555
OPTION TrAdINg STrATegIeS
 2. buy spot gold. The jeweler can buy spot gold and store it until August. In this case, he locks
in apurchase price of $1,198.90/oz plus carrying costs (interest, storage, and insurance). This
approach eliminates price risk, but also removes the potential of benefiting from any possible
price decline.
 3. buy gold futures. The jeweler can purchase one contract of August gold futures, thereby
locking in aprice of $1,200/oz. The higher price of gold futures vis-à-vis spot gold reflects the
fact that futures embed carrying costs. Insofar as the price spread between futures and spot gold
will be closely related to the magnitude of carrying costs, the advantages and disadvantages of
this approach will be very similar to those discussed in the above strategy.
 4. buy an at-the-money call. Instead of purchasing spot gold or gold futures, the jeweler could
instead buy an August $1,200 gold futures call at apremium of $38.80/oz. The disadvantage of
this approach is that if prices advance the jeweler locks in ahigher purchase price: $1,238.80/
oz. However, by purchasing the call, the jeweler retains the potential for asubstantially lower
purchase price in the event of asharp interim price decline. Thus, if, for example, spot prices
declined to $1,050/oz by the time of the option expiration, the jeweler’spurchase price would
be reduced to $1,088.80/oz (the spot gold price plus the option premium).
6 In effect, the pur-
chase of the call can be viewed as aform of price risk insurance, with the cost of this insurance
equal to the “premium.”
7
 5. buy an out-of-the-money call. As an example, the jeweler could purchase an August
$1,300 gold futures call at apremium of $9.10/oz. In this case, the jeweler forgoes protection
against moderate price advances in exchange for reducing the premium costs. Thus, the jeweler
assures he will have to pay no more than $1,309.10/oz. The cost of this price protection is $910
as opposed to the $3,880 premium for the at-the-money call. In asense, the purchase of the
out-of-the-money call can be thought of as aprice risk insurance policy with a “deductible.” As
in the case of purchasing an at-the-money call, the jeweler would retain the potential of benefit-
ing from any interim price decline.
As should be clear from the above discussion, options meaningfully expand the range of choices
open to the hedger. As was the case for speculative applications, the choice of an optimal strategy will
depend on the trader’s (hedger’s) individual expectations and preferences. It should be stressed that
this section is only intended as an introduction to the concept of using options for hedging. Acompre-
hensive review of hedging strategies would require afar more extensive discussion.
6 Technically speaking, since gold futures options expire before the start of the contract month, the effective
purchase price would be raised by the amount of carrying costs for the remaining weeks until August.
7 The use of futures for hedging is also often described as “insurance.” However, in this context, the term is
misapplied. In standard application, the term insurance implies protection against acatastrophic event for acost
that is small relative to the potential loss that is being insured. In using futures for hedging, the potential cost is
equivalent to the loss protection. For example, if the jeweler buys gold futures, he will protect himself against
a $10,000 increase in purchase cost if prices increase by $100/oz, but he will also realize a $10,000 loss on
his hedge if prices decline by $100/oz. In this sense, the use of the call for hedging comes much closer to the
standard concept of insurance: the magnitude of the potential loss being insured is much greater than the cost
of the insurance.

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685
Achievement, elements of, 586–587
Acreage figures, 355
Action, taking, 583
Actual contract series, 279–280
Adjusted R
2, 642
Adjusted rate mortgages (ARMs), 423, 424
Advice, seeking, 580
Agricultural markets. See also U.S. Department of
Agriculture (USDA)
acreage figures, 355
cattle (see Cattle)
corn (see Corn)
cotton (see Cotton)
grain prices and, 351
hogs (see Hog production)
production costs and, 351
seasonal considerations and, 356
wheat (see Wheat market)
AMR. See Average maximum retracement (AMR)
Analogous season method, 374
Analysis of regression equation:
autocorrelation and (see Autocorrelation)
dummy variables and, 659–663
Durbin-Watson statistic, as measure of
autocorrelation, 652–654
heteroscedasticity and, 672–673
missing variables, time trend and, 655–658
multicollinearity and, 663–666
outliers and, 649–673
residual plot, 650–651
topics, advanced, 666–671
apriori restriction, 660
Arbitrage, pure, 530
ARMs. See Adjusted rate mortgages (ARMs)
At-of-the-money call, buying, 555
At-of-the-money options
definition of, 480
delta values and, 485
ATR. See Average true range (ATR)
Autocorrelation:
definition of, 651
Durbin-Watson statistic as measure of, 652–654
implications of, 654–655
transformations to remove, 670–671
Availability of substitutes, 361
Average maximum retracement (AMR), 331
Average parameter set performance, 311
Average percentage method, seasonal index,
391–394
Average return, 323, 326
Average true range (ATR), 262, 463
Backward elimination, stepwise regression, 682
Bad luck insurance, 257
Balanced spread, 455
Balance table, 373–374
Bar charts, 35–39
Bear call money spread, 535–538
case 1: short call with lower strike price/long call
with higher strike price, 535–536
case 2: short call with lower strike price/long call
with higher strike price, 537–538
Index

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686
Index
Bullishness:
bullish put trade, 477
fundamentals and, 349
market response analysis and, 404, 405
Bullish Texas option hedge, 517–519
Bull market:
flags, pennants and, 131–132
intramarket spreads and, 460
run days in, 118
spread trades and, 443
thrust days and, 116, 117
Bull put money spread:
case 1: long put with lower strike price/short put
with higher strike price, 538–539
case 2: long put with lower strike price/short put
with higher strike
price, 540
“Bull trap”:
about, 205–211
confirmation conditions, 208, 209
Butterfly spread, 542
Buy and sell signals, trend-following systems and,
252
Buy hedge, cotton mill, 12–13
Call options, 477
Calmar ratio, 331
Calmness, 585
Cancel if close order. See CIC (cancel if close) order.
Candlestick charts, 43–44
“real body,” 43, 44
“shadows,” 43
Carrying-charge markets, 282
Carrying charges, limited-risk spread and, 446,
447–448
Carryover stocks, 355, 432–433
Case-Shiller Home Price Index, 423, 424
Cash settlement process, 4
Cash versus futures price seasonality, 389–390
Cattle:
cattle-on-feed numbers, 352–354
futures, 348, 385
inflation and, 385
production loss, 351
spread trades and, 444–445
Central limit theorem, 609–612
Change of market opinion, 204
Bearishness:
bearish put trade, 477
fundamentals and, 349
market response analysis and, 404, 406
Bearish Texas option hedge, 519–520
Bear market:
of 1980-1982, 366–367
flags, pennants and, 133–134
run days in, 118, 119
spread trades and, 443
thrust days and, 116
“Bear trap”:
about, 205–211
confirmation conditions, 208, 210
Beat the Dealer, 587
Bell-shaped curve, 601
Benchmark, 327
Bernanke, Ben, 431–432
Best fit, regression analysis and, 591–593
deviations, 591–592
least-squares approach, 592–593, 594
“Best linear unbiased estimators” (BLUE), 621
Bet size, variation in, 581
“Black box” system, 576
Blind simulation approach, system optimization, 311
BLASH approach, 27–28
BLUE. See “Best linear unbiased estimators” (BLUE)
Bottom formations. See Top and bottom formations
Bowe, James, 482–483
Box size, 42
Breakout(s), 86–89
confirmation of, 86
continuation patterns and, 180–181
counter-to-anticipated, flag or pennant, 219–222
definition of, 33
downside, 87, 88
false signals for, 151, 153
false trend-line, 211–213
flags, pennants and, 128
opposite direction breakout of flag or pennant
following normal, 222–225
upside, 87, 89
winning signals for, 152, 153
Breakout systems, 243–244
British pound (BP), intercurrency spreads and,
472–473
Bull call money spread, 534–535

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687
Index
Comfortable choices, trading principles
and, 584
Comfort zone, trading within, 577
Commissions, 19
Commodities:
bearing little or no relationship to general rule,
444–445
conforming to inverse of general rule, 444
demand curves and, 361
general spread trade rule and, 443–444
intercommodity spread and, 441–442
nonstorable, 351, 360, 444
perishable, 360, 364
Commodities, 357
Commodity Traders Consumers Report, 434
Commodity trading advisors (CTAs), 23, 578
Comparing indicators, 157–165
difference indicators, 158, 159
indicator correlations, 161–162, 163
popular comparisons, 164
Comparisons:
nominal price levels, 355
one-year, 350
two managers, 320–322
Compounded return, 323
Computer testing of trading systems. See Testing/
optimizing trading systems
Confidence, 579–580
Confidence interval(s), 612–614
for an individual forecast, 627–629
multiple regression model and, 642
Confirmation conditions, 247–250
bull or bear trap, 208
pattern, 249, 250
penetration as, 248
time delay and, 248–249
Confirmation myth, 170
Congestion phases. See Continuation patterns
Consistency, 582
Constant-forward (“perpetual”) series, 281–282
Consumer price index (CPI), 383
Consumption:
definition of, 363
demand and, 357, 363–366
price and, 364
as proxy for inelastic demand, 370
Contingent order, 18
Chart(s):
BLASH approach, 27–28
equity, 566
linked-contract (see Linked-contract charts)
Random Walkers and, 29–34
types of (see Chart types)
Chart analysis, 149–154
confirmation conditions and, 150
false breakout signals, 151, 153
long-term chart, 152, 154
most important rules in, 205–231
spread trades and, 449
trading range and, 150
winning breakout signals, 152, 153
Chart-based objectives, 189
Chart patterns, 109–147
continuation patterns, 123–134
flags and pennants (see Flags and pennants)
head and shoulders, 138–141
one-day patterns (see One-day patterns)
reversal days, 113–116, 147
rounding tops and bottoms, 141–143
run days, 116, 118–119
spikes (see Spikes)
thrust days, 116, 117
Top and bottom formations (see Top and bottom
formations)
Triangles (see Triangles)
wedge, 146–147
wide-ranging days (see Wide-ranging days)
Chart types, 35–44
bar charts, 35–39
candlestick charts, 43–44
close-only (“line”) charts, 40–42
linked contract series: nearest futures versus
continuous futures, 39–40
point-and-figure charts, 42–43
CIC (cancel if close) order, 188
Close-only (“line”) charts, 40–42
CME/COMEX contract, 459
Cochrane-Orcutt procedure, 671
Code parameter, 293
Coefficient of determination (r
2), 630–633
Coffee:
intercommodity spreads and, 453–454, 456
seasonal index and, 400
spread trade example, 445–446

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688
Index
Countertrend systems, 254–256
contrary opinion, 256
definition of, 236
fading minimum move, 255
fading minimum move with confirmation delay, 255
general considerations, 254–255
oscillators, 255
types of, 255–256
Countertrend trade entry signals, 182
Covered call write, 526–527
Covered put write, 527–528
CPI. See Consumer price index (CPI)
CR
2 (corrected R2), 642–643
CRB Commodity Yearbook, 414
Credit spread, 535
Crop reports, 434
Crop years, intercrop spread and, 441
Crossover points, moving averages and, 182
Crude oil market. See also WTI crude oil
money stop and, 185
poor timing and, 425
seasonal index and, 399
CTAs. See Commodity trading advisors (CTAs)
Currency futures, 471–476
intercurrency spreads, 471–473
intracurrency spreads, 473–476
Curvature, breaking of, 229, 230
Daily price limit, 8–9
Data errors, 679
Data insufficiency, conclusions and, 357
Data vendors, futures price series selection and, 287
Day versus good-till-canceled (GTC) order, 16
Degrees of freedom (df), 615, 640, 644
Deliverable grade, 9
Delivery, 4
Delta (neutral hedge ratio), 484–485
Demand:
consumption and, 357, 363–366
definition of, 359–362, 363
elasticity of, 361–362
highly inelastic, 370–371
incorporation of (see Incorporation of demand)
increase in, 364
inflation and, 355
price and, 362–363
quantifying, 362–363
stable, 368
Continuation patterns, 123–134
flags and pennants (see Flags and pennants)
trading range breakouts and, 180–181
triangles (see Triangles)
Continuous (spread-adjusted) price series,
282–285
Continuous distribution, 600–601
Continuous futures. See also Nearest vs. continuous
futures
price gaps and, 282
rule of seven and, 194–196
Continuous futures charts:
creation of, 47
measured moves and, 190–193
nearest futures vs., 39–40
Continuous parameter, 292–293
Contract months, 5, 8
Contract rollovers. See Rollover dates
Contract size, 5
Contract specifications:
about, 5–9
sample, 6–7
Contrary opinion, 203–204, 256
Conversion, 530
Copper:
inflation and, 385
price-forecasting model, 366–367
price moves and, 428, 429
Corn:
ethanol production and, 680
intercommodity spreads and, 457–459
major resistance area and, 427
price movements and, 430
production, 348
seasonal index and, 401
unexpected developments and, 419,
420, 421
Corrected R
2 (CR2), 642–643
Correlation coefficient (r), independent variables
and, 665–666
Correlation matrix, 666
Costs. See also Carrying charges
production, price declines and, 351–352
transaction, 295–296, 313
Cotton:
carryover and, 432–433
unexpected developments and, 418
yields, 355

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689
Index
Dummy variables, 659–663
Durbin-Watson statistic, as measure of
autocorrelation, 652–654
Eckardt, Bill, 578, 584
Edge, having an, 576
Efficient market hypothesis, 428, 431
Elasticity of demand, 361–362
Elementary statistics, 597–618
central limit theorem, 609–612
confidence intervals, 612–614
measures of dispersion, 597–599
normal curve (Z) table, reading, 604–606
population mean, 607
populations and samples, 606
probability distributions, 599–604
sampling distribution, 608–609
standard deviation, 599, 607
t-test, 614–618
E-Mini Dow:
descending triangle, 127
futures, uptrend line, 60
intermarket stock index spreads, 461–470
E-Mini Nasdaq 100:
double bottom, 135, 137
downtrend lines and, 67
flags and pennants, 130
intermarket stock index spreads, 461–470
uptrend lines and, 59, 61
wide-ranging down bar, 123
E-Mini S&P 500:
intermarket stock index spreads, 461–470
market response analysis and, 408, 409
options on futures and, 482, 484
price envelope bands and, 107, 108
seasonal index and, 399
trend lines and, 74
upthrust/downthrust days and, 117
Employment report:
stock index futures response to, 408–409
T -Note futures response to monthly, 404–407
ENPPT . See Expected net profit per trade (ENPPT)
Equal-dollar-spread ratio, 472
Equal-dollar-value spread, 455–460
Equally weighted term, 453
Equilibrium, 363, 365
Equity change, intercurrency spreads and, 472–473
Equity chart, 566
Demand curve, 359, 361
Demand-influencing variables, 368–370
DeMark, Thomas, 66, 69, 199
DeMark sequential, 199–203
Dependent variable, determining, 675–676
Detrended seasonal index, 394
Deviation:
definition of, 623
total, 630–631
Diagonal spread, 542
Diary, maintaining trader’s, 565
Difference indicators:
Close – Close vs. Close – MA, 158
ratio versions, 159
Discipline, 578
Discrete parameter, 293
Discrete variable, 600
Discretionary traders, losing period adjustments,
562–563
Disloyalty/loyalty, 583–584
Dispersion, measures of, 597–599
Disturbance, definition of, 623
Diversification:
planned trading approach and, 560, 561–562
trend-following systems and,
256–258
Dividends, 462
Dollar:
equal-dollar-value spread, 455–460
intercurrency spreads and, 471
price, 383
Dollar value, option premiums and,
477–478
Double top, penetration of, 227–229
curvature, breaking of, 229
Double tops and bottoms:
double bottom, 137–138
double top, 136
triple top, 129
Down run day, 118, 268
Downthrust day, 116
Downtrend channels, 62, 63
Downtrend lines:
definition of, 57
examples of, 59, 61, 65
false breakout signals, 211, 213
Driehaus, Richard, 578, 585
Druckenmiller, Stanley, 581, 584

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691
Index
Generic trading systems:
breakouts (see Breakout systems)
moving averages and, 237–243
Gold:
fundamental analysis and, 347, 371
futures (see Gold futures)
intramarket stock index spreads and, 461
market response analysis and, 410
prices, 284
seasonal index and, 400
spot, buying, 555
Gold futures:
buying, 555
volume shift in, 10
Gold/silver spread, 454
Good-till-canceled (GTC) orders. See GTC orders
Government regulations, potential impact
of, 415
Government reports, unexpected developments
and, 420
GPR (gain-to-pain ratio), 328–329
Grain prices, 351
Great Recession, 423
Gresham’slaw of money, 312
Grinder, John, 586
Gross domestic product (GDP):
deflator, 383
independent variables and, 677
GTC orders:
about, 16
order placement and, 568
stop-loss points and, 183, 188
trade exit and, 569
Hard work, skill versus, 576–577
Head and shoulders:
about, 138–141
failed top pattern, 227–229
Heating oil:
alternative approach, 396–397
average percentage method, 391, 392–394,
398
link relative method, 394–396, 398
Hedge, definition of, 517
Hedge ratio, neutral (delta), 484–485
Hedging, 11–13
applications, 554–555
buy hedge, 12–13
Fundamental analysis:
about, 16
analogous season method, 374
balance table, 373–374
danger in using, 417
discounting and, 428–430
expectations, role of, 379–381
fallacies. see Fallacies
forecasting model, building, 413–415
gold market and, 371
index models, 376–377
inflation, incorporation of, 383–388
long-term implications versus short-term
response, 432–435
market response analysis (see Market response
analysis)
money management and, 426–427
“old hand” approach, 373
pitfalls in, 418–426
reasons to use, 427–428
regression analysis, 374–375
seasonal analysis and, 389–401
spread trades and, 449
supply-demand analysis, 359–371
technical analysis and, 21–24, 417–418, 426–427
trading and, 417–435
types of, 373–377
FundSeeder.com, 343
Futures markets, nature of, 3–4
Futures price series selection, 279–288
actual contract series, 279–280
comparing the series, 285–287
constant-forward (“perpetual”) series, 281–282
continuous (spread-adjusted) price series, 282–285
nearest futures, 280
Gain(s):
expected, 550, 551
maximization of, 583
Gain-to-pain ratio (GPR), 328–329
Gardner, John, 314
GDP . See Gross domestic product (GDP)
General rule, spreads, 443–445
about, 443
applicability and nonapplicability, 443–444
commodities bearing little or no relationship to,
444–445
commodities conforming to inverse of, 444

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692
Index
Intercurrency spreads, 471–473
equity change and, 472–473
reasons for implementing, 471–472
Interest rate differentials, intracurrency spreads and,
473, 476
Interest rate parity theorem, 475
Interest rate ratios, intracurrency spreads
and, 475
Interest rates:
option premiums and, 482–483
recession and, 367
Intermarket spreads, 442, 453, 462–470
Internal trend lines, 73–78
alternate, 75
versus conventional, 74, 76–77
support and resistance and, 106
International Cocoa Agreement, 356
International Sugar Agreement, 356
In-the-money options:
definition of, 480
delta values and, 485
Intracurrency spreads, 473–476
interest rate differentials and, 473, 476
interest rate ratios and, 475
Intramarket (or interdelivery) spread, 441
Intramarket stock index spreads, 461–462
Intrinsic value, of options, 489
Intuition, 586
Investment insights, 343
Japanese stock market, 22
Japanese yen (JY), intercurrency spreads and, 471
Jobs report. See Employment report
Kitchen sink approach, 312
Kuwait, 1990 invasion of, 420
Last notice day, 9
Last trading day, 9
Leading Indicator myth, 171–172
Least-squares approach, 592–593, 594
Lefèvre, Edwin, 178, 570, 580–581
Lessons, trader’sdiary and, 565
Leverage:
negative, 320
risk and, 320
through borrowing. see Notional funding
Limit days, automatic trading systems and, 296
financial markets and, 13–14
general observations on, 13–15
sell hedge, 11–12
Heteroscedasticity, 672–673
Hidden risk, 320
Hildreth-Lu procedure, 671
Hite, Larry, 585
Hog production:
fundamentals and, 348, 350, 356
regression analysis and, 374, 589–591
regression equation and, 633
supply-demand analysis and, 360, 365
Hope, as four-letter word, 584
Housing market:
Case-Shiller Home Price Index, 423
housing bubble, 2003-2006, 423, 425
Implied volatility, 483–484
Incorporation of demand:
demand change, growth pattern in, 368
demand-influencing variables, identification of,
368–370
highly inelastic demand (and supply elastic
relative to demand), 370–371
methods for, 367–371
need for, 366–367
stable demand, 368
Independence, 579
Independent variables:
forecasting model, building, 415
multicollinearity and, 665
regression analysis and, 677, 679
Index models, 376–377
Individual contract series, 279–280
Inflation:
adjustments, 355
price data for, 414
price-forecasting models and, 383–388
Inflationary boom, 422
Inflation indexes, 383
Information, viewing old as new , 349–350
Intelligence, 582–583
Intercommodity spreads, 441–442. See also Limited-
risk spread
about, 441–442
contract ratios and, 453–460
Intercrop spreads, 441, 460
Hedging (continued)

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693
Index
Market(s):
agricultural, 351
bear (see Bear market)
bull (see Bull market)
correlated, leverage reduction and, 562
excitement and, 585
exiting position and, 584–585
free, 357
housing (see Housing market)
nonrandom prices and, 587
planned trading approach and, 560
trading results and, 317
Market characteristic adjustments, trend-following
systems and, 251–252
Market direction, 449
Market hysteria, 585
Market-if-touched (MIT) order, 18
Market observations. See Rules, trading
Market opinion:
appearances and, 582–583
change of, 204
Market order, 16
Market patterns, trading rules and, 572–573
Market Profile trading technique, 585
Market psychology, shift in, 429
Market response analysis, 403–411
isolated events and, 409–410
limitations of, 410–411
repetitive events and, 403–410
stock index futures response to employment
reports, 408–409
T -Note futures response to monthly U.S.
employment report, 404–407
Market Sense and Nonsense: How the Markets Really Work,
319
Market statistics, balance table and, 373–374
Market wizard lessons, 575–587
Market Wizards books, 575, 579, 580, 581, 585, 586
MAR ratio, 330, 335
MBSs. See Mortgage-backed securities (MBSs)
McKay, Randy, 576, 581, 583
Measured moves (MM), 190–193
Measures of dispersion, 597–599
Mechanical systems. See Technical trading systems
Metals. See Copper; Gold market
Method:
determination of, 576
development of, 576
Limited-risk spread, 446–448
Limit order, 17
“Line” (close-only) charts, 40–42
Linearity, transformations to achieve, 666–669
Linearly weighted moving average (LWMA),
239–240
Linked-contract charts, 45–56
comparing the series, 48
continuous (spread-adjusted) price series, 47
creation of, methods for, 46–48
nearest futures, 46–47
nearest vs. continuous futures, 39–40, 48–51,
52–56
necessity of, 45–46
Linked contract series: nearest futures versus
continuous futures, 39–40
Link relative method, seasonal index, 394–396
Liquidation information, 564
Live cattle. See Cattle
Livestock markets, 287. See also Cattle; Hog
production
Long call (at-the-money) trading strategy, 491–492
Long call (out-of-the-money) trading strategy,
493–494
Long futures trading strategy, 489–490
Long put (at-the-money), 503–504
Long put (in-the-money), 506–508
Long put (out-of-the-money), 504–506
Long straddle, 515–516
Long-term implications versus short-term response,
432–435
Long-term moving average, reaction to, 181–182
Look-back period, 173
Losing period adjustments, planned trading
approach and, 562–563
Losing trades, overlooking, 313
Losses:
partial, taking, 583
temporary large, 245
Loyalty/disloyalty, 583–584
Lumber, inflation and, 384
“Magic number” myth, 170
Managers:
comparison of two, 320–322
negative Sharpe ratios and, 325
MAR. See Minimum acceptable return (MAR)
Margins, 19

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695
Index
Option trading strategies, 487–555
comparing, 487–489
hedging applications and, 554–555
multiunit strategies, 543–544
optimal, choosing, 544–554
profit/loss profiles (see Profit/loss profile)
spread strategies, other, 542–543
Orders, types of, 16–19
Ordinary least squares (OLS), 654
Organization of the Petroleum Exporting Countries
(OPEC), 356, 425
Original trading systems, 261–278
run-day breakout system, 268–273
run-day consecutive count system, 273–278
wide-ranging-day system (see Wide-ranging-day
system)
Oscillators, 167–170, 255
Out-of-the-money call, buying, 555
Out-of-the-money options:
definition of, 480
delta values and, 485
Outright positions, spread tables and, 440, 441
Overbought/oversold indicators, 198–199
Parabolic price moves, 585
Parameter(s):
definition of, 291, 606
types of, 292–293
Parameter set:
average performance, 311
definition of, 291
Parameter shift, trend-following systems
and, 247
Parameter stability, optimizing systems
and, 297
Past performance, evaluation, 319–341
investment insights, 343
return alone, 319–322
risk-adjusted return measures, 323–335
visual (see Visual performance evaluation)
Patience, virtue of, 580–581
Pattern(s). See also Chart patterns; Continuation
patterns; One-day patterns
market, 572–573
seasonal, 415
Pattern recognition systems, definition of, 237
Penetration of top and bottom formations, 225–229
Observations, market. See Rules, trading
OCO (one-cancels-other) order, 18
Oil. See Crude oil market; Heating oil; WTI
crude oil
“Old hand” approach, 373
OLS (Ordinary least squares), 654
One-cancels-other (OCO) order, 18
One-day patterns:
about, 109–123
spikes, 109–113
One-tailed test, 614, 617
One-year comparisons, 350
OPEC. See Organization of the Petroleum Exporting
Countries’ (OPEC)
Open interest, volume and, 9–10
Open-mindedness, 585
Optimization:
definition of, 297
past performance and, 313
Optimization myth, 298–310
Optimizing systems, 297–298
Option(s):
fair value of, theoretical, 483
qualities of, 489
Option premium curve, theoretical, 481
Option premiums, 480–483
components of, 480
interest rates and, 482–483
intrinsic value and, 480
strike price and current futures price, 480–481
theoretical versus actual, 483–484
time remaining until expiration,
481–482
time value and, 480–483
volatility and, 482
Option-protected long futures:
long futures + long at-the-money put, 520–521
long futures + long out-of-the-money put,
522–523
Option-protected short futures:
short futures + long at-the-money call, 523–524
short futures + long out-of-the-money call,
524–525
Options on futures, 477–485
about, 477–479
delta and (neutral hedge ratio), 484–485
option premiums and (see Option premiums)

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696
Index
Preforecast period (PFP) price, 677–678
Premium(s):
definition of, 477
dollar value of option, 477–478
Price(s):
consumption and, 364
dollar price, 383
grain, 351
nonrandom, 587
preforecast period (PFP) price, 677–678
strike or exercise, 477
supply, demand and
swings (see Price swings)
target levels and, 356–357
Price changes, price series and, 285
Price envelope bands, 107–108
Price-forecasting models:
adding expectations as variable in, 380
demand and, 366–367
inflation and, 383
Price-indicator divergences, 171–172
Price levels:
nearest futures and, 91, 101
nearest futures price series and, 48
nominal, comparing, 355
price series and, 285
Price movements:
dramatic, 428
fitting news to, 431–432
linked series and, 286
parabolic, 585
trend-following systems and, 245, 246
Price oscillator, 163
Price quoted in, 5
Price reversals, 229
Price seasonality, cash versus futures, 389–390
Price-supporting organizations, 356
Price swings:
nearest futures and, 101
nearest futures price series and, 48
Price trigger range (PTR), 262
Probability:
distributions, 599–604
heads and tails coin tosses, 390
real versus, 390–391
Probability-weighted profit/loss ratio (PWPLR),
550–551
Producer price index (PPI), 383
Pennants. See Flags and pennants
People’s Republic of China (PRC), 418
Percent retracement, reversal of minor reaction,
179–180
Percent return, optimizing systems and, 297
Performance evaluation, visual. See Visual
performance evaluation
Perishable commodities, 360
“Perpetual” (constant-forward) series, 281–282
Personality, trading method and, 576
Personal trading, analysis of, 565–566
Perspective:
keeping, 587
lack of, 351
Petroleum. See Crude oil market; Heating oil;
Organization of the Petroleum Exporting
Countries’ (OPEC); WTI crude oil
Philosophy, trading, 559, 578
Pivotal events, 422
Planned trading approach, 559–566
markets to be traded, 560
personal trading, analysis of, 565–566
planning time routine and, 563
risk control plan (see Risk control plan)
trader’sdiary, maintaining, 565
trader’sspreadsheet, maintaining, 563–564
trading philosophy and, 559
Point-and-figure charts, 42–43
Population, definition of, 598
Population mean, estimation of, 607
Population regression line, 619–620
Populations and samples, 606
Position, trading around, 581–582
Position exit criteria, 189–204
change of market opinion, 204
chart-based objectives, 189
contrary opinion, 203–204
DeMark sequential, 199–203
measured moves, 190–193
overbought/oversold indicators, 198–199
rule of seven, 194–196
support and resistance levels, 196–197
trailing stops, 204
PPI. See Producer price index (PPI)
PRC. See People’s Republic of China (PRC)
Precious metals market. See also Gold market
carrying charges and, 446
demand and, 362

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697
Index
Prudence, 583
PTR. See Price trigger range (PTR)
Pure arbitrage, 530
PWPLR. See Probability-weighted profit/loss ratio
(PWPLR)
Pyramiding:
midtrend entry and, 182
rejected signals and, 251
trend-following systems and, 252–253
Quantum Fund, 22
Random error, 628, 679
Random sample, definition of, 608
Random variable, 599
Random Walkers, 29–34
Rate of change, 163
Ratio call write, 532–534
Reaction count, 179–180
Recession, severe, 367. See also Great Recession
Regression analysis, 589–595, 675–683
about, 374–375, 589–591
assumptions of, basic, 620
best fit, meaning of, 591–593
dependent variable, determining, 675–676
example, practical, 593
forecast error and, 679–680
independent variables, selecting, 677
least-squares approach, 592–593, 594
practical considerations in applying, 675–683
preforecast period (PFP) price and, 677–678
regression forecast, reliability of, 593–595
simulation, 680–681
step-by-step procedure, sample, 682–683
stepwise regression, 681–682
survey period length and, 678–679
Regression coefficients:
computing t-value for, 626
multicollinearity and, 665
sampling distribution of, 621
testing significance of, 620–626
Regression equation, 619–635
analyzing (see Analysis of regression equation)
coefficient of determination R
2, 630–633
confidence interval for an individual forecast,
627–629
extrapolation, 630
misspecification and, 679
Production costs, price declines and, 351–352
Profit(s):
partial, pulling out, 584
slow systems and, 245, 246
winning trades and, 570–571
Profit/loss matrix, short puts with different strike
prices, 514
Profit/loss profile:
alternative bearish strategies, three, 548
alternative bullish strategies, three, 547
alternative neutral strategies, two, 549
bear call money spread, 536, 538
bearish “Texas option hedge,” 520
bear put money spread, 539, 542
bull call money spread, 535
bullish “Texas option hedge,” 518
bull put money spread, 541
covered call write, 527
covered put write, 528
definition of, 488
key option trading strategies and, 489–542
key trading strategies and, 489–542
long call (at-the-money), 492, 495
long call (out-of-the-money), 494
long futures, 490
long futures and long call comparisons, 497
long futures and short put comparisons, 514
long put (at-the-money), 504
long put (in-the-money), 507
long put (out-of-the-money), 505
long straddle, 516
option-protected long futures, 521, 522
option-protected short futures, 524, 525
ratio call write, 533
short call (at-the-money), 498
short call (in-the-money), 501
short call (out-of-the-money), 500
short futures, 491
short futures and long put comparisons, 509
short futures and short call comparisons, 503
short put (at-the-money), 510
short put (in-the-money), 513
short put (out-of-the-money), 511
short straddle, 517
synthetic long futures, 529
synthetic short futures, 532
trading strategies and, 488–489
two long calls vs. long futures, 544

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699
Index
detrended, 394
link relative method, 394–396, 398
Seasonal patterns, forecasting model, 415
Securitizations, 423
SEE. See Standard error of the estimate (SEE)
Segmented trades, analysis of, 565–566
Sell hedge, cotton producer, 11–12
Sell signals, trend-following systems and, 252
SER. See Standard error of the regression (SER)
Series selection. See Futures price series selection
Settlement type, 9
Sharpe ratio, 323–325, 334, 343. See also Symmetric
downside-risk (SDR) Sharpe ratio
Short call (at-the-money) trading strategy,
498–499
Short call (in-the-money) trading strategy, 500–502
Short call (out-of-the-money) trading strategy,
499–500
Short futures trading strategy, 490–491
Short put (at-the-money), 509–510
Short put (in-the-money), 512–513
Short put (out-of-the-money), 510–512
Short straddle, 516–517
Short-term response versus long-term implications,
432–435
Sideways market, moving averages and, 79, 81
Signal price, limit days and, 296
Signals, failed, 205, 206
Simple moving average (SMA), 165–167
Simple regression, 625
Simulated results, 312–313
fabrication, 313
kitchen sink approach, 312
losing trades, overlooking, 313
optimization and, 317
risk, ignoring, 312–313
terminology and, 311
transaction costs, 313
well-chosen example, 312
Simulation, blind, 311
Single market system variation (SMSV), 256–257
Skill, hard work versus, 576–577
Sklarew , Arthur, 194
Slippage:
automatic trading systems and, 295
sampling distribution and, 608
transaction costs and, 291
trend-following systems and, 247
Rules, trading, 567–574
analysis and review of, 573–574
market patterns and, 572–573
miscellaneous, 571–572
risk control (money management), 569–570
trade entry, 568–569
trade exit, 569–570
winning trades, holding/exiting, 570–571
Run-day breakout system, 268–273
basic concept, 268
daily checklist, 269
illustrated example, 270–273
parameters, 269
parameter set list, 270
trading signals, 269
Run-day consecutive count system, 273–278
basic concept, 273
daily checklist, 274
definitions, 273
illustrated example, 275–278
parameters, 274
parameter set list, 274
trading signals, 273–274
Run days, 116, 118–119, 268
Russell 2000 Mini, intermarket stock index spreads,
461–470
Samples, populations and, 598, 606
Sampling distribution, 608–609
Sands, Russell, 434
Saucers. See Rounding tops and bottoms
Saudi Arabia, 425
Scale order, 18
Schwager, Jack, 319
Schwartz, Marty, 22, 585
SDR Sharpe ratio, 327–328, 334
SE. See Standard error (SE)
Seasonal analysis, 389–401
cash versus futures price seasonality,
389–390
expectations, role of, 390
real or probability, 390–391
seasonal index (see Seasonal index)
seasonal trading, 389
Seasonal considerations, ignoring, 356
Seasonal index, 391–401
alternative approach, 396–401
average percentage method, 391–394

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700
Index
stock index futures and (see Stock index futures)
time, 542
types of, 441–442
Spread seasonality, 449
Spreadsheet, maintaining traders, ’ 563–564
Stability:
of return, 338
time (see Time stability)
Standard deviation:
calculation of, 323, 599
estimation of, 607
Standard error (SE), 612, 627
Standard error of the estimate (SEE), 627
Standard error of the mean, 612
Standard error of the regression (SER):
about, 627
multiple regression model and, 641–642
simulation and, 681
Standardized residuals, regression run analysis and,
647
Statistic, definition of, 606
Statistics:
elementary (see Elementary statistics)
forecasting model, building, 414
influence of expectations on actual, 381
using prior-year estimates rather than revised,
379–380
Steidlmayer, Peter, 585
Stepwise regression, 681–682
Stochastic indicator, 199
Stock index futures:
dividends and, 462
intermarket stock index spreads, 462–470
intramarket stock index spreads, 461–462
most actively traded contracts, 463
response to employment reports, 408–409
spread pairs, 463
spread trading in, 461–470
Stock market collapse, 425
Stop, trailing. See Trailing stop
Stop close only, 18
Stop-limit order, 17
Stop-loss points, 183–188
flags and pennants and, 184–185
money stop and, 185, 187
relative highs and relative lows, 185, 186
relative lows and, 185, 186
selecting, 183–188
SMSV . See Single market system variation (SMSV)
Soros, George, 22
Source/product spread, 442
Soybeans, inflation and, 384
Spike(s), 109–113
definition of, 112–113
reversal days and, 147
“spike days,” 237
Spike days. See Spike(s)
Spike extremes, return to, 213–216
Spike highs:
penetration of, 214–215
qualifying conditions and, 110–111
significance of, 109
spike extremes and, 213–216
Spike lows:
penetration of, 215
price declines, 109
significance of, 110
Spike penetration signals negated, 216
Spike reversal days, 115–116
Spot gold, 555
Spread-adjusted (continuous) price series, 282–285
Spread order, 15, 19
Spreads:
about, 439–440
analysis and approach, 448–449
balanced, 455
butterfly, 542
chart analysis and, 449
credit, 535
currency futures and (see Currency futures)
definition of, 440
diagonal, 542
equal-dollar-value spread, 455–460
fundamentals and, 449
general rule (see General rule, spreads)
historical comparison and, 448
intercommodity (see Intercommodity spreads)
intercrop, 441, 460
intermarket, 442, 453
intramarket (or interdelivery), 441
limited-risk, 446–448
pitfalls and points of caution, 449–451
rather than outright - example, 445–446
reason for trading, 440–441
seasonality and, 449
similar periods, isolation of, 449

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Introduction
Congratulations on
downloading “
Options Trading,”
and thank you for doing so.
The world of options trading is growing increasingly chaotic, and downloading this book is the first step you can take towards actually doing something about it. The first step is also always the easiest. However, the information you find in the following chapters is so important to take to heart as they are not concepts that can be put into action immediately. If you file them away for when they are really needed, then when the time comes that you actually use them, you will be glad you did.
To that end, the following chapters will discuss the primary preparedness principals that you will need to consider if you ever hope to really be successful in the investing world. This means you will want to consider the quality of your options—including the potential issues raised by their current value, how they can be best utilized in an emergency case to drive in quick cash, and how to operate with them properly.
With stock selection out of the way, you will then learn everything you need to know about trading in awide variety of markets including stocks, forex, and commodities (using the options instrument in each market). Rounding out the three primary requirements for successful options trading, you will then learn about crucial risk management principles and what they will mean for you. Finally, you will learn how investing is the quickest way to reach financial freedom.
There are plenty of books on this subject on the market, thanks again for choosing this one! Every effort was made to ensure it is full of as much useful information as possible, so please enjoy!

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CFD
This is akey point
that actually explains why there is much less bureaucracy for forex trading than for buying and selling bank shares. CFDs (Contract for Difference) are contracts for differences that follow the performance of agiven underlying (share, currency, index, etc.) and that can be exchanged, that is, bought or sold. CFDs differ from shares because they are not co-owned by acompany and therefore do not give voting rights to those holding them. However, CFDs offer the same economic benefits as equities, such as profits, dividends, and splits.
In even more technical terms, the CFD exchanges the difference in value between the opening price of the certain underlying security (e.g., share) and its closing price. Following this mechanism, the trader who negotiates CFDs:
Gets apositive result if it buys before the underlying goes up
Gets anegative result if it sells before the underlying goes down
The mechanism is very simple, and we are sure that it is already clear. We need to buy if we think that astock is close to the upside, we need to sell it if we think that astock is close to the downside. CFDs follow the values of the underlying assets so you can get positive results just like shareholders, but playing at home from the comfort of your home.

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Chapter 5: Ways to Trade
The main method for
investing in the forex market, therefore, remains the classic forex market. When you operate on the forex market, you are actually buying and selling currencies.
However, over the years, other financial instruments have been introduced to invest in forex and currencies indices on the forex exchange. We are talking about CFD (contract for difference) and binary options. The main feature of these two financial instruments is the following: when you use them to invest in forex, you will not actually own the lots you are investing in.
That said, for those who do not intend to trade online, it could make little sense. Let'stry to clarify. Both CFDs and binary options are contracts between investors and brokers. It'snot like the classic forex market, where traders buy and sell among themselves. In CFDs and binary options, the asset movement (in this case the buying and selling of currencies) does not take place.
CFDs and binary options are used to speculate on the performance of the value of equity securities. If the trader'sforecast is correct, the operation will lead to aprofit; vice versa, if the trader'sprediction is wrong, the operation will lead to aloss. So, the mode of operation is similar to the stock market: if Iinvest on the upside, whether Ido it with CFDs or actually buy currencies, Ionly earn money if the value increases.
As we explained in the previous paragraphs, CFDs are also derivative instruments, so they are used to speculate on the performance of asset values. This means that when you buy and sell CFDs, you will never own the asset traded (as opposed to classic forex trading).
Moreover, as with binary options, with CFDs it is possible to trade on:
Equity securities
Equity indices
Forex currencies pairs
Commodities
ETF
Leverage plays an important role in CFD trading: through leverage, we can literally multiply the value of our investment. Just to give an example, if you use alever of 1: 100 and invest € 100, thanks to this lever you can move well € 10,000 (using only your hundred!). All this is made possible thanks to the leverage, which is asort of "loan" (if we can define it) by the broker, thanks to which you can invest more money than you really have.
But if we talk about eToro, we can'tavoid talking about Social Trading. For those who do not know, eToro was the first broker to have introduced Social Trading in CFDs. Thanks to Social trading it is possible to invest by copying (automatically) the operations carried out by the other traders registered on the eToro platform. All you need is acouple of clicks to find the traders to follow, choose the amount to invest, and you're done. In this way, even novice traders can exploit the knowledge and experience of professional traders, copying their operations.
The online trading strategies are based on the study of mathematical and graphic analysis that can suggest the trader the best moment to buy and sell. As we have seen today, it is possible to invest in the stock market thanks to online trading, choosing between trading binary options and trading with the forex market.
Precise right away that there is no suitable trading strategy for all traders, but there are different trading strategies, based on traders and their style of trading. Therefore, it is possible to customize different online trading strategies on the basis of their trading objectives, their intellectual and psychological abilities.
We also recommend using 2 proven techniques not to turn winnings into losses:
stop loss: it establishes amaximum loss that you are willing to suffer;
take profit: you place adynamic exit level that rises slowly.

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Chapter 10: Swing Trading Options
Swing trading with
options can be extremely difficult. This is why we decided to create this chapter, in which we go through some of the main ideas and concepts to always keep in mind, to be profitable from the start. Now, it is clear that at the beginning it is not easy to take money out of the market. However, with the right guidelines, it is not that difficult to achieve success in ashort period of time. Anyway, let'sget into some of the key factors to consider when it comes to swing trading with options.
“
If you are undecided, stay still.”
It is not necessary to invest continuously. If you do not have precise ideas, it is better to do nothing and wait for clearer signs. Often times, the market is full of indecision: keep calm and stack up money for the future.
"Cut losses and let profits run.”
This is perhaps the best known and most important rule for those investing in the stock market. An indispensable factor for the application of this rule is the identification, immediately after the purchase, of the stop loss. This is how much you are willing to lose on that investment (consider when determining the average daily excursion of the stock). The cold and systematic application, even if painful, of the stop loss will preserve you from huge losses that would make the sale more and more traumatic, freezing capital that could be invested elsewhere.
“Learn from your mistakes.”
Errors are not always negative: if you follow astrategy with amethod, if you apply the stop losses, you will not make particularly serious mistakes. Errors are an integral part of stock trading: you need to analyze why you made them and what you can learn from them. In this way, asmall loss can become agood investment lesson for the future.
“Take profit and invest them back.”
If one of our titles is on the rise, take profit will be applied as the stock grows. Astock cannot grow indefinitely, when the trend is reversed, selling at the top, we will have had aprofit avoiding further descents. If then the title should go up again, it does not matter, it will go better next time. You cannot always sell at the top since you cannot time the market.
"Buy on the rumor and sell on the news."
When positive news on acertain title officially comes out, pay attention. It may already be too late to invest in that title since the market could already have priced it in.
Do not believe in “safe investments.”
If someone tells you that atitle will certainly reach acertain price, he either does not understand much of the stock market or is only doing his own interests.
“Never become emotionally attached to astock.”
Some investors always follow alimited number of companies that they consider more reliable than others. There are no titles better than others, but only favorable situations and unfavorable situations. Often, instead of admitting an error, one perseveres on it with the consequence of being heavily unbalanced on astock. This is really bad, especially if you are overcommitted to astock in which, at that moment, the market does not believe in.
"Always maintain certain liquidity available."
Cyclically we find ourselves in situations of several days of generalized decline of the whole stock exchange and often, for lack of liquidity, we cannot grasp excellent buying opportunities. Keep some money aside to jump on big opportunities.
“Choose the right platform
.”
One important rule for investing in the stock market is that the platform makes adifference. Carefully selecting safe, honest and reliable trading platforms is the first step to make money. Those who start investing in the stock market for the first time must be careful to choose platforms that are really simple to use, perhaps with high-quality educational support. Some platforms also offer add-on tools, such as notifications, social trading and free analysis tools to guide less experienced traders.
“Invest only in what you understand.”
As the "guru" of finance Warren Buffett said, "never, never, invest in something that you do not understand, and above all, that you do not know.” The overwhelming majority of investors can achieve their capital growth goals by using the most common financial instruments, which are almost always simple to understand. The complex tools are best left to the great experts in the field.
“Diversify your portfolio.”
When investing, the word to keep in mind is “diversification.” Never invest in asingle title, because if that sinks, your money will come to the same end. It is always better to have diversified investments to minimize the specific risks of acompany, amarket, an asset class or acurrency. The more you diversify and the lower the probability of having drastic falls.
“Understand and evaluate the risk.”
The risk is an intrinsic component of every investment. If it does not exist, there is no return. Whether they are government bonds, stocks or mutual funds, they all have arisk component, which will obviously be greater if y

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once bought, are not to be sold. It is, therefore, better to evaluate the industrial trends in the long term and then buy them, leaving aside the passengers' enthusiasm.
“
When investing in real estate, know the area you are investing in
.”
To start with, it is good that you put your focus on your area of residence or, if you live in abig city, even on your neighborhood or on one that you know well. If you think to act on afield of action too large, you risk dispersing too much energy towards something that can present totally different solutions. Dedicate yourself only to residential buildings, apartments or houses. The commercial ones, even if they can be very profitable, have other rules and in general greater difficulties. The same for the land: you can do big business, but it is not something suitable for those who start.
“
Choose the right leverage and use it to your advantage
.”
Real estate investments must be done with leverage. If you want to make an investment only with your money, then the essence of real estate investment is not clear to you. In fact, the concept of financial leverage allows you to invest with money that is not yours but to make money directly for you. Leverage an economic tool that allows you to get where you would not get only with your own strength. You can take out amortgage (if you can afford it) or engage financial partners. It may seem strange to you, but it is not at all: even the richest need partners and remember that afigure that seems almost unimaginable to you, it may be normal to somebody else.
"
Verba volant, scripta manent
"
the Latins used to say. So never make verbal agreements, even if it is arelative or achildhood friend. Consult alawyer to have the templates of the documents to be used. Like everything, at first it will seem difficult, but after afew times you will become an expert in basic legal practices for the sale of real estate, and you will be able to create documents in avery short time even by yourself.
“
Consider shorter positions
.”
In the fixed income universe, ashort duration approach is potentially able to reduce sensitivity to rising interest rates, while optimizing the returns/risk rations
“
Know your risk/reward ratio
.”
Ahigher return may be tempting, but you must be sure not to take too many risks about the remuneration you would get. In bond markets, this means avoiding lengthening duration in acontext of rising interest rates. Increasing investments in riskier assets may seem appropriate at the moment (when the macroeconomic scenario is quite positive), but it could turn out to be arather risky choice if the situation should change. For example, the yields offered by high yield debt, on average 3% in Europe and 5.5% in the United States, would not be sufficient to compensate investors if insolvencies passed from their current level of 2% to amore normal one of the 5%. Conversely, market areas with agood risk/return profile, with high-rated issuers offering attractive returns, include emerging market debt, subordinated financial bonds, and hybrid corporate bonds. Aiming at long-term quality makes it possible to take on fair risks, helping to limit the impact of any negative macroeconomic event.
“Take the currency pairing into account.”
Global investments are exposed to currency risks. High yield bonds and emerging market funds, for example, are usually denominated in US dollars, but the underlying bonds they hold may be issued in another currency. Fund managers may choose to include currency risk in the overall portfolio risk as exchange rates fluctuate or decide to contain this risk through currency hedging.
“
Stay flexible, keep some cash aside
.”
It is important to have the flexibility to underwrite and liquidate investments to seize the best opportunities. However, trades are expensive and can quickly erode earnings. This happens above all in the bond markets, given the relatively low levels of returns. The bid-ask spread is on average 30-40% of the yield, so an excess of trades erodes this margin and obviously reduces the total return. Even holding portfolios with structurally short duration, allowing short-term bonds to come to maturity naturally, can improve returns because you will effectively pay the bid-ask spread once.
“
Build up your portfolio over time
.”
If investing asmall sum such as 5000 Euro, will not allow you to live on that income, it can certainly represent an opportunity, to make money. Also, even if you have good economic availability, the ideal is always "to make it safe," start to invest from small figures and then fuel the investment over time.
“The past does not equal the future.”
The story is not indicative of how an investment will result in the future and investors should always try to weigh the potential risks associated with aparticular investment, as well as its possible returns.
Once you have established aprofitable options trading strategy that generates apassive income every single month, you cannot fl


xiii
IntroduCtIon
You have atremendous advantage over algorithmic trading models,
investment bank trading desks, hedge funds, and anyone who appears on or
pays attention to cable business news shows. This book is written to show
where that advantage lies and how to exploit it to make confident and suc-
cessful investment choices. In doing so, it explains how options work and
what they can tell you about the market’sestimation of the value of stocks.
even if, after reading it, you decide to stick with straight stock in-
vesting and never make an option transaction, understanding how options
work will give you atremendous advantage as an investor. The reason for
this is simple: by understanding options, you can understand what the rest
of the market is expecting the future price of astock to be. Understanding
what future stock prices are implied by the market is like playing cards with
an opponent who always leaves his or her hand face up on the table. You
can look at the cards you are dealt, compare them with your opponent’s,
and play the round only when you are sure that you have the winning hand.
By incorporating options into your portfolio, you will enjoy an even
greater advantage because of apeculiarity about how option prices are
determined. Option prices are set by market participants making trans-
actions, but those market participants all base their sale and purchase
decisions on the same statistical models. These models are like sausage
grinders. They contain no intelligence or insight but rather take in afew
simple inputs, grind them up in amechanical way, and spit out an option
price of aspecific form.
An option model does not, for instance, care about the operational
details of acompany. This oversight can lead to situations that seem to be
too good to be true. For instance, Ihave seen acase in which an investor

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could commit to buy astrong, profitable company for less than the amount
of cash it held—in effect, allowing the investor to pay $0.90 to receive adollar plus ashare of the company’sfuture profits! Although it is true that
these kinds of opportunities do not come along every day, they do indeed
come along for patient, insightful investors.
This example lies at the heart of intelligent option investing, the es-
sence of which can be expressed as athree-step process:
1. Understanding the value of astock
2. Comparing that intelligently estimated value with the mechani-
cally derived one implied by the option market
3. Tilting the risk-reward balance in one’sfavor by investing in the
best opportunities using acombination of stocks and options
The goal of this book is to provide you with the knowledge you need to be
an intelligent option investor from the standpoint of these three steps.
There is alot of information contained within this book but also alot
of information left out. This is not meant to be an encyclopedia of option
equations, ahandbook of colorfully named option strategies, or atreatise on
financial statement analysis. Unlike academic books covering options, such
as hull’sexcellent book,
1 not asingle integration symbol or mathematical
proof is found between this book’scovers. Understanding how options are
priced is an important step in being an intelligent option investor; doing dif-
ferential partial equations or working out mathematical proofs is not.
Unlike option books written for professional practitioners, such as
natenberg’sbook,2 you will not find explanations about complex strategies
or graphs about how “the greeks”3 vary under different conditions. Floor
traders need to know these things, but intelligent option investors—those
making considered long-term investments in the financial outcomes of
companies—have very different motivations, resources, and time horizons
from floor traders. Intelligent option investors, it turns out, do better not
even worrying about the great majority of things that floor traders must
consider every day.
Unlike how-to books about day trading options, this book does not
have one word to say about chart patterns, market timing, get-rich-quick
schemes, or any of the many other delusions popular among people who
xiv  •   Introduction

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Introduction    • xv
will soon be paupers. Making good decisions is avital part of being an
intelligent option investor; frenetic, haphazard, and unconsidered trading
is most certainly not.
Unlike books about securities analysis, you will not find detailed dis-
cussions about every line item on afinancial statement. Understanding
how acompany creates value for its owners and how to measure that value
is an important step in being an intelligent option investor; being able to
rattle off information about arcane accounting conventions is not.
To paraphrase Warren Buffett,
4 this book aims to provide you with
asound intellectual framework for assessing the value of acompany and
making rational, fact-based decisions about how to invest in them with the
help of the options market.
The book is split into three parts:
• part Iprovides an explanation of what options are, how they are
priced, and what they can tell you about what the market thinks the
future price of astock will be. This part corresponds to the second
step of intelligent option investing listed earlier.
• part II sets forth amodel for determining the value of acompany
based on only ahandful of drivers. It also discusses some of the
behavioral and structural pitfalls that can and do affect investors’
emotions and how to avoid them to become abetter, more rational
investor. This part corresponds to the first step of intelligent option
investing listed earlier.
• part III turns theory into practice—showing how to read the nec-
essary information on an option pricing screen; teaching how
to measure and manage leverage in aportfolio containing cash,
stocks, and options; and going into detail about the handful of op-
tion strategies that an intelligent option investor needs to know to
generate income, boost growth, and protect gains in an equity port-
folio. This part corresponds to the final step of intelligent option
investing listed earlier.
no part of this book assumes any prior knowledge about options or
stock valuation. That said, it is not some sort of “Options for Beginners” or
“My First Book of valuation” treatment either.

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Investing beginners will learn all the skills—soup to nuts—they need
to successfully and confidently invest in the stock and options market. peo-
ple who have some experience in options and who may have used covered
calls, protective puts, and the like will find out how to greatly improve their
results from these investments and how to use options in other ways as
well. professional money managers and analysts will develop athorough
understanding of how to effectively incorporate option investments into
their portfolio strategies and may in fact be encouraged to consider ques-
tions about valuation and behavioral biases in anew light as well.
The approach used here to teach about valuation and options is
unique, simple without being simpleminded, and extremely effective in
communicating these complex topics in amemorable, vivid way. read-
ers used to seeing option books littered with hockey-stick diagrams and
partial differential equations may have some unlearning to do, but no mat-
ter your starting point—whether you are anovice investor or aseasoned
hedge fund manager—by the end of this book, Ibelieve that you will look
at equity investing in anew light.
xvi  •   Introduction

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1
Part I
OptiOns FOr the
intelligent invest Or
Don’tbelieve anything you have heard or read about options.
If you listen to media stories, you will learn that options are modern
financial innovations so complex that only someone with an advanced
degree in mathematics can properly understand them.
Every contention in the preceding sentence is wrong.
If you listen to the pundits and traders blabbing on the cable business
channels, you will think that you will never be successful using options
unless you understand what “put backspreads, ” “iron condors, ” and count-
less other colorfully named option strategies are. You will also learn that
options are short-term trading tools and that you’ll have to be arazor-sharp
“technical analyst” who can “read charts” and jump in and out of positions
afew times aweek (if not afew times aday) to do well.
Every contention in the preceding paragraph is so wrong that believing
them is liable to send you to the poor house.
The truth is that options are simple, directional instruments that
we understand perfectly well from countless encounters with them in
our daily lives. They are the second-oldest financial instrument known to
humanity—in aquite literal sense, modern economic life would not be
possible without them. Options are instruments that not only can be used
but should be used in long-term strategies; they most definitely should be
traded in and out of as infrequently as possible.

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2  •   The Intelligent Option Investor
The first part of this book will give you agood understanding of
what options are, how their prices are determined, and how those prices
fluctuate based on changes in market conditions.
There is agood reason to develop asolid understanding of this
theoretical background: the framework the option market uses to determine
the price of options is based on provably faulty premises that, while
“approximately right” in certain circumstances, are laughably wrong in
other circumstances. The faults can be exploited by intelligent, patient inves-
tors who understand which circumstances to avoid and which to seek out.
Without understanding the framework the market uses to value
options and where that framework breaks down, there is no way to exploit
the faults. Part Iof this book, in anutshell, is designed to give you an
understanding of the framework the market uses to value options.
This book makes extensive use of diagrams to explain option theory,
pricing, and investment strategies. Those readers of the printed copy of this
book are encouraged to visit the Intelligent Option Investor website (www
.IntelligentOptionInvestor.com) to see the full-color versions of the type of
illustrations listed here. Doing so will allow you to visualize options even
more effectively in the distinctive intelligent option investing way.

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3
Chapter 1
OptiOn Fundamentals
This chapter introduces what an option is and how to visualize options in
an intelligent way while hinting at the great flexibility and power asensible
use of options gives an investor. It is split into three sections:
1. Option Overview: Characteristics, everyday options, and abrief
option history.
2. Option Directionality: An investigation of similarities and differ -
ences between stocks and options. This section also contains an
introduction to the unique way that this book visualizes options
and to the inescapable jargon used in the options world and abit
of intelligent option investor–specific jargon as well.
3. Option Flexibility: An explanation of why options are much more
investor-friendly than stocks, as well as examples of the handful of
strategies an intelligent option investor uses most often.
Even those of you who know something about options should at the
very least read the last section. You will find that the intelligent option
investor makes very close to zero use of the typical hockey-stick diagrams
shown in other books. Instead, this book uses the concept of arange of
exposure. The rest of the book—discussing option pricing, corporate
valuation, and option strategies—builds on this range-of-exposure concept,
so skipping it is likely to lead to confusion later.
This chapter is an important first step in being an intelligent option
investor. Someone who knows how options work does not qualify as be-
ing an intelligent option investor, but certainly, one cannot become an

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4  •   The Intelligent Option Investor
intelligent option investor without understanding these basic facts. The
concepts discussed here will be covered in greater detail and depth later in
this book. For now, it is enough to get asense for what options are, how to
think about them, and why they might be useful investment tools.
Characteristics and History
By the end of this section, you should know the four key characteristics
of options, be able to name afew options that are common in our daily
lives, and understand abit about the long history of options as afinancial
product and how modern option markets operate.
Jargon introduced in this section is as follows:
Black-Scholes-Merton model (BSM)
Listed look-alike
Central counterparty
Characteristics of Options
Rather than giving adefinition for options, I’ll list the four most important
characteristics that all options share and provide afew common examples.
Once you understand the basic characteristics of options, have seen afew
examples, and have spent some time thinking about them, you will start to
see elements of optionality in nearly every situation in life.
An option
1. Is acontractual right
2. Is in force for aspecified time
3. Allows an investor to profit from the change in value of another
asset
4. Has value as long as it is still in force
This definition is broad enough that it applies to all sorts of options—
those traded on apublic exchange such as the Chicago Board Options
Exchange and those familiar to us in our daily lives.

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Option Fundamentals   • 5
Options in Daily Life
The type of option with which people living in developed economies are
most familiar is an insurance contract. Let’ssay that you want to fully insure
your $30,000 car. You sign acontract (option characteristic number 1)
with your insurance company that covers you for aspecified amount of time
(option characteristic number 2)—let’ssay one year. If during the coverage
period your car is totaled, your insurance company buys your wreck of acar (worth $0 or close to it) for $30,000—allowing you to buy an identical
car. When this happens, you as the car owner (or investor in areal asset)
realize aprofit of $30,000 over the market value of your destroyed car
(option characteristic number 3). Obviously, the insurance company is
bound to uphold its promise to indemnify you from loss for the entire term
of the contract; the fact that you have aright to sell aworthless car to your
insurance company for the price you paid for it implies that the insurance
has value during its entire term (option characteristic number 4).
Another type of option, while perhaps not as widely used by everyday
folks, is easily recognizable. Imagine that you are astruggling author who
has just penned your first novel. The novel was not agreat seller, but one day
you get acall from amovie producer offering you $50,000 for the right to
draft ascreenplay based on your work. This payment will grant the producer
exclusive right (option characteristic number 1) to turn the novel into amovie, as well as the right to all proceeds from apotential future movie
for aspecific period of time (option characteristic number 2)—let’ssay
10 years. After that period is up, you as the author are free to renegotiate an-
other contract. As astruggling artist working in an unfulfilling day job, you
happily agree to the deal. Three weeks later, apopular daytime talk show
host features your novel on her show, and suddenly, you have a New York
Times bestseller on your hands. The value of your literary work has gone
from slight to great in asingle week. Now the movie producer hires the
Cohen brothers to adapt your film to the screen and hires George Clooney,
Matt Damon, and Julia Roberts to star in the movie. When it is released,
the film breaks records at the box office. How much does the producer pay
to you? Nothing. The producer had acontractual right to profit from the
screenplay based on your work. When the producer bought this right, your
literary work was not worth much; suddenly, it is worth agreat deal, and

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6  •   The Intelligent Option Investor
the producer owns the upside potential from the increase in value of your
story (option characteristic number 3). Again, it is obvious that the right
to the literary work has value for the entire term of the contract (option
characteristic number 4).
Keep these characteristics in mind, and we will go on to look at how
these defining elements are expressed in financial markets later in this
chapter. Now that you have an idea of what an option looks like, let’sturn
briefly to ashort history of these financial instruments.
A Brief History of Options
Many people believe that options are anew financial invention, but in
fact, they have been in use for more than two millennia—one of the first
historically attested uses of options was by apre-Socratic philosopher
named Miletus, who lived in ancient Greece. Miletus the philosopher was
accused of being useless by his fellow citizens because he spent his time
considering philosophical matters (which at the time included astudy of
natural phenomena as well) rather than putting his nose to the grindstone
and weaving fishing nets or some such thing.
Miletus told them that his knowledge was in fact not useless and that
he could apply it to something people cared about, but he simply chose not
to. As proof of his contention, when his studies related to weather revealed
to him that the area would enjoy abumper crop of olives in the upcoming
season, he went around to the owners of all the olive presses and paid them
afee to reserve the presses (i.e., he entered into acontractual agreement—
option characteristic number 1) through harvest time (i.e., the contract
had aprespecified life—option characteristic number 2).
Indeed, Miletus’sprediction was correct, and the following season
yielded abumper crop of olives. The price of olives must have fallen because
of the huge surge of supply, and demand for olive presses skyrocketed
(because turning the olive fruit into oil allowed the produce to be stored
longer). Because Miletus had cornered the olive press market, he was able
to generate huge profits, turning the low-value olives into high-value oil
(i.e., he profited from the change in value of an underlying asset—option
characteristic number 3). His rights to the olive presses ended after the har-
vest but not before he had become very wealthy thanks to his philosophical

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Option Fundamentals   • 7
studies (i.e., his contractual rights had value through expiration—option
characteristic number 4).
This is only one example of an ancient option transaction (afew thou-
sand years before the first primitive common stock came into existence),
but as long as there has been insurance, option contracts have been awell-
understood and widely used financial instrument. Can you imagine how
little cross-border trade would occur if sellers and buyers could not shift the
risk of transporting goods to athird party such as an insurance company?
How many ships would have set out for the Spice Islands during the Age of
Exploration, for instance? Indeed, it is hard to imagine what trade would
look like today if buyers and sellers did not have some way to mitigate the
risks associated with uncertain investments.
For hundreds of years, options existed as private contracts specifying
rights to an economic exposure of acertain quantity of acertain good over
agiven time period. Frequently, these contracts were sealed between the
producers and sellers of acommodity product and wholesale buyers of
that commodity. Both sides had an existing exposure to the commodity
(the producer wanted to sell the commodity, and the wholesaler wanted to
buy it), and both sides wanted to insure themselves against interim price
movements in the underlying commodity.
But there was aproblem with this system. Let’ssay that you were a
Renaissance merchant who wanted to insure your shipment of spice from
India to Europe, and so you entered into an agreement with an insurer. The
insurer asked you to pay acertain amount of premium up front in return
for guaranteeing the value of your cargo. Your shipment leaves Goa but is
lost off Madagascar, and all your investment capital goes down with the
ship to the bottom of the Indian Ocean. However, when you try to find
your option counterparty—your insurer—it seems that he has absconded
with your premium money and is living alife of pleasure and song in
another country. In the parlance of modern financial markets, your option
investment failed because of counterparty risk.
Private contracts still exist today in commodity markets as well as
the stock market (the listed look-alike option market—private contracts
specifying the right to upside and downside exposure to single stocks,
exchange-traded funds, and baskets is one example that institutional
investors use heavily). However, private contracts still bring with them a

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8  •   The Intelligent Option Investor
risk of default by one’scounterparty, so they are usually only entered into
after both parties have fully assessed the creditworthiness of the other.
Obviously, individual investors—who might simply want to speculate on
the value of an underlying stock or exchange-traded fund (ETF)—cannot
spend the time doing acredit check on every counterparty with whom
they might do business.
1 Without away to make sure that both parties are
financially able to keep up their half of the option bargain, public option
markets simply could not exist.
The modern solution to this quandary is that of the central counter -
party. This is an organization that standardizes the terms of the option con-
tracts transacted and ensures the financial fulfillment of the participating
counterparties. Central counterparties are associated with securities
exchanges and regulate the parties with which they deal. They set rules
regarding collateral that must be placed in escrow before atransaction
can be made and request additional funds if market price changes cause
acounterparty’saccount to become undercollateralized. In the United
States, the central counterparty for options transactions is the Options
Clearing Corporation (OCC). The OCC is an offshoot of the oldest option
exchange, the Chicago Board Option Exchange (CBOE).
In the early 1970s, the CBOE itself began as an offshoot of alarge
futures exchange—the Chicago Mercantile Exchange—and subsequently
started the process of standardizing option contracts (i.e., specifying the
exact per-contract quantity and quality of the underlying good and the
expiration date of the contract) and building the other infrastructure and
regulatory framework necessary to create and manage apublic market.
Although market infrastructure and mechanics are very important for
the brokers and other professional participants in the options market,
most aspects are not terribly important from an investor’spoint of view
(the things that are—such as margin—will be discussed in detail later in
this book). The one thing an investor must know is simply that the option
market is transparent, well regulated, and secure. Those of you who have abit of extra time and want to learn more about market mechanics should
take alook through the information on the CBOE’sand OCC’swebsites.
Listing of option contracts on the CBOE meant that investors needed
to have asense for what afair price for an option was. Three academics,
Fischer Black, Myron Scholes, and Robert Merton, were responsible for

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Option Fundamentals   • 9
developing and refining an option pricing model known as the Black-
Scholes or Black-Scholes-Merton model, which Iwill hereafter abbreviate
as the BSM.
The BSM is atestament to human ingenuity and theoretical elegance,
and even though new methods and refinements have been developed
since its introduction, the underlying assumptions for new option pricing
methods are the same as the BSM. In fact, throughout this book, when you
see “BSM, ” think “any statistically based algorithm for determining option
prices .”
The point of all this background information is that options are not
only not new-fangled financial instruments but in fact have along and
proud history that is deeply intertwined with the development of modern
economies themselves. Those of you interested in amuch more thorough
coverage of the history of options would do well to read the book, Against
the Gods: The Remarkable History of Risk, by Peter Bernstein (New York:
Wiley, 1998).
Now that you have agood sense of what options are and how they are
used in everyday life, let’snow turn to the single most important thing for afundamental investor to appreciate about these financial instruments: their
inherent ability to exploit directionality.
Directionality
The key takeaway from this section is evident from the title. In addition to
demonstrating the directional power inherent in options, this section also
introduces the graphic tools that Iwill use throughout the rest of this book
to show the risk and reward inherent in any investment—whether it is an
investment in astock or an option.
For those of you who are not well versed in options yet, this is the
section in which Iexplain most of the jargon that you simply cannot escape
when transacting in options. However, even readers who are familiar with
options should at least skim through this explanation. Doing so will likely
increase your appreciation for the characteristics of options that make
them such powerful investment tools and also will introduce you to this
novel way of visualizing them.

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10  •   The Intelligent Option Investor
Jargon introduced in this section is as follows:
Call option Moneyness
Put option In the money (ITM)
Range of exposure At the money (ATM)
Strike price Out of the money (OTM)
Gain exposure Premium
Accept exposure American style
Canceling exposure European style
Exercise (an option)
Visual Representation of a Stock
Visually, agood stock investment looks like this:
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40
60
80
100
120
140
160
180
200
5/20/2013 249 499
Date/Day Count
Stock Price
749 999
Future Stock Price
Last Stock Price
You can make alot of mistakes when investing, but as long as you are right
about the ultimate direction astock will take and act accordingly, all those
mistakes will be dwarfed by the success of your position.
Good investing, then, is essentially aprocess of recognizing and
exploiting the directionality of mispriced stocks. Usually, investors get
exposure to astock’sdirectionality by buying, or going long, that stock. This
is what the investor’srisk and reward profile looks like when he or she buys
the stock:

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Option Fundamentals   • 11
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20
40
60
80
100
120
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160
180
200
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Date/Day Count
Stock Price
749 999
GREEN
RED
As soon as the “Buy” button is pushed, the investor gains expo-
sure to the upside potential of the stock—this is the shaded region la-
beled “green” in the figure. However, at the same time, the investor
also must accept exposure to downside risk—this is the shaded region
labeled “red. ”
Anyone who has invested in stocks has avisceral understanding of
stock directionality. We all know the joy of being right as our investment
soars into the green and we’ve all felt the sting as an investment we own
falls into the red. We also know that to the extent that we want to gain
exposure to the upside potential of astock, we must necessarily simultane-
ously accept its downside risk.
Options, like stocks, are directional instruments that come in two
types. These two types can be defined in directional terms:
Call option Asecurity that allows an investor exposure to astock’supside potential (remember, “Call up”)
Put option Asecurity that allows an investor exposure to astock’sdownside potential (remember, “Put down”)
The fact that options split the directionality of stocks in half—up and
down—is agreat advantage to an investor that we will investigate more in
amoment.
Right now, let’stake alook at each of these directional instruments—
call options and put options—one by one.

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12  •   The Intelligent Option Investor
Visual Representation of Call Options
In asimilar way that we created adiagram of the risk-reward profile of owner-
ship in acommon stock, anice way of understanding how options work is to
look at avisual representation. The following diagram represents acall option.
There are afew things to note about this representation:
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1. The shaded area (green) represents the price and time range over
which the investor has economic exposure—Iterm this the range
of exposure. Because we are talking about call options, and because
call options deal with the upside potential of astock, you see that
the range of exposure lies higher than the present stock price
(remember, “Call up”).
2. True to one of the defining characteristics of an option mentioned
earlier, our range of exposure is limited by time; the option pictured
in the preceding figure expires 500 days in the future, after which
we have no economic exposure to the stock’supside potential.
3. The present stock price is $50 per share, but our upside exposure only
begins at $60 per share. The price at which economic exposure begins
is called the strike price of an option. In this case, the strike price is
$60 per share, but we could have picked astrike price at the market price
of the stock, further above the market price of the stock (e.g., astrike
price of $75), or even below the market price of the stock. We will inves-
tigate optimal strike prices for certain option strategies later in this book.

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Option Fundamentals   • 13
4. The arrow at the top of the shaded region in the figure indicates
that our exposure extends infinitely upward. If, for some reason,
this stock suddenly jumped not from $50 to $60 per share but
from $50 to $1,234 per share, we would have profitable exposure
to all that upside.
5. Clearly, the diagram showing apurchased call option looks agreat deal
like the top of the diagram for apurchased stock. Look back at the top
of the stock purchase figure and compare it with the preceding figure:
the inherent directionality of options should be completely obvious.
Any time you see agreen region on diagrams like this, you should
take it to mean that an investor has the potential to realize again on the
investment and that the investor has gained exposure. Any time an option
investor gains exposure, he or she must pay up front for that potential gain.
The money one pays up front for an option is called premium (just like the
fee you pay for insurance coverage).
In the preceding diagram, then, we have gained exposure to arange
of the stock’supside potential by buying acall option (also known as along
call). If the stock moves into this range before or at option expiration, we
have the right to buy the stock at our $60 strike price (this is termed exer -
cising an option) or simply sell the option in the option market. It is almost
always the wrong thing to exercise an option for reasons we discuss shortly.
2
If, instead, the stock is trading below our strike price at expiration, the
option is obviously worthless—we owned the right to an upside scenario
that did not materialize, so our ownership right is worth nothing.
It turns out that there is special jargon that is used to describe the
relationship between the stock price and the range of option exposure:
Jargon Situation
In the money (ITM) Stock price is within the option’srange of exposure
Out of the money (OTM) Stock price is outside the option’srange of exposure
At the money (ATM) Stock price is just at the border of the option’srange of
exposure
Each of these situations is said to describe the moneyness of the option.
Graphically, moneyness can be represented by the following diagram:

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14  •   The Intelligent Option Investor
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As we will discuss in greater detail later, not only can an investor use
options to gain exposure to astock, but the investor also can choose to accept
exposure to it. Accepting exposure means running the risk of afinancial loss if
the stock moves into an option’srange of exposure. If we were to accept expo-
sure to the stock’supside potential, we would graphically represent it like this:
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Any time you see ashaded region labeled “red” on diagrams like this, you
should take it to mean that the investor has accepted the risk of realizing aloss
on the investment and should say that the investor has accepted exposure. Any
time an option investor accepts exposure, he or she gets to receive premium
up front in return for accepting the risk. In the preceding example, the investor
has accepted upside exposure by selling acall option (a.k.a. ashort call).

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Option Fundamentals   • 15
In this sold call example, we again see the shaded area representing
the exposure range. We also see that the exposure is limited to 500 days
and that it starts at the $60 strike price. The big difference we see between
this diagram and the one before it is that when we gained upside exposure
by buying acall, we had potentially profitable exposure infinitely upward;
in the case of ashort call, we are accepting the possibility of an infinite
loss. Needless to say, the decision to accept such risk should not be taken
lightly. We will discuss in what circumstances an investor might want to
accept this type of risk and what techniques might be used to manage that
risk later in this book. For right now, think of this diagram as part of an
explanation of how options work, not why someone might want to use this
particular strategy.
Let’sgo back to the example of along call because it’seasier for
most people to think of call options this way. Recall that you must pay apremium if you want to gain exposure to astock’sdirectional potential. In
the diagrams, you will mark the amount of premium you have to pay as astraight line, as can be seen here:
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Breakeven Line: $62.50
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Ihave labeled the straight line the “Breakeven line” for now and have as-
sumed that the option’spremium totals $2.50.
You can think of the breakeven line as ahurdle the stock must cross
by expiration time. If, at expiration, the stock is trading for $61, you have
the right to purchase the shares for $60. You make a $1 profit on this trans-
action, which partially offsets the original $2.50 cost of the option.

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16  •   The Intelligent Option Investor
It is important to note that astock does not have to cross this line for
your option investment to be profitable. We will discuss this dynamic in
Chapter 2 when we learn more about the time value of options.
Visual Representation of Put Options
Now that you understand the conventions we use for our diagrams, let’sthink about how we might represent the other type of option, dealing with
downside exposure—the put. First, let’sassume that we want to gain expo-
sure to the downside potential of astock. Graphically, we would represent
this in the following way:
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First, notice that, in contrast to the diagram of the call option, the
directional exposure of aput option is bounded on the downside by $0,
so we do not draw an arrow indicating infinite exposure. This is the same
downside exposure of astock because astock cannot fall below zero dollars
per share.
In this diagram, the time range for the put option is the same 500 days
as for our call option, but the price range at which we have exposure starts
at astrike price of $50—the current market price of the stock—making this
an at-the-money (ATM) put. If you think about moneyness in terms of arange of exposure, the difference between out of the money (OTM) and in
the money (ITM) becomes easy and sensible. Here are examples of differ-
ent moneyness cases for put options:

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