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Trading Options For Dummies®

To view this book's Cheat Sheet, simply go to www.dummies.com and search for “Trading Options For Dummies Cheat Sheet” in the Search box.

Introduction

Welcome to Trading Options For Dummies, 3rd Edition!

This book is all about introducing you to option strategies for managing risk, delivering profits, and navigating a variety of market conditions. Yet, unlike other investments books, this one is geared to managing risk first, with the knowledge that profits will follow. With that in mind, the approaches described here focus on reducing potential losses from traditional stock positions and building an option strategy repertoire that’s designed to increase your chances of making sound trades whether the markets are moving up, down, or sideways. To incorporate the comprehensive steps required when trading, it also provides discussions on market and sector analysis, as well as things to look for when trying out a new strategy.

An option contract is a unique security that comes with contract rights and obligations. When used correctly, an option contract strikes a balance between the risk of loss, the amount of money you put at risk, and reward, providing you with leverage while still allowing you to reduce overall trade risk. Of course, there’s another side to that leverage, increased risk, which will be managed, which is the main reason you should take the time to read through this book carefully. You need to understand the risks and characteristics associated with these contracts.

remember When applying for options trading with your broker, the broker will send you the reference guide Characteristics and Risks of Standardized Options. This publication, written by the Options Clearing Corporation (OCC), must be distributed by brokers to their clients prior to allowing them to trade options. It describes option contract specifications, mechanics, and the risks associated with the security. Together, that publication and the one you’re reading right now help you to understand your risks and use options effectively.

About This Book

As mentioned, this book is in its third edition. That’s great for you because not only has it stood the test of time, it is updated, and many of the quirks and other technical issues that arose with any book’s earlier editions have been addressed, making this a highly improved work. And no, I’m not being conceited. Of course, nothing is perfect, but as you’ll find out when you start trading options, the more you do anything, the better it gets.

There are hundreds of trading titles out there, including those focusing on option strategies. This book focuses primarily on approaches aimed at managing risk — the consistent theme throughout. By setting it up this way, you can read about different topics while keeping that key objective in mind. So go ahead, jump around to areas that interest you most.

This book can be read from cover to cover or used as a reference guide. Each strategy provided identifies risks and rewards associated with the position. It also identifies alternative strategies to consider for risk management, when applicable. There are a million ways to successfully trade the markets, but certain challenges are universal to all of them. Tools and techniques focused on addressing these challenges are also provided throughout.

To make reading and understanding the world of options trading a bit easier, I’ve used some conventions to help you along the way:

Foolish Assumptions

Here’s what I assume about you:

Icons Used in This Book

I’ve also added icons to highlight different core ideas and give you some hard-earned trading insight. I use the following icons to point out these insights:

technicalstuff When encountering this icon, you’ll find slightly more detail-oriented tools and considerations for the topic at hand, but the information included with icons isn’t necessary to your understanding of the topic at hand.

tip This icon is used to give you experienced insight to the current discussion. Consider these to be asides that any trader might mention to you along the way.

remember Some topics previously discussed or assumed to be part of your base knowledge are identified by the Remember icon. This also flags important things to keep in mind. If you hesitate for a moment when reading the core content, check for one of these to keep progressing smoothly.

warning Concepts that reiterate ways to manage potential risks appear with this icon. It highlights important things to watch out for if you want avoid trouble.

Beyond the Book

In addition to the material in the print or e-book you’re reading right now, this product also comes with some access-anywhere goodies on the Web. Check out the free Cheat Sheet and other free articles at www.dummies.com. Just search for trading options.

Where to Go from Here

Whether you’re seeking to improve longer-term investing or shorter-term trading results, you will find strategies aimed at both goals in this book. By using the techniques in the book and viewing yourself as a risk manager, your losses should decrease allowing you to move forward to increased profits.

You may decide to pick up this reference while evaluating your investments on a quarterly basis or keep it handy at your desk for weekly trading assessments. During your regular review routine, you may also find that current market conditions that once kept you on the sidelines are now ideal for strategies you reviewed here.

Ready to go? You have lots of options ahead. (Get it?)

If you’ve recently been perplexed with action in the markets, you may want to start with Chapter 5. It identifies different things happening in the options markets that may clarify stock market activity.

Those new to trading options or who feel you can benefit from a refresher, should consider perusing Part 1. Because the markets are ever-evolving, Chapter 3 gets you up to speed on current conditions.

If you have a basic handle on option contracts and want to quickly access unique ways to capitalize on different stock movement, consider jumping to Part 4. This part includes a variety of approaches you just can’t match with stocks.

Chapter 18 provides my thoughts on what it takes to be a successful option trader. Because trading options comes with many of the same challenges encountered when trading any security, you may want to make it the first thing you read to help you succeed with your current trading.

If you’re looking for trading ideas, you can also visit my website: www.joeduarteinthemoneyoptions.com.

Part 1

Getting Started

IN THIS PART …

Appreciate and analyze options while making the market work for you.

Get introduced to options contracts and values.

Find your way around options markets and get introduced to the Greeks.

Get familiar with option risks and rewards.

Chapter 1

Options Trading and the Individual Investor

IN THIS CHAPTER

check Getting to appreciate options

check Analyzing options with any market in mind

check Making the markets work for you

Whatever your level of experience, trading style, general tendency for holding onto positions, and risk profile, as an individual investor you can add options on individual stocks, indexes, and exchange traded mutual funds (ETFs) to your investment war chest. Perhaps the best reason to add options to your trading or investing strategies is that they allow you to both manage your risk and grow your assets. And because there are so many ways to use options, just about anyone can use them — as long as you take the time to learn the associated risks and rewards and become familiar with the particular strategies that suit your purposes. This is achieved by a process of retraining — rewiring — your brain to think in a slightly different way than your norm. No, rewiring your brain won’t hurt. But it will help you to see the markets in a different and more profitable way.

The first step in the rewiring process is to know that there is a difference between trading and investing, especially in terms of time frames. Investing is all about using the power of time and the benefits of compounding to build wealth over long periods. The traditional buy and hold strategy for stocks is a perfect example, as is the owning of rental properties for long periods to generate income. This long-term-oriented, patient mindset works well for stocks and mutual funds but not always for options because of the time limit in the life of an option, unless you trade long-term options, which is a viable trading tactic addressed in this book. But don’t confuse options trading with some random, haphazard exercise. As you’ll find out, options trading is a cautious and very precise exercise.

Trading, as opposed to investing, is by design a shorter-term targeted and closed-end proposition, where you may hold a position for minutes, hours, days, or weeks depending on the specifics of the situation and your trading plan. Options can be used for both trading over the short term as well as for the protection of longer-term investments, especially during times when the value of the longer-term holdings declines or goes sideways. No matter your time frame — whether you hold positions for short or long periods — your goal is essentially the same. You want to have more money at some point in the future than what you have now and increase your wealth using opportunities provided by the markets. This chapter is all about starting the rewiring process by giving you the big picture on options and thus setting the stage for the more detailed chapters that follow.

Giving Yourself a Financial and Strategic Checkup

Before you start any kind of trading or investing program, it’s a good idea to know three things:

Any time you add a new trading strategy, you will face a learning curve. So, as you begin to trade options, be patient and prepare to spend as much time as you need learning the craft, or you will lose money, often in a hurry.

Here are some simple steps in order to get a good start. Even if you are experienced in other forms of investing, or have experience with options, you should still stop and consider the following:

Understanding Options

Options are financial instruments that are priced based on the value of another underlying asset or financial measure. In this book, the focus is mainly on options with value based on stocks and stock market indexes, although there is also a very useful section on options based on exchange traded mutual funds (ETFs).

There are two kinds of options: calls and puts. When you add them to your current investing and trading tools and strategies, you can participate in both bullish (rising markets) and bearish (falling markets) moves in any underlying you select. And although not all stocks have options associated with them, you can use options to limit your total portfolio risk — to protect an individual existing position such as a stock or ETF, and to generate income through specific strategies known as spreads and writes.

tip In the options market, it’s acceptable to call the security that an option is based on the underlying. I will use this term in this chapter and throughout the book. If you’re going to trade options, you have to get used to the lingo.

To fully understand and use stock and index options to limit risk or as a standalone trading strategy, you must also have a thorough understanding of the asset on which they’re based. This understanding may require a more thorough level of analysis and detail beyond your current approach. For example, because volatility is a key component of option prices, you will have to look at the underlying’s volatility more carefully as part of your analysis in order to pick the best possible option for your particular strategy.

This book will help you by focusing on techniques that compare options to their underlying security or other securities. Chapter 9 goes into detail on several approaches that you can apply toward this goal when you analyze stocks and index options.

I like to think of all securities, including options, as risk-management tools and trading them in terms of designing an overall strategy. So, your primary focus is to understand the risks associated with the use of the tools, including all of the following:

The sections that follow address these key components of options trading to give you a good platform for designing rewarding positions and cutting any losses before they become catastrophic.

Knowing option essentials

A listed stock option is a contractual agreement between two parties with standard terms. All listed options contracts are governed by the same rules. When you create a new position, one of two things is triggered:

  • By buying an option, you are buying a specific set of rights.
  • By selling an option, you are acquiring a specific set of obligations.

These rights and obligations are standard and are guaranteed by the Option Clearing Corporation (OCC), so you never have to worry about who’s on the other end of the agreement. Chapter 3 provides more information and detail on the Options Clearing Corporation and its central role in options trading.

Time is everything to option traders. Indeed, the one particular wrinkle in options, and the primary risk involved, is twofold: time value decay, which stocks do not possess and leverage, that causes option prices to change in larger percentage moves both up and down. The price of a call option rises when its underlying stock goes up. But if the move in the stock is too late, because it happens too close to the expiration date, the call can expire worthless. You can literally buy yourself more time, though — some options have expiration periods as late as 9 months to 2 1/2 years.

When you own call options, your rights allow you to

  • Buy a specific quantity of the underlying stock (exercise).
  • Buy the stock by a certain date (expiration).
  • Buy the specific quantity of stock at a specified price (known as the strike price).

In other words, the price of the call option rises when the stock price goes up because the price of the rights you bought through the option is fixed while the stock itself is increasing in value.

Conversely, a put option gains value when its underlying stock moves down in price, while the timing issue is the same. The move in price still has to occur before the option contract expires or your option will expire worthless. Your put contract rights include selling a specific quantity of stock by a certain date at a specified price. If you own the rights to sell a stock at $60, but events such as bad news about the company pushes the stock price below $60, those rights become more valuable.

A significant part of your skill as an options trader is your ability to select options with expiration dates that allow time for the anticipated moves to occur. This may sound too challenging at the moment, but as you learn more, it will make perfect sense because successful options trading is all about giving yourself time and giving the option time to deliver on your expectations. Of course, there are some basic trading rules of thumb that help, including the development of proper trade design and management techniques, such as planning your exit from a position before you trade in order to cut losses. Planning your exit is a simple but required part of any trade, and it is one good habit that will save you money and heartache if a position moves against you.

All stocks with derived options available for trading have multiple expiration dates and strike prices. There are two important pricing factors to keep in mind:

  • Options with more time until the expiration date are more expensive.
  • Options with more attractive strike prices are more expensive.

Information about options and your available choices are widely available on the Internet, especially from your broker. It takes time and practice to rewire your trading brain to where you can pick the best options based on current market conditions and your outlook for the underlying asset. But as you read the different sections in this book, you will start to adjust and you will get a good feeling for how to go about this. Even more important is how you manage your emotions and how you gain trading discipline. This is best achieved by developing a maximally effective trading plan with easy-to-follow rules that includes planning for different scenarios. For more on this, see Chapter 8.

Trying different strategies before deploying them in real time

Options are different from stocks both in terms of what they represent — leverage, rights, and obligations instead of partial ownership of a company — and how they’re created, by demand. These important distinctions result in the need for additional trading and decision-making beyond the basic buy or sell considerations. Part of the learning process, as you transition from direct stock trading to options trading, is developing a new and complementary way of thinking. That includes not just evaluating the price of a stock or an index, but also how the price of the underlying asset along with other factors, such as supply and demand for the option and overall market conditions involved in options prices all come together. Your final decision, as the trade develops, may be to exercise your rights under the contract or simply exit the position in the market. Fortunately, market prices will help you with those decisions, and so will some thoughts from Chapters 9 and 18.

If you haven’t traded options in the past, your best approach (as I already mentioned) is to try out some trading strategies on paper and see how things work out. Your goal here is simple: You want to get to the point where you think of your option trades based not just on the option but on the underlying security.

Before you invest real money, you should be able to do the following:

  • Gain a comfortable feel for the activity and characteristics of underlying stocks or indexes on which you are looking to trade options and understand their relationship both to the market and to the options related to them.
  • To be able to mix and match sound strategies to particular market situations while keeping the preceding principles in mind.

Are these extra complications worth it? For many people, the answer is yes — especially when you consider the combined risk reduction and profit potential that options trading offers. And even though making the transition may sound difficult, the actual differences in stock and option mechanics are pretty straightforward and manageable. At the end of the day, the big advantage to options is the way they provide you with leverage while giving you a mechanism to control the rights to the stock rather than the stock itself. Trust me, you’ll get used to trading options on expensive stocks that have big dollar moves for a fraction of the cost compared to owning the shares straight out.

But it’s not all fun and games. An important aspect of rewiring your brain involves paying special attention to how the real market action affects the value of options over time. Once you get this part of the puzzle locked in, the rest will fall into place more easily, and your paper trading will be more satisfying. Along with paper trading, you can also backtest options trading. And don’t worry about how long this rewiring process may take. Any time you spend on decreasing your risk of big losses in the future is worth your trouble.

tip Widely available options trading and technical analysis programs let you backtest your strategies. Some brokerage houses offer sophisticated analytical packages to their active traders for low prices or free of charge. Backtesting means that you review how a set of strategies has worked in the past.

tip Paper trading and backtesting an options-based trading approach may take a little more time than a stock approach. The advantage is that it could save you a lot of money. Consider paper trading as part of your trading plan. And even though it may slow down your pace, and possibly delay your getting started in real-time trading, this type of studious approach will let you address different option trading nuances in advance, and will get you in the habit of being a disciplined trader.

Putting options in their place

There is a time and a place for everything. And options are used best when deployed optimally — meaning when the risk reward ratio offers you the best mix of both profit potential as well as risk reduction.

When you buy an option contract, you have two choices: You can exercise your rights, or you can trade your rights away based on current market conditions and your trading objectives. You can do either one based on what is happening in the markets or to any individual position at the particular time and by executing the best strategy for what the situation calls for. The most important thing is that you know what your choices are before making the trade because you have planned for either situation.

You can use options to reduce your risk by hedging a particular position or by hedging your whole portfolio. The goal of a hedge is that the value of the option goes in the opposite direction of the underlying, thus keeping the total value of the combined position as high as possible when the underlying falls in value. If your analysis of the situation makes you so bearish that you are looking to capitalize from a falling market, options are a much less expensive and have lower risk of dollar losses than selling individual stocks short. Chapter 10 is all about portfolio protection.

Options also let you leverage your positions. Because options cost less than stocks, you can participate in a market for less than if you owned the actual shares. For example, a $500 investment in an option strategy may give you as much profit potential as a $5,000 investment in an individual stock. This is an excellent way to reduce risk, as you are spending less capital but potentially getting a similar rate of return to what you might receive if you owned the actual underlying stock, depending on your position size. You can apply this leverage even more astutely if you are speculating and are willing to cap your profits.