytocalculatethedeltaforanoption.Allyouneedissnapshotsoftheboththestock’svalueandtheoption’svalue.Takeacalloption,for instance.Let’ssaythestockison themarketfor$30, and there’s a call optionwith twomonths to go before expiration that’scurrently ATM (at the money) and a $30 call contract that may currently bepurchasedfor$1pershare.Whenthestockgoesupinvalue,let’ssayto$32,thecalloptionisalsogoingtobecomemorevaluable.(Inthiscasethecalloptionissuddenly$2inthemoney.)Let’ssaythatthecalloptiongoesfrom$1pershareto$2pershare.Thedeltaof theoptioniscalculatedbydividingthechangeinthe option price by the change in the stock price. In this example you get 1dividedby2,or.5.Thisiscommonlyreferredtoasa“50delta.”

Fg.22:Theequationaboveholdstrueforbothcallandputoptions.

Usingthisformula,youcanseewhycalculatingthedeltavalueofaputoptionalwaysresultsinanegativenumber.Asthepriceofthestockgoesup,thevalueoftheputoptionalwaysgoesdown,soyoualwaysendupdividinganegativenumberbyapositivenumber,orviceversa,resultinginanegativedeltavalue.

Note : Another common principle of delta that’s illustrated in the example above is that once theoptionisITM,it’susuallygoingtohaveadeltavaluebetween.5and1.0.Theoppositeisalsotrue.Ifthecalloptionisoutofthemoney,thenit’sprobablygoingtohaveadeltavaluebetween0and.5.Furthermore,thevalueofdeltachangesdramaticallyastheendoftheoptioncontractnears.Forinthemoneyoptionsnear the endof their contracts, delta valuesare very close to1.Forout of themoneyoptionsneartheendofthecontract,deltavaluesareveryclosetozero.

UsingDeltatoPreventCommonFrustrations

Oneofthethingsthatfrustratesbeginner-leveloptionstraders,andmayturnthem off to options entirely, is purchasing an option and watching the stockvaluemove$2oreven$3inthe“right”directiononlytofindthatthevalueofthe option has barely changed. Many beginners first approaching the optionsmarketmaybedrawntotheveryinexpensive,outofthemoneyoptioncontractswithverylittletimeleftonthecontracts.Sureyoucangetoneofthesecontractsfor$20,butit’snotlikelytomakeyouanymoney.Thereasonforthisisthatthedeltavalueofoutof themoneyoptioncontractsnear thepointofexpirationisclosetozero.Evenifthestockmovessignificantlytowardthemoney,theoptionmay not gain any significant value. A lot of these extremely cheap, nearlyexpiredOTMoptionsaretheequivalentsofaHailMarypass.Learninghowtoreadanoption’sdeltavaluecanspareyoufromthisfrustration.

Gamma

Gammameasures the expected changeof thedelta value in relation to a $1change in the price of a stock. Remember, the delta value is anything butconstant throughout the life of an option, but the extent towhich it fluctuatesmay hinge on a few different factors, such as the proximity to the option’sexpirationdate.

Note:Whentheexpirationdateapproaches,thegammavalueishigh,becausesmallchangesintheprice of the stock can dramatically change the delta value. In “Options for the Beginner andBeyond,”EdwardOlmsteadusestheexampleofacalloptionthat’sslightlyOTMandveryclosetoexpiration.Thedeltavaluefortheoptionmaybeclosetozero,butasmallchangebringingthestockslightly intothemoneymayresult inadeltavalueclosetoone.Thus, thestock,at thispointhasahighergammavalue19.

Forthebeginner-leveloptionstrader, themostimportantthingtounderstandabout thegammametric is theconceptofgammarisk. Ifyourgammalevel ishigh and you’re in a position tomake a profit orminimize loss by selling orexercising your option, then youmaybewise to do so since the option couldquicklydeteriorate.Though gamma analysis is used by the pros, especially in risk assessments,

it’snotessentialthatyouhaveathoroughunderstandingofhowtoleveragethismetricwhenyou’rejuststartingout.Thebottomlineofthegammametricisthatwhengammaincreases,thepricesofyouroptionsaremoresensitivetochangesinthepriceofthestock.

Theta

Theta measures the price change of an option in relation to a unit of time(usuallyaday).Asyouknowbynow,thecloseranoptiongetstoitsexpirationdate,thelessvalueittendstohave—allotherfactorsbeingequal.Whatthethetametricdoesisquantifytheextent towhichthisvalueischangingonaday-by-daybasis.Theta,therefore,isanegativevalue.Thislostvalue,inoptionsjargon,isoftenreferredtoas“thetadecay.”Forabeginner,youshouldunderstandthatthetadecaydetractsfromthevalue

ofanoptionatanever increasingrate.Ifyou’vegotanoptionyou’rethinkingaboutselling,andtherearethreeweeksorsoleftinthecontract,bepreparedforthe thetadecay tomakea seriousdent in thevalueofyouroption.Thecloseryougettoyourexpirationdate,themoreseverethethetadecay.In Options for Beginners, Edward Olmstead offers an illustration on theta

decayusingsimplesquareroots.Hesays,“Themagnitudeofthetaforanat-the-money option varies inversely as the square root of the time remaining untilexpiration20.”Thatmayseemlikeabitofamouthfull,butwhenyouconsideritwithinthecontextofarealscenarioit’sabitclearer.

Note(advanced):Forexample—ifIhaveanATMoptionthat’sgoingtoexpirein45days,itsthetadecay will proceed at 1/3 the speed relative to the same option at the money, with only 5 daysremainingonthecontract.Thiscanbecalculatedbydividing45by5(=9)thentakingtheinverseofthesquareroot(3)toget1/3.

Again, if you can’t get your head fully around theta yet, just know that thetime decay becomes more impactful the closer the option comes to expiring.Alsounderstand,however, that theta isnever theendall/beall thatdeterminesthe value of your options. Any investor should realize from the moment shepurchasesanoptionthatit’sgoingtostartgoingdowninvalueandthat,inorderfor theoption toproveprofitable, theunderlying assetmustmove in the rightdirection with a decent magnitude of delta force behind it (assuring that theoptionpricewillmoveintherightdirectionaswell).

Fg.26:Thepaceatwhichanoption’svaluedeterioratesbecomesquickerandquickerastheoption’sexpirationdateapproaches.

VegaWedon’thaveanimageof theGreeklettervega,becausevegaisnotareal

Greek letter.Vega indicates theamountof changeexpected inanoptionpricefor every percent change in implied volatility. Remember, options withunderlyingassetsperceivedtobehighlyvolatiletendtobemoreexpensivethanoptionswithmorestableunderlyingassets.Vegaismeanttoshowthespecificdegreetowhichchangesinimpliedvolatilitymayaffectthepriceofanoption.

RhoThefinalGreekwewilldiscussisRho,whichisconsideredbytheexpertsto

be the least important of all theGreeks21. Rhomeasures the effect of interestrates (onUS treasury bills) on the pricing of options. TheRhometric can beeither negative (for puts) or positive (calls). As of the writing of this book(2015),interestratesaresolowthattheRhometricisnegligible.19Olmstead,Edward.OptionsfortheBeginnerandBeyond.UpperSaddleRiver,NJ:FTPrenticeHall.2006.Print.20Olmstead,Edward.OptionsfortheBeginnerandBeyond.UpperSaddleRiver,NJ:FTPrenticeHall.2006.Print.21Sincere,Michael.UnderstandingOptions.NewYork:McGrawHill,2014.Electronicbook.

|6|PopularOptionsStrategies

Asstatedpreviously,you’renotgoingtoautomaticallyprofitonanoptionjustbecauseyouroptionisITM.Youalsohavetoaccountfortheamountyoupaidtoowntheoption.Tradersuseaconceptcalleda“breakevenpoint”tohelpthemclarifywhenthey’reactuallyholdingaprofitableoption.Forcalls,yourbreakevenpointcanbecalculatedsimplybyaddingyourstrike

pricetothepremiumyoupaidtoowntheoption.IfIowna$49calloptiononastockworth$50(alreadyITM),andIpaid$2asharetoownthisoption,thenmybreakevenpointisequalto$49+$2or$51.Oncethestockrisesabove$51,thenandonlythenismyoptiontrulyprofitable.

Note : For the purpose of this discussion, assume that the options are being held to the point ofexpiration.In thescenarioabove, there is,ofcourse,awayto turnaprofit,evenwithout thestockreachingitsbreakevenpoint.Forinstance,ifthestockrisesto$51,thenthepriceoftheoptionwillprobablyspikeuphigherthanthe$2youpaidforit,andyoucanthenselltheoptiontoanotherpartyataprofitbeforethestockevenreachesthebreakevenpoint.

Here’s an example of how utilizing the breakeven point is helpful whenassessingandmonitoringoptionsstrategy:Chapter3discussedsellingthecoveredcalloption,wherebyanoptionissold

onastockyouown,onethatyou’recomfortablesellingatacertainprice.YouusedDuPont,whichwas tradingat$32.18,andyousoldacoveredcalloptionwithastrikepriceof$35.Yousold theoptionforabout$.50pershare.Usingthis strategy, in order for the party who bought your option to reach hisbreakeven point, the price of DuPont would have to climb to at least $35.50before the expirationperiod.Now, from theperspective of your position, and,assuming that you’re truly committed to unloading all of your DuPont stock,there is anotherbreakevenpoint thatyouneed tokeep inmind.Youcollected$50(.50x100) fromthesaleof the$35calloption,and,as theownerof100shares of DuPont, you’re losing $50 every time the stock declines by $.50.Therefore, as thewriter/seller of the covered call, your breakeven point is thepriceyoupaidforthestock,$32.18,minustheper-sharepriceofthecalloption

($.50)—$31.68.Inotherwords,evenifyoupadyourcoffersbysellingthecalloption,yourDuPontplayisstillgoingtolosemoneyifyouendupgettingoutat$31.68orlower.

StraddlingaStockUsingOptionsThe straddle tactic is both easy to understand and potentially useful for

investors who believe that they can spot interesting trends in the market. InChapter 4, we took a look at theWWE stock when trying to assess impliedvolatilityanditseffectonthepricingofoptions.EverylateMarchorearlyApril,theWWEbrings its signatureproduct, “Wrestlemania”, to themarket.There’salways a whole lot of talk about whether the current year’s Wrestlemania isgoing to be a successful event, and in the aftermath of the spectacle majorchangesarerevealedthataffectthedirectionofthecompany,mostnotably,whoisgoingtobetheWWE’snewchampion,aswellaswho’sgoingtoberetiringorwho’sgoingtobecomingbackorsteppinguptoabiggerrole.IfyoulookattheWWE’s stock performance chart over the last five years (Fg. 29), you’llnoticethattherearesomesignificantfluctuationsinthestock’spriceoccurringbetweenthemonthsofMarchandMay.Forthesakeofargument,let’ssaythatyoucan’tpinpointwhetherornotWrestlemanialeadstotheplummetingofthestock’s value or raises it, but you’re quite certain that it changes it in someparticularway,anddramatically.

Fg.28:Intheexampleabove,“(exp)”isusedasastand-inforanygivenexpirationmonth.

Inthisevent,youmightconsiderusingastraddlestrategy.Inastraddle,aputandacalloptionarepurchasedforthesamestockatthesamestrikeprice.Let’ssaythatnextFebruarytheWWEstockistradingataround$15pershare.YoudecidetostraddlethestockbypurchasinganATMcallandanATMputoption.Each option costs you a dollar per share to purchase, so you’ve technicallyinvested$200ifyou’rebuyingstandard100shareputandcallcontracts.

YouknowthatWrestlemaniaisonAprilthirdthisyear,soyouselectthethirdFridayinAprilforyourexpirationdate.Now,inorderforyoutomakemoneyonyourstraddle,theWWEstockneedstobeeitherabove$17($2above$15)orbelow$13($2below$15)bytheendofthecontract.Hence,breakevenpointson the straddle strategy are expressed as two limits: above x or below y orbeyondtherangeofxtoy.Instraddleplays,youneedhigherimpliedvolatilitytohaveagoodchancetopassthebreakevenpoint,but,unfortunately,asalways,options with higher implied volatility are likely to prove to be expensive.Furthermore, whenever a company is about to release big news or put asignificant product on the market for the first time, the price of all optionsassociatedwiththatstockareinclinedtospikesomewhatinanticipationofsomemajormovement.

TheStrangleThestranglestrategyislikethestraddleexceptthecallandtheputaresetto

differentprices,usuallywiththeputstrikepricebeinglower.Investorsgenerallyturn to the stranglewhen they’d rather pay a little bit less in premiumswhilebettingthatthestockwillmovewellpastthebreakevenpointforeitheroption.Forexample,GeneralMotorsistradingat$33.YoudecidetopursueastranglestrategybypurchasingacheapOTMcalloptionwithastrikepriceof$36.Thecall costs you 50 cents per share in premiums. You concurrently purchase acheapputoptionwithastrikepriceof$31,andyoupay$1pershare.Yourtotal(combined)premiumpaymentis$1.50.Therefore,inordertobreakevenonthestrangle,youneedGeneralMotors to riseabove$37.50 ($36+$1.50)ordropbelow $29.50 ($31-$1.50). Just as with your straddle strategy, the stranglestrategyshouldbedrivenon theassumption thata stock isgoing tochange inprice,eitherupordown(you’renotsurewhich).Astranglewillgiveyoumoreoptions thana straddleandwill alsogive the investor a chance toenter intoamarketpositionforpotentiallylessmoney.

ABull(orBear)SpreadThe vertical spread refers to the simultaneous purchase and sale of calls or

puts on the same stock at different strike prices. As with the previous twostrategies,thepurposeofthespreadistoprovidetheinvestorwithflexibilityofpositioning.Let’sreusetheGeneralMotorsexample,assumingthestockisstilltradingatabout$33.IfyoudecidetobuyacallonGMwithastrikepriceof$35andsellacallwithastrikepriceof$37,you’restillgoingtoenduppayinganoverallnetpremium,as the$35calloption thatyoubought ismoreexpensivethan the $37 option that you sold. For the purpose of this illustration, let’sassumethatyoupaid$.50tobuyyour$35callandthatyousoldyour$37callfor $.20. Therefore, your total premium payment to establish your currentpositionis$.30.

Note:Forcallspreadssuchasthisone,it’snotnecessarytoownthestock.Intheeventthatthe$37callgetsexercised,youwillhavepresumablyalreadyexercisedyour$35call.

Inorderforyourspreadtopassthebreakevenpoint,thestockmustrisehigherthan$35.30($35+ .30). If thestockendsupatanypointbetween$35.30and$37(withinthespread),thenthe$37callwillnotbeexercisedandyou’lltakeaprofit.Shouldthestocksoarabove$37andyou’reforcedtoobligethecallyousold,thenyourprofitwillcapoutat$1.70($37-$35.30)regardlessofhowmuchhigherthestocksurgesabove$37.Inotherwords,evenifthestocksoarsto$40orhigher, for all intents andpurposes, inyouruniverse, the stockendedupat$37,asyouarepre-obligedtosellthestockatthisprice.Themoralof thestoryonspreads is that theyallowyou tocutdownon the

expenseofyourpremiums,buttheylimit,toanextent,yourcapacityforprofit.Spreadsareverypopularamongprofessionalinvestorswhowouldgladlytradeawayashot-in-the-darkchanceatseeinganenormousprofitifitmeanscuttingdownontheirrisk.

ThetradeillustratedinFg.32inwhichtwocallsareconcurrentlyboughtandsoldatdifferentstrikepricesisknownasabullspread,astheinvestorneedsthestocktobehavebullishly(goup)inordertoseeaprofit.Abearspreadcanbeexecutedbysimultaneouslypurchasingandsellingput

optionsonthesamestockatdifferentstrikeprices.Justlikeinthebullspread,you’retradinglimitedprofitabilityforalessexpensivepremium.Here’salistofseveralotherstrategiesforyourconsideration.Yourbrokercan

enlightenyouastowhetherornotthey’dworkforyouand,ofcourse,youcanvirtuallypracticethemuntilyou’recomfortablewithattemptingthemforreal.

TheCash-SecuredPutThecash-securedputisusedbyinvestorswhoarelookingtoacquireownershipofastock,butwanttogetinwithminimalexpenditure.Toaccomplishthis,theinvestorwritesaputoptionthat’sslightlyOTM.Ifthestockdoesn’tgodowninpriceandtheputoptionisnotassigned,thentheinvestorpocketsthepremiumand may write/sell another put option. When the stock waxes bearish, theinvestorpurchasestheunderlyingstocknearthestrikepriceandhopesthatthestock turns quickly bullish before his new acquisition is assigned via the putoption.Themainideaofthecash-securedputistousepremiumrevenuesfromthesaleoftheputoptiontomitigatethecostofacquiringthesought-afterstock.

TheMarriedPutAmarried put weds long stock with a long put to provide protection for theinvestor.Forthisstrategy,youpurchasethestockandtheputatthesametime.Thisstrategyfunctionslikeaninsurancepolicyandprovidesa“floor”shouldtheasset’s price plunge suddenly and drastically. Experts say the married putprovides the investor with limited risk and unlimited reward. As with manystrategies, timing is key, but with the married put you can protect yourselfagainstpotentialshort-termlosses.

TheProtectiveCollarTheprotectivecollarstrategyoccurswhenaninvestorpurchasesanout-of-the-money(OTM)putoptionandwritesanOTMcalloptionatthesametimeforthesameunderlyingasset(i.e.sharesofstock).Thisstrategyworksbestafteralongpositioninastockhasproducedsignificantgainsandistheperfectwaytolockinprofitwithoutsellingyourshares.Trytopurchasethestockandtheputduringlow-volatility conditions for the best outcome.This allowsyou to buy longer-termprotection.

Fg.34:Theprotectivecollarstrategylimitsbothprofitandlossandisagoodwaytoprotectaninvestmentduringuncertaintimes.

TheButterflySpreadAccording to Dr. Joe Duarte,cite the Butterfly Spread combines theaforementionedbullputspreadandbearputspreadexpiringthesamemonthforadebit.Theimageofthebutterflyisusedbecausethetwoshortputspossessthesamestrikepriceandaresaidtomakeupthebodyofthebutterfly.Conversely,thetwolongputsincludedifferentstrikeprices(aboveandbelowtheproverbial“body”) and they are said to be thewings.This strategy provides limited riskwith limited reward and can get expensive due to the trading costs associatedwiththethreepositionsinvolved.However, it’saninterestingstrategyandonethat’sgoodtotryonpaperasyoupracticeyouroptionstrading.

Fg.35:Thebutterflyspreadstrategyisusefulwhenastockappearstobestablewithinacertainpricerange

TheIronCondorWhilewe’rediscussingwingedcreatures…theIronCondorinvolvesaninvestorholdingbothalongandashortpositionintwodifferentstranglescenarios.Thisisafairlycomplexstrategythatisnotmeantforthebeginnerasittakestimetomaster.However,onceyou’rereadytoexceedthesafehavensofcoveredcallsandotherbeginnerstrategies,andifyou’resomeonewhoreallyenjoys“havingsome skin in thegame”,you’ll love the excitementof the IronCondor.Whenyou’reready,askyourbrokeraboutitand,again,practiceitonpaperuntilyoufeelconfidentabouttheparticulars.

Fg.36:Theironcondorcombinesmultiplestrategiesintoonegivingtheinvestorawidebutlimitedrangeinwhichtoprofit

Remember,NOstrategyisriskfree.Allcarrydifferentdegreesofrewardandrisk,andyouneedtodecide–asyouprogress–whetheryouwishtocontinuetoplayitsafeorifyou’rewilling(andcanafford)tobealittlemoreaggressiveinyourinvestments.Abrokerwhohasyourbestinterestsinmindshouldbeabletolead you in the right direction in regards to testing different strategies. If youtrusthim–andyoushouldonlymaintainabrokeryoutrust–gowithhisadvice.

RollingPositionsThe term “rolling” refers to one of the most common ways to adjust an

option’s position.You can roll either a long or a short option position, but inordertostayintunewiththebeginner-levelknowledgeinthisbook,we’llfocusonrollingtheshortposition.Understand, first of all, that with rolling, there are no guarantees. As with

everythingyoudointheoptionsmarket,youare“speculating”andhopingthatthemovesyoumake result in a profit rather than a loss.Wheneveryou roll ashortposition,you’rebuyingbackanoptionyouinitiallysold--therebyclosingthat position--and writing/selling a new option on the same stock but with adifferentstrikeprice,therebyopeninganewposition.Let’stakealookatthreeofthemorebasictypesofrollingpositions:

RollingtheCoveredCallWhenyouchoose to roll a coveredcall,yougo in the“upandout”direction.You’relookingtogo“up”instrikepriceandtogo“out”intime.Thiswayyoubalance the decrease in premium you’d encounter for selling a higher OTMstrikepriceincontrasttothegreaterpremiumyou’dreceiveforsellinganoptionthatisfurtherfromitsexpirationdate.Here’sanexample:Supposeyouselectabuy-to-closeorderforthefront-month80-strikecall.At

theexactsametime,youselltoopenanout-of-the-money85-strikecall(thisis“rollingup”)thatexpiresin60days(thisisreferredtoas“rollingout”).Dueto

highertimevalue,theback-month85-strikecallistradingfor$2.50.So,youpay$2.30 to buy back the front-month call and receive $2.50 for the back-monthcall.Hence,youdothistradeforanetcreditof$0.20($2.50saleprice-$2.30purchaseprice)oratotalof$20.Therearepositivesandnegativeshereandmaybesomethingsthatmakeyou

abitnervous.Ononehand,sinceyouraisedthestrikepriceoftheoptionto$85,you can potentially make more profit on the stock since the obligation wasoriginallyat$80.Youhadtobuybackthefirst-monthcallformoremoneythanyou receivedwhen selling it, BUT you covered that cost by selling the back-monthstrikecallformorepremium.Theriskispresentbecausetherearetwomonthsleftbeforetheexpirationdate

of thenewoptions,andyouhavenoideawhatmighthappenwiththepriceofthe stock during that period of time. It may proceed in your favor…but youmight see a loss aswell.Remember, there’s time for themarket tomove in adirectionthatwon’tbetoyouradvantage.Youhavetodecidewhetherornotit’sworthtakingthatchance.

RollingaCash-SecuredPutInthisscenario,youwanttoroll“downandout”inordertoavoidassignment.Thisisconversetothe“upandout”directionyouwanttogowhenrollingthecoveredcall.Here’sanexample:You’regoingtosella30-daycash-securedputonyourfavoritestock,Melody

MusicalInstruments.Ithasastrikepriceof$50.Whenthestockwastradingat$52, you received a premium of $.80 per share for selling the put option.However, thestock isnow tradingatonly$49.50,and it’sgettingclose to theexpirationdate.You’reworried.So,youneedtobesuretoavoidassignmentbybuying back that front-month 50-strike put and, therefore, cancel yourobligation.However, that front-monthputyousoldwaybackwhenfor$.80 isnowsellingfor$1.45.So,whatcanyoudotoaccomplishtheroll?Youneedtoenterabuy-to-close

order for the front-month 50-strike put. In the same trade, you need to sell to

openaback-month48.50-strikeput(thisistherollingdownpart),90daysfromexpiration(rollingout)whichistradingfor$1.70.Bydoingthis,youreceiveanetcreditof$0.25($1.70-$1.45)oratotalof$25.Theincreaseintimevalueofthe90-dayoptionthereforeallowsyoutorollfor

anetcreditof$25eventhoughtheback-monthputisfurtherout-of-the-money.Thecaveat?Wheneveryoudoadownandoutroll,youmighttakealossonthefront-monthput. In addition,you’renot sure inwhatdirection themarketwillmove in the months before the expiration, so you really haven’t secured anygains on the back-month put, which exposes you to further risk. Hence, youshouldalwaysdoadownandoutrollfortheshortestpossibletimeperiod.

RollingaShortCallSpreadSimilar to rolling individual options, you can roll a spread by moving strikeprices upor down andmovingout in time.However,with a spread, there aregenerallyfouroptionstobetradedduringtheprocess(closingtwoandopeningtwo)insteadofjusttwo.This,initself,makesitalittlemorecomplicatedrightoffthebat.Rememberthatfavoritestock...MelodyMusicalInstruments?Well,nowit’s

tradingat$53andyou’reinabearishposition.Yourbrokeradvisesyoutosella55/60shortcallspread30daysfromexpirationtime.Assuch, let’ssayyou’regoingtoreceiveanetcreditof$1.00.Butnowthestockisheadingupwardsandis selling at $55.50. There are only 15 days left until the expiration date and,sadly,thecosttobuybackthespreadhasrisento$1.70.Youthinkthat this is justafluke,andyourresearchshowsthat thisstockis

going togobackdown.So,youdecide to roll up andout.Thatmeansyou’rerollingupinstrikepriceandoutinexpirationtime.So,youbuybackthe55/60shortcallspreadfor$1.70and,atthesameexact

time,sellanothershortcallspreadthathasashortstrikeof60,alongstrikeof65, and is 45days fromexpiration.As a result, you receive a credit of $1.10.Youwindupwithanetdebitof-$.60.However,ifthestockisbelow$60bythetimeyoureachthenewexpirationdate,you’llbebackinthemoneytothetune

of$.40.(That’sthe$1.00netcredittoopenthe55/60spreadminusthe$1.70netcredittocloseit,plusthe$1.10netcredittoopenthenew60/65spread.)Soundcomplicated?It is!And,remember,yourforecastsabout thedirection

of thestockpricesneed tobeon-the-mark ifyou’regoing tonavigate this rollsuccessfully.Youshoulddefinitelyditchinsteadofrollifyou’renotconfidentinyourpredictions.

Note:Thesearealladvancedtechniquesthatyouneedn’ttryiftheymakeyouuncomfortable.Thereareplentyofotherwaystomakemoneyinoptions–waysthatarefraughtwithawholelotlessrisk.Again,ifyouwishtotrythese,dothemonpaperfirstsoyoucantrulyunderstandthepitfalls.

Conclusion

Aswasstatedintheintroductionofthisbook,optionstradinghasbeeninuseinsomeformforthousandsofyears.Alloftheprinciplesthatyou’velearnedhere(and will learn elsewhere) about successful options trading aren’t limited tostocks. The CBOE and other exchanges offer opportunities to buy and selloptions for a myriad of other securities such as currencies, exchange tradedfunds,mutualfunds,futures,commodities,andmore.Ifyoualreadyholdafairdegree ofmarket expertise in any of these areas, then you’ll be able to applyyourknowledgeintheoptionstrade.In his Trading Options for Dummies, Dr. Joe Duarte offers these tips for

stayingontherightcourseasyoucontinuetonavigateaninvestmentworldthatcanbebothriskyandconfusing.Hesuggestsyourememberthesefourthings:

GetApproval:Remember,youmustalwaysgetapprovalfromyourbrokertobegintradingoptions.This isanSECrule!Ifyouaregrantedapproval, itmeans that your financial situation matches the requirements for optionstrading.Newtraderswillmostlikelygetapprovedforbasicoptionstrategiesonly.

Practice:Aswithtradingstocks,youcan“papertrade”optionsaswell.Thiswill provide youwith knowledgewithout risk and prepare you to enter the“real world” of options trading. Practice until you’re comfortable with thebasicstrategies.

Be Disciplined : Keep abreast of the items in your portfolio and followYOUR rules for each trade you’vemade. For example, if you enter a tradewithanintentionofnotholdingitforlongerthanamonth,stickityourgunsandproceedinthatdirection.

KeepTrackoftheexpirationdates:Essentialtomanagingthepositionofanoptionisknowingtheexpirationdate.Atfirst,whenyou’reonlydealing

withatradeortwo,thismightnotbetoodifficult,butonceyougetindeep,you’llneedtodeviseasystemtokeeptrackofeachexpirationdate.

What we’ve hopefully accomplished through the writing of this book is asummary-leveldescriptionoftheessentialmechanicsofoptionstrading.Asyoucan probably infer, there are a whole lot more (and more complex) optionstradingstrategiesavailablebeyondtheworldofspreads,strangles,andstraddles.There are also many great resources you can access which catalog otherstrategies and methods for managing a successful options trade. If you’reinterestedinsomeofthehigher-level,appliedmathstrategiesthatcanhelpyoulearnhowtoformfinecalculationsonriskandearningspotential,thencheckoutSimonVine’sbook,OptionsTradingStrategyandRiskManagement.Ifyou’relookingforanearsavantor“quant” level lookatoptions, thencheckoutC.B.Reehl’sTheMathematicsofOptionsTrading.Don’t, however, let a distaste for complex mathematics dissuade you from

exploringtheoptionsmarket.Thereareplentyofsuccessfultraderswhodojustfineusingsound,fundamental,sensibleandsimpleknowledge.Goodluck...andhavefun!

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Glossary

American-StyleOption—Anoptionthatmaybeexercisedatanypointpriortotheexpirationdate.

AskPrice—Apricethataparticularpartyiswillingtotakeinexchangeforastockorsomeothersecurity.

BidPrice—Apricethataparticularpartyiswillingtopaytoobtainastockorsomeothersecurity.

Call—Anoptionthatguaranteesthe“owner”therighttopurchaseastockatacertainprice(strikeprice)beforeaspecifiedexpirationdate.

CoveredCall—Whenatradersellingacalloptionownstherequisitesharesintheunderlyingassetandisthereforeabletoreadilyproducethesharesiftheoptionis“calledin”.

CostBasis—Thecostbasisforastockistheoriginalcostofobtainingthestockadjustedforrevenueobtainedthroughthestock,suchasdividends,capitaldistribution,andanyrevenuesgainedfromsellingoptionsonthestock.

ChicagoBoardOptionsExchange(CBOE)-Thefirsttradingexchangetolegitimizeandregulatethetradingofstockoptions.

European-StyleOption—Anoptionthatmayonlybeexercisedontheexactdateofexpiration.

GammaRisk—Alevelofriskaffectingtheprofit/lossofanoption,wherebysmallchangesinthevalueoftheunderlyingassetmaydrasticallyreducethedeltavalueofthestock,leavingtheinvestorinapositioninwhichasmallchangecansignificantlyeliminateordiminishprofit.

Greeks—Acollectionofmetricsusedtodescribetheanticipatedbehaviorofoptionvalueinresponsetovariousfactorssuchaschangesintheunderlyingvalue(delta),changesintime(theta),changesininterestrates(rho),changesinvolatility(vega)andanticipatedchangesinthedeltavalue(gamma).

HistoricalVolatility—Theobservedvolatilityofaparticularfinancialinstrumentasobservedbypastperformance.(Contrastwith“impliedvolatility”)ImpliedVolatility—Animportantmeasurementofanoptionsvaluethatpredictsthevolatilityinpriceforanoption.Thehighertheimpliedvolatility,themorelikelythatthestockwilldramaticallychangeinvalue.Distinctfromhistoricalvolatilityinthatimpliedvolatilityattemptstopredictfuturebehavior,whereashistoricalvolatilityisanevaluationofpastbehavior.

InTheMoney(ITM)-Whenanoption’sstrikepricewillyieldimmediateintrinsicvalue.AcalloptionisITMwhenthestrikepriceislowerthantheactualvalueoftheunderlyingasset.AputoptionisITMwhenthestrikepriceishigherthantheactualvalueoftheunderlyingasset.

IntrinsicValue—Theamountbywhichacalloption’sstrikepriceislowerthantheunderlyingassetprice,ortheamountbywhichaputoption’sstrikepriceishigherthantheunderlyingassetprice.Anoptionwithintrinsicvaluecanbeexercisedforaprofitifandonlyifthepremiumpaidtoobtaintheoptionislessthantheintrinsicvalue.

LongPosition—Instocktrading,alongpositionreferstotheholdingofanystockorderivativethatwillincreaseinvaluewhenthestockgoesup.

Limitorder—Whenatraderagreestopurchaseacertainfinancialassetatorbelowacertainprice.Alimitorderisusuallysetatapricesomewhereinbetweentheaskpriceandthebidprice.

Moneyness—Thedifferencebetweenanoption’ssetstrikepriceandthepriceoftheunderlyingassetorstock,ortheextenttowhichanoptionisinoroutofthemoney.Moneynessprofoundlyinfluencesthepricingofoptions.

NakedCallWriting—Whenatradersellingacalloptiondoesnotowntherequisitesharesintheunderlyingassetandisthereforenotabletoreadilyproducethesharesiftheoptionis“calledin.”

NakedPut—Whenatraderpurchasesaput(therighttosellastockatacertainprice)withoutactuallyowningtheunderlyingstock.

OptionsClearingCorporation(OCC)-AcorporationformedbytheChicagoBoardOptionsExchangeresponsibleforensuringthatoptionscontractsareenforced.

OptionsChain—Apricelistingofcallandputoptionsatvariousstrikepricesandexpirationdates.

OutoftheMoney(OTM)-Acalloptionisoutofthemoneywhenthevalueofthestockislowerthanthestrikeprice.Aputoptionisoutofthemoneywhenthevalueofthestockishigherthanthestrikeprice.

Owner—Thepartyinanoptionscontractentitledtoexercisetheoption.(Comparewith“Writer.”)Premium—Thepricepaidtoownastockoption.

Put—Anoptionthatguaranteesthe“owner”therighttosellastockatacertainprice(strikeprice)beforeaspecifiedexpirationdate.

ShortPosition—Instocktrading,ashortpositionreferstotheholdingofanystockorderivativethatwillincreaseinvaluewhenthestockgoesdown.

Spread-Anoptioninvestmentstrategywherebyacall(orput)issimultaneouslyboughtandsoldcreatingacheaperoverallpremiumpricewhilelimitingprofitabilitytoacertainextent.

StockOption—Acontractguaranteeingtherighttopurchase(call)orsell(put)aspecificstockatspecificpricewithinaspecificperiodoftime.

Straddle—Anoptionsinvestmentstrategywherebyaputandacalloptionarepurchasedforthesamestockatthesamestrikeprice.

Strangle—Anoptioninvestmentstrategywherebyaputandcalloptionarepurchasedforthesamestockbutatdifferentstrikeprices,usuallywiththeputstrikepricebeinglowerandthecallpricebeinghigher.

StrikePrice—Apricethat’sspecifiedinanoptionscontractatwhichthebuyeroftheoptionmaypurchaseastock(inacall)orsellastock(inaput)withintheperiodspecifiedbythecontract.

TimeDecay—Thephenomenonofanoptionlosingvalueovertime.

TimeValue—Anelementthatcontributestotheoverallvaluationofanoptiononthebasisoftheamountoftimeremaininginanoptioncontractpriortotheexpirationdate,themoretimeremaininginthecontract,themorevaluabletheoption.

UnderlyingAsset—Theassetfromwhichanoptionisderived.Withstockoptions,stocksaretheunderlyingassets.

Volatility—Thepropensityofacertainfinancialinstrumenttosignificantlyfluctuateinvalueovertime.

WastingAsset—Anassetthatdeclinesinvalueovertime.Becauseoptionslosevaluetheclosertheygettotheirexpirationdates,theyareconsideredtobewastingassets.

Writer—Thepartyinanoptionscontractobligedtobuyorsellastockwhentheownerexercisesanoption.(Comparewith“Owner.”)

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