986
Chicago Board Options Exchange (CBOE), 22
structured products listed, 618
Chicago Mercantile Exchange, 507, 509, 510, 672
option quotes, 515-516
trading limits on futures options, 680
Chicago Board of Trade:
trading limits on futures contracts, 658
trading limits on futures options, 680
Classes of options, 5-6
Closing transactions, 6
Collar, 275, 840
no-cost, 278-280
Commissions, 17-18
Concepts, advanced, 846-907 (see also Advanced
concepts)
Conservative covered write, 46
Contango, 697
Conversion, 253-255, 428-430, 431-438 (see also Put
options basics and Arbitrage)
reversal, 254, 428-430, 431-438
risks in, four, 433-43 7
summary, 437-438
Convertible security, covered writing against, 88-90, 94
Covered call writing, 39-94
definition, 39
diversifying return and protection, 66-70
"combined" write, 67-69
techniques, fundamental, 66-69
techniques, other, 69-70
execution of order, 56-58
contingent order, 57
net position, establishing, 57-58
follow-up action, 70-87, 94
aggressive action if stock rises, 71, 79-81
assignment, action to avoid if time premium
disappears, 71, 86-87
expiration, at or near, 83-85
getting out, 82-83
locked-in loss, 73
protective action if stock drops, 71-79
rolling action, 71-80 (see also Rolling action)
rolling forward/down, 83-85
spread, 76
uncovered position, avoiding, 86
when to let stock be called away, 86-87
importance, 39-42
for downside protection, 39
increase in stock price, benefits of, 40-41
profit graph, 41-42
quantification, 41-42
and naked put writing, differences between,
294-295
objective, 42
Index
PERCS (Preferred Equity Redemption Cumulative
Stock), 91
philosophy, 42-45
annual returns, 47
as conservative strategy, 46-4 7
Depository Trust Corp (DTC), role of, 43
in-the-money covered writes, 43-45, 93
letter of guarantee, 43
out-of-the-money covered writes, 43-45, 93
physical location of stock, 43
total return concept, 45-47, 60-61, 93
return on investment, computing, 47-56
compound interest, 53-54
downside break-even point, 48, 49-50
in margin accounts, 50-53
price,changesin,55-56
return if exercised, 47-48
return if unchanged, 48, 49
size of position, 54-55
static return, 49
selecting position, 58-62
downside protection, 59-60
returns, projected, 59
strategy, importance of, 60-62
total return concept, 60-61
special writing situations, 87-93
against convertible security, 88-90, 94
against LEAPS, 91, 94
against warrants, 90-91
incremental return concept, 87-88, 91-93
and stock ownership, 42
summary, 93-94
and uncovered put writing strategy, similarity of,
293-294
writing against stock already owned, 62-66
caution, 65-66
Covered pit sale, 300
Covered straddle write, 302-305
Crack spread, 702-704
Credit spread, 170, 179
Cross-currency spreads, 701
Cumulative density function (CDF), 806
Customer margin method, 5
Customer margin option requirements, 667
Day trading, call buying and, 101-102
Debit spread, 170
Definitions, 3-35 (see also under particular definition or
under Options)
Delta, 848-853, 866
calculation of by Black-Scholes model, 457
excess value, 764

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988
Futures and futures options (continued)
position limits, 657
pricing, 659-660
speculating, 655-656
spot and spot price, 658
as stock with expiration date, 653
tenns, 656-657
trading hours, 657
trading limits, 657-658
units of trading, 657
futures options trading strategies, 67 4-683
delta, 676-677
equivalent futures position (EFP), 676-677
follow-up actions, 692-694
limit bid, 679
limit offered, 680
mathematical considerations, 677-679
mispricing strategies, common, 683-694 (see also
Futures and futures option, mispricing strate
gies)
price relationships, 67 4-676
summary, 694
and trading limits, 679-683
mispricing strategies, common, for futures options,
683-694
backspreading puts, 686-688
follow-up action, 692-694
implied volatility, 685
points, 687-688
ratio spreading calls, 688-689
strategies for profiting, two, 685-689
summary, 694
volatility skewing, 683, 685, 693-694
which strategy to use, 690-692
options on futures, 660-673
assignment, 673
automatic exercise, 662-663
bid-offer spread, 665
cash settlement future, 661
commissions, 665
customer margin system, 667, 671
definition, 660
description, 660-662
exercise, 673
foreign currency options, 671-673
margins, 666-671
mathematical considerations, 677-679
month symbols, 665
notice day, 661-662
Philadelphia Stock Exchange (PHUC), 671, 673,
678-679
physical currency options, 671-673
on physical futures, 661, 678-679
position limits, 666
quote symbols, 664
"round-tum" commission, 665-666
serial options, 663-666
Index
SPAN margin (Standard Portfolio Analysis of
Risk), 667-671 (see also SPAN)
striking price intervals, 662
standardization less than for equity or index options,
652
summary, 695
Futures Magazine, 661
Futures option strategies for futures spreads, 696-721
futures options, using in futures spreads, 704-720
calendar spread, 704-709
follow-up considerations, 714-719
intramarket spread strategy, 719
long combinations, 709-714
spreading futures against stock sector indices,
719-720
futures spreads, 696-704
contango, 697
crack spread, 702-704
cross-currency spreads, 701
intermarket, 700-704
intramarket, 697-700
pricing differentials, 696-697
reverse carrying charge market, 697
TED spread, 701-702, 712-714
summary, 720-721
Futures spread, futures option strategies for, 696-721
(see also Futures option strategies)
Gamma, 853-859, 867, 882
neutral spread, 882
Gamma of the gamma, 865-866, 902-905
GARCH (Generalizes Autoregressive Conditional
Heteroskedasticity), 731-732, 814, 819
General Electric (GE), 567
General Motors (GM), 567
Gold and Silver Index (XAU), 588, 719
Good-until-canceled order, 34
Government National Mortgage Association
certificates, 420
Graphs, 957-960
"Greeks," 848-866 (see also Advanced concepts)
calculating, 901-902
to measure excess value, 763-764
Hedge ratio, 99-101, 457
advantages of, 482-485
delta spread, 484
neutral spread, 483-485
Hedge wrapper, 275
Hedging, futures contracts and, 653-655

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990
Index spreading (continued)
spreads using options, 583-584
options, using in index spreads, 584-587
striking price differential, 587
volatility differential, 587
summary, 588
Value Line Index, 579, 582
Inflection points, 792-793
Insider trading, 7 45-7 46
Institutional block positioning, 482-485 (see also
Mathematical applications)
Institutional use of market basket strategies, 556
Inter-index spreading, 579-587 (see also Index
spreading)
"Interest play" strategy, 438-439
Interest rates, effects of on LEAPS, 371-37 4
Intermarket futures spreads, 700-704
Intermediate-term trading, call buying and, 102-103
Intramarket futures spreads, 697-700
iShares, 638
Japanese Nikkei 225 Index, 532, 601
Kicker, 136, 169
LEAPS (Long-term Equity AnticiPation Securities), 5,
367-410
basics, 368-369
expiration date, 368
standardization less, 368
striking price, 369
type,368
underlying stock and quote symbol, 368
and call buying, 95
definition, 367
dividends, effects of, 371-37 4
to establish collar, 279
history, 367
and implied volatility, 735, 736
index options, 505-506
interest rates, effects of, 371-372
and long-term trading, 103
options, 616-617
popularity, 367
pricing, 369-37 4
rho, 864-865
selling, 390-403
assignment, early, 401-402
covered writing, 390-396
incremental return, 391
rolling down, 394
Index
short LEAPS instead of short stock, 400-402
straddle selling, 402-403
uncovered call selling, 399-400
uncovered LEAPS, 396-399
whipsaw, 403
short-term options, three sets of comparison with,
374-375
and speculative option buying, 382-390
buying "cheap," advantages of, 385-386
delta, 387-390
less risk of time decay, 383-385
spreads using, 403-409
backspreads,407-408
bull spread using calls, 403-404
calendar spreads, 408-409
diagonal, 405-407
strategies, 375-382
buying LEAPS as initial purchase instead of buy-
ing common stock, 378-381
LEAPS instead of short stock, 382
margin, using, 380-381
protecting existing stock holdings with LEAPS
puts, 381-382
as stock substitute, 375-378
summary, 409-410
symbols, 26-27
writing against, 91, 94
"Leg" into spread, 171
out of spread, 180, 207
out of put calendar spread, 335
Letter of guarantee, 43
Limit bid, 679
Limit offered, 680
Limit order, 28, 33
"Locals," 509
Locked-in loss, 73-76
Locking in profits, four strategies for, 108-1 11
Lognormal distribution of stock prices, 783-81 I
(See also Stock prices, distribution oO
Long-term Equity AnticiPation Securities (LEAl'Si
See also LEAPS
Long-term trading, call buying and, 103
Maintenance margin, 509
Major Market Index (XMI), 499
Market basket of stocks, 531-537 (see also Stock ind,·\
hedging strategies)
Market dynamics, nonquantifiable, as influt·11t·,· 011
market price, 15
Market-makers, 22
Market order, 32
Market not held order, 33
"Married" put and stock for tax purposC's, !J:l I

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992
Option purchase and spread, combining, 339-341 (see
also Spreads combining calls and puts)
Options:
arbitrageurs, role of, 19-21
risk arbitrage, 21
assignment, 7, 16-17
anticipating, 18-22 (see also Assignment)
margin requirements, 15-17
classes and series, 5-6
closing transaction, 6
commissions, 17-18
definition, 3-4
as derivative security, 4
"European" exercise options, 7
exercising, 6-7, 15-16
after, 17
early, due to discount, 19-20
early, due to dividends on underlying stock, 20-22
premature, 19-22
holder, 6
in-the-money, 7, 8
LEAPS, 5
symbols, 26-27
markets, 22 (see also Option markets)
open interest, 6
opening transaction, 6
option price and stock price, relationship of, 7-9
order entry, 32-34
good-until-canceled order, 34
information, 32
limit order, 33
market order, 32
market not held order, 33
stop-limit order, 33-34
stop order, 33
out-of-the-money, 7
parity, 8-9
premature exercise, 19-22 (see also Options, exercis
ing)
premium, 7-8
price, factors influencing, 9-15 (see also Price of
option)
profits and profit graphs, 34-35
specifications, four, 4
standardization, 4-5
expiration dates, 5
striking price, 5
symbology, 23-27
CBOE's Web site, 23
expiration month code, 23
LEAPS, 26-27
option base symbol, 23
stock splits, 27
striking price code, 24-25
summary, 27
wraps, 25-26
time value premium, 7-8, 11
trading details, 27-32
limit order, 28
one-day settlement cycle, 28
position limit and exercise limit, 31-32
rotation, 28
value, 4
as "wasting" asset, 4
writer, 6
Index
Options to buy, selecting, 101-103 (see also Call buying)
Options Clearing Corp. (OCC), 6, 15-16, 673
Options on futures, 660-673 (see also Futures and
futures options)
Options and Treasury bills, buying, 413-421
advantages, 413, 421
annualized risk, 416-418
excessive risk, avoiding, 420-421
how strategy works, 413-421
risk adjustment, 418-420
risk level, keeping even, 415-416
summary, 421
synthetic convertible bond, 414
Order entry for options, 32-34 (see also Options)
Original Issue Discount (OID), 592-593
Out-of-the-money:
call spread, 222-225
covered writes, 43-45, 93
definition, 7
for put options, 246-247
Outright option purchases and sales, effect of, on
implied volatility changes on, 757-762
Pairs trading, 454-455
Parity, 8-9
Percentile of implied volatility approach, 814-818
composite implied volatility reading, 815
historical and implied volatility, comparing, 817-818
PERCS (Preferred Equity Redemption Cumulative
Stock), 91, 619-637
call feature, 620-622
redemption price, 622
sliding scale, 620-621
covered call write, equivalent to, 622-623
definition, 619
life span, 619
owning as equivalent to sale of naked put, 626
price behavior, 623-625
strategies, 625-636
delta of imbedded call, using, 630-631
hedging PERCS with common stock, 631-6:32
issue price, determining, 633-634

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994
Put option basics (continued)
strategies, 245-247
time value premium, 246-247
Put option buying, 256-270
as alternative to short sale of stock, 256-258
purpose, 256
equivalent positions, 270
protected short sale, 270
follow-up action, 262-266
call option, 264
listed call, buying, 263
profits, five tactics for locking in, 262-266
loss-limiting actions, 267-270
calendar spread strategy, 269-270
"rolling-up" strategy, 267-269
margin account required, 269
ranking prospective purchases, 261-262
selection of which put to buy, 258-261
delta, 260-261
in-the-money puts, concentrating on, 259
Put option strategies, 243-410 (see also under particular
heading)
basics, 245-255
buying, 256-270
call and put strategies, similarities between, 244
LEAPS, 367-410
listed put options newer than listed call options, 244
put, sale of, 292-301
put buying in conjunction with call purchases,
281-291
put buying in conjunction with common stock own-
ership, 271-280
put spreads, basic, 329-335
ratio spreads using puts, 358-366
spreads combining calls and puts, 336-357
straddle, sale of, 302-320
summary, 366
synthetic stock positions created by puts and calls,
321-328
Put options, assignment of, 7
Put spreads, basic, 329-335
bear spread, 329-332
advantage over call bear spread, 330-332
as debit spread, 329
bull spread, 332-333
as credit spread, 332
formulae, 333
risk limited, 333
calendar spread, 333-335
bearish, 334-335
neutral, 334
option spreads, three simplest forms of, 329
Index
Qualified covered calls, 961-962
Ratio calendar combination, 364-366 (see also Ratio
spreads using puts)
Ratio calendar spread, 222-225 (see also Calendar and
ratio spreads)
Ratio call spreads, 210-221
and calendar spreads, combining, 222-229 (see also
Calendar and ratio spreads)
combination of bull spread and naked call write, 212
definition, 210
follow-up action, 217-221
delta, adjusting with, 219-221
equivalent stock position (ESP), using, 220-221
profits, taking, 221
ratio, reducing, 218-218
philosophies, three differing, 213-217
altering ratio, 215-216
as ratio write, 213-214
"delta spread," 213, 216-217
for credits, 213, 214-215
preferred over ratio writes, 211-212
ratio write, similarity to, 210
dissimilarity, 210-211
summary, 221
Ratio call write equivalent to naked straddle write, 306
Ratio call writing, 146-171
call spread strategies, introduction to, 168-171
credit/debit spread, 170
diagonal spread, 169
horizontal spread, 169
kicker, 169
"leg" into spread, 171
long/short side, 170
splitting quote, 171
spread, definition, 168
spread order, 169-171
vertical spread, 169
combination of covered call writing and naked call
writing, 146, 150
definition, 146
delta-neutral trading, 167-168
follow-up action, 158-168
altering ration of covered write, 160
closing out write, 166-167
delta, adjusting with, 160-163
equivalent stock position (ESP), 162-163, 167
position delta, 162-163, 167
rolling up/down as defensive action, 160
stop orders, using as defensive strategy, 163-166
"telescoping" action points, 166-167
investment required, 150-151
and ratio call spreads, similarity to, 210

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996
SIS (Stock Index return Security) (continued)
track record, 598, 599
trading at discount to cash value, 598-600
trading at discount to guarantee price, 600-601
60/40 rule, 919-920
SPAN (Standard Portfolio Analysis of Risk), 514-515,
667-671
advantages,667
example, 668, 669, 670
how it works, 667-671
maintenance margin, 667
purpose, 667
risk array, 667, 668, 669
Speculating in futures contracts, 655-656
Splitting quote, 171
Splitting strikes, 325-328 (see also Synthetic stock
positions)
Spot/spot price for futures contracts, 658
Spread, diagonalizing, 236-241
advantage,236,241
backspreads,240-241
even-money spread, 240
bear spread, 239-240
bull spread, 236-239
often improvement over normal bull spread, 239
definition, 236
for any type of spread, 241
Spreads, 76, 168-171 (see also under particular head)
backspread,232-235
diagonal, 240-241
bear, using call options, 186-190
bull, 110-111, 113-116, 117, 172-185
butterfly, 200-209
calendar, 116-117, 191-199
categories, three, 169
definition, 168
diagonal, 169, 236-241 (see also Spreads,
diagonalizing)
even money, 240
horizontal, 169
using LEAPS, 403-409 (see also LEAPS)
"leg" into, 171
out of, 180, 207
out-of-the-money call spread, 222-225
ratio call, 210-221
reverse, 230-235
reverse calendar, 230-232
reverse ratio, 232-235
unequal tax treatment on, 929-930
vertical, 169
Spread order, 169-171
Spreads combining calls and puts, 336-357
butterfly spread, 336-338
arbitrageur, role of, 338
box spread, 338
commissions high, 338
Index
equivalent of completely protected straddle write,
338
establishing, four ways for, 336-338
striking prices, three, 336
calendar combination, 345-348, 353-354, 356-357
superior to calendar straddle, 349-350
calendar straddle, 348-350, 354, 356-357
as neutral strategy, 349
criteria for, three, 354
inferior to calendar combination, 349-350
diagonal butterfly spread, 350-353, 354-355, 356-357
criteria, four, 355
legging out, 351-352
follow-up action for bull or bear spreads, 341-344
option purchase and spread, combining, 339-341
bearish scenario, 341, 342
bullish scenario, 339-340, 342
selecting, 353-356
criteria, five, 353-354
summary, 356-357
Standard Portfolio Analysis of Risk (SPAN), 514-515
Standard & Poor (S&P):
Depository Receipt (SPDR), 637-638
expiration, 510-511
100 Index (OEX), 497, 500-501, 582-583
400 Index, 497
500 Futures, 532
500 Index (SPX), 497, 502, 507, 583, 584
Standard & Poor's Stock/Bond Guide, 88
Stock:
buying below its market price, 299-300
underlying, price of as related to option price, 9-10
Stock index hedging strategies, 531-578
follow-up strategies, 557-559
rolling to another month, 557-559
impact on stock market, 561-565
"circuit breaker" of NYSE, 562
at expiration, 564-565
before expiration, 561-563
portfolio insurance, 563-564
regulatory bodies, concern of, 562
trading ban, 562
index, simulating, 566-574
hedge, monitoring, 572-573
high-capitalization stocks, using, 566-571
largest-capitalization stocks, four, 567
options instead of futures, using, 573-57 4
regression analysis, 566
tracking error risk, 571-572
index arbitrage, 547-556
commissions, 552-554
computerized method of order entry, 555-556

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998
Striking price:
as factor influencing price, 9-10
code, 24-25
definition, 3, 4
fractional, 29
standardization, 5
Structured products, 589-640
adjustment factor, 602-604
cost, measuring, 605-607, 608
break-even final index value, 604-605
exotic options, 590
imbedded call, computing value of when underlying
is trading at discount, 602
income, products designed to provide, 618-639
covered write of call option, resembling, 619
Creation Units, 638
Diamonds, 638
Exchange-Traded Funds (ETFs), 637-639 (see
also Exchange-Traded Funds)
HOLDRS, 639
iShares, 638
NASDAQ-100 tracking stock (QQQ), 638, 639
options on ETFs, 639
PERCS (Preferred Equity Redemption
Cumulative Stock (PERCS), 619-637 (see also
PERCS)
Russell 2000 Value Fund and 2000 Growth Fund,
638
more appeal for investors than for traders, 589
"riskless" ownership of stock or index, 590-618
annual adjustment factor, 594
bull spread, 608-612
cash value, 593-594
constructs, other, 607-613
dividends, 594
equity-linked notes, 618
financial engineers, role of in structured products,
590,607
imbedded call option, cost of, 594-595
income tax consequences, 592-593
LEAPS options, 616-617
list, 618
multiple expiration dates, 613
multiplier, 614
option strategies involving structured products,
613-618
Original Issue Discount (OID), 592-593
phantom interest, 592
price behavior p1ior to maturity, 595-596
SIS (Stock Index return Security), 596-601 (see
also SIS)
strike price, 592, 615-618
structure, 590-593
when underlying index drops, 617
Index
summary, 640
Suitability of strategy for individual investor, 3
Swiss franc contract for foreign currency options, 672
Symbology, options, 23-27 (see also Options)
Synthetic convertible bond, 441 (see also Options and
Treasury bills)
Synthetic long call, 271
Synthetic long stock, 321-323
Synthetic stock positions created by puts and calls, 321-
328
splitting strikes, 325-328
bearishly oriented, 327-328
bullishly oriented, 325-327
protective collar, 328
summary, 328
synthetic long stock, 321-323
synthetic short sale, 323-325
leverage, 324
"Synthetic" strategies, 118
put, 118-121
Tau, 859-862
Tax considerations, put purchase, 275
Taxes, 908-931
assignment, 914-920
applicable stock price (ASP), 917
qualified covered call, 917-920, 961-962
"too-deeply-in-the-money" definition, 916
equity options, strategies for, 925-930
deferring put holder'sshort-term gain, 928
deferring short-term call gain, three tactics for,
928
difficulty of deferring gains from writing, 928-929
spreads, unequal tax treatment on, 929-930
exercise, 913-914
history, 908-909
"married" put and stock, 924
"new" stock, delivering to avoid large long-term gain,
920-921
"versus purchase" notation 921
option as capital asset, 908
problems, special, 922-925 (see also under particular
problem heading)
profit strategies and tax strategies, separating, 931
protecting long-term gain/avoiding long-term loss,
924-925
put assignment, 921-922
put exercise, 921
short sale rule, 923-925
summary, 925, 930-931
tax treatment, basic, 910-913
call buyer, 910-911
call writer, 910, 911-912

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1000
Volatility trading, basics of (continued)
"fudge factor," 731, 733
implied volatility, 727, 732-743
as predictor of actual volatility, 737-7 43
LEAPS, 735, 736
percentile, 734-735
range, 735-737
time left in option, 736-737
Volatility Index ($VIX), 738
moving averages, 732
summary, 748
trading, 7 43-7 44
why volatility reaches extremes, 7 44-7 48
bear market in underlying stock, 746-747
cheap options, 747-748
illiquid options, 745-746
insider trading, 7 45
sellers of volatility, danger for, 7 48
supply and demand of public, 747
Volatility trading techniques, 812-845
as art and science, 812
summary, 844-845
trading volatility prediction, 814-837
backspreads, 827, 834-836 (see also Volatility
trading techniques, volatility backspread)
calendar spread, selling, 833
composite implied volatility reading, 815
histogram, construction of, 831-832
historical volatility, comparing current and past,
821-824
implied and historical volatility, comparing, 817-
818
percentile of implied volatility approach, 814-817
probability calculator, 824, 827-829
reverse calendar spread, 833-834
selecting strategy to use, 824-826
selling volatility, 826-827, 833-836
stock price history, using, 829-832
summary, 836-837
volatility chart, reading, 818-821
when volatility is out of line, determining,
814
volatility backspread, 827, 834-836, 841
margin, 836
not for LEAPS options, 835
volatility skew, trading, 837-844
collar, 840
Index
differing implied volatilities on same underlying
security, 837-838
forward/positive volatility skew, 843
reverse/negative volatility skew, 839-840
summary, 844
wrong predictions, two ways for, 813
volatility skew, 813
Warrants:
covered writing against, 90-91
rho, 872-873
Wash sale rule, 922-923
Whipsaw, 403
Wrap symbols, 25-26
Writer, definition, 6
XMI (Major Market Index), 499

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such as buying acar. You’ve been saving up for afew months, but you’re not quite ready to head to the dealership—except, one day, you drive past alocal salesroom and spot the hatchback of your dreams.
Because you want to buy that car, you decide to speak with the dealer and negotiate. You work out adeal that will allow you to buy the vehicle from him in two months for the price of $10,000. Because the dealer is agreeing to keep the car for you and fix the price, you will also be paying $300 to secure that option for yourself.
The two months start to pass and one of two things might happen:
The dealer opens the hood of the vehicle and discovers it has an engine system that’scompletely one of akind and was atest by the manufacturer. That makes the car ultra valuable as acollector’sitem. Under normal circumstances, the dealer would instantly double its asking price—but, because he made an agreement with you, he can’t. He is obligated to sell that car to you as long as you buy it before the two months are up. Obviously, you’re keen to exercise that right, so, you purchase the car for $10,000 and decide to sell it for $20,000—doubling your money in the process.
The dealer opens the trunk of the vehicle and discovers that it contains adead body. It’sremoved and the car is cleaned but the police investigation causes quite abit of damage. The value of the vehicle halves and, under normal circumstances, the dealer would slash the asking price to $5,000. However, because you entered into the agreement, the dealer must still sell you that car at the agreed price of $10,000. On the other hand, because you as the buyer are not obligated to make the purchase, you can always decide to walk away and see what the Toyota dealer has in stock instead. You won’thave lost because of the $5,000 value, but the dealer will get to keep the $300 you paid to create the opportunity for yourself in the first place.
That, in anutshell, is how options trading works. As the buyer of an option, you are in exactly the same position as you would be if you had gone out to buy that car. You cannot know what the future will bring—and it does have ahabit of throwing out the unexpected—but you can make adecent prediction.
Now, let’szoom in alittle bit closer. Though options trading really is as simple as the example we just looked at, there are afew more things you need to know in more detail before we move on.
First, as mentioned above, there are two types of options:
Calls:
They give the right to BUY an asset at aspecified price before the time limit expires. You’ddo this, for example, if you felt confident that acertain stock was going to continue rising in price for aperiod of time. The call allows you to purchase that stock at alower price at atime when it has risen to amuch greater value.
Puts:
They give the right to SELL an asset at aspecified price before the time limit expires. You’ddo this, for example, if you felt confident that acertain stock was going to continue dropping in price for aperiod of time. That would allow you to sell that stock at ahigher price at atime when it is worth awhole lot less.
Let’stranslate what we know into atrading example so that you can see how options trading works in the real world. This time, we’ll look at aput because, as you are now aware, the example of purchasing avehicle was an illustration of acall—you obtained the right to BUY before the deadline.
This time, we’ll look at what might happen if you purchased aput option which would give you the right but not the obligation to SELL before adeadline. We’ll assume you’re looking at aparticular stock in your portfolio that is currently trading at $1. Knowing the market, you have predicted that it is going to drop to $0.50 within the next three months.
You purchase an option with atrader that will allow you to sell the stock in three months at $0.75. If, during the interim, it turns out you are correct and the stock drops to $0.50 you have made aprofit of $0.25 on the sale. If, on the other hand, you were wrong in your prediction and the stock climbs to $1.20 you have no obligation to sell it and lose that $0.20 profit.
To understand this example fully, it’simportant to know the difference between abuyer and aseller as it’slikely that you’ll end up filling both roles over the course of your options trading experience.
Abuyer is NOT OBLIGATED to actually buy or sell the stock when the deadline arrives. What he or she has bought is the right to make that purchase or sale but it is not an obligation.
Aseller is OBLIGATED to buy or sell the stock when the deadline arrives. As the seller, you made apromise when the contract was agreed to and you must fulfill it when the time comes no matter what the consequences might be.
If follows, therefore, that you could find yourself in four very different situations during an options trading event. Let’soutline them for your reference as that is often where it can start to seem confusing.
Call buyer
—you have the choic

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n the time comes no matter what the consequences might be.
If follows, therefore, that you could find yourself in four very different situations during an options trading event. Let’soutline them for your reference as that is often where it can start to seem confusing.
Call buyer
—you have the choice to buy astock at the deadline but you are not obligated to do so.
Put buyer
—you have the choice to sell astock at the deadline but you are not obligated to do so.
Call seller
—you are obligated to sell astock at the deadline and you will keep the premium that was included to secure the deal.
Put seller
—you are obligated to buy astock at the deadline and you will keep the premium that was included to secure the deal.
There are more intricacies to options trading but we’ll cover those in more detail later. First, make sure you have afull understanding of the basics—they are the essence of options trading and the heart of your experience as atrader.
Why Options Rather than Stocks?
One very good question that newcomers often ask is why atrader would want to trade in options rather than stocks. What’sthe difference? Is one better than the other?
It’strue that the stock market is less complicated to work with. All you really need to worry about in the case of the stock market is the direction things are heading. Down is bad for your shares but could be good for buying. Up is good for your shares and could be good for selling.
With stock trading, you are also seldom going to lose 100 percent of your investment if things go sideways. If you pick astock thinking it will climb but instead it plummets, you can sell quickly and lose only the difference between your initial investment and the price of that stock as you sell.
Not so with options trading, where you will lose the lot if you make abad judgment call. Stock trading can be agreat introduction to the market but it is not as flexible and it is less likely to win big compared to an options trade.
When you enter the options trading market, you quickly find out that you actually have three things to worry about—and what those things are doing is not so simple as “down is bad, up is good.” You are interested in the direction stocks are heading but you can make big money on adownward direction as easily as upward if you make the right call. Meanwhile, you are also concerned about your timing and the magnitude of the trade.
In anutshell, the biggest reason to choose options over stocks is that it provides you with flexibility within your own portfolio and allows you to play the market at its own game whether you are abull or abear.
So let’stake acloser look at options trading and its benefits, shall we?
Why is Options trading Worth the Risk?
So, what’sthe point of all this horse trading? If, while reading the previous chapters, it seemed that options trading involves alot of risk and an uncertain gain, you might be interested to know that that’snot necessarily the case. It all depends how you go about trading your options.
While, yes, you can place your focus on awhole slew of risky ventures and you would stand to either lose afortune or gain even more, that’snot the only way to trade options. Let’stake alook at the advantages of options trading.
When you trade in options, the uncertainty lessens. You create an option that tells you exactly how much you will either lose or gain once the deadline arrives—unlike trading in stocks, you are not at the mercy of the markets. You have confirmation from the outset as to what you will either receive or spend on aparticular date.
Options are more versatile than stocks and that means you can make money no matter what the state of the market is. It doesn’tmatter if stocks are dropping as it would if you were simply trading in stocks. With an option strategy, you can take advantage of what’shappening in the markets in either direction.
You can also use options trading as aform of security to protect your investments. That might sound strange, but it’sactually avery common strategy known as “hedging.” If, for instance, you are concerned that astock you own alarge amount of is set to drop, but you’re not completely sure, you can use an options trade to protect yourself against that possibility. You would simply buy aput that would allow you to sell that stock at agreatly reduced loss at the deadline—you wouldn’tbe obligated to make that sale if you turned out to be wrong but you can do so if your fears prove to be well founded.
You can also “hedge” to protect yourself against risk altogether. If it seems that the market as awhole is set to drop over the coming months, you can hedge your entire portfolio by buying exchange-traded funds. Those will actually gain value as the market drops in value—it’savery common strategy among the experts.
The opposite of “hedge” is to “speculate” and it’sone of the most profitable ways to invest if it’sdone properly. Beware, however, that it is also the strategy that carries the most risk. By speculat


e will actually gain value as the market drops in value—it’savery common strategy among the experts.
The opposite of “hedge” is to “speculate” and it’sone of the most profitable ways to invest if it’sdone properly. Beware, however, that it is also the strategy that carries the most risk. By speculating, you can leverage the investments you have made and you have the chance to make alot of money in the process—all for arelatively small cost.
Finally, arguably the most important advantage of options trading is that you don’tneed to know the complicated and advanced strategies in order to prevail. Actually, it’sthe simple strategies that are very often the best. That means you can dive into options trading with the confidence that you can learn as you go without sacrificing your potential for profit.
How to Get Started in Options trading
Walking you through the learning curve of options trading will always start with the most basic move you’ll need to make—setting yourself up in aposition to actually be able to trade.
To trade in options, you’re going to need an options account. Don’tworry, we’re going to talk awhole lot more in the coming chapters about what to do with your account once you have it. For now, it’simportant that you know your starting point and just how easy it is to reach it.
One thing to know before you pick your firm is that times have changed considerably over the last couple of decades when it comes to options trading. Back before the internet became such aconstant part of our lives, your brokerage firm—or, at least, your personal representative at the firm—would make your options trades on your behalf and you paid ahefty price for their services. Nowadays, however, you’ll be doing most of your trades yourself.
Commissions for your representative is, thus, awhole lot lower than it used to be which means it won’tcost you an arm and both legs to rely on your rep in the early days of your experience with options. While you are learning, feel free to make use of your firm’sservices to place and confirm your trades if it helps you to feel more comfortable getting to know the process.
With that in mind, there are going to be certain things to look for when you select your firm.
Compare commission prices to make sure you’re getting agreat deal.
Make sure the firm has up-to-date software and is capable of setting up trades quickly and reliably to make sure you get the trades you want at the best prices.
Check out the hours of service to ensure the firm is compatible with your needs. In these days of online firms, you could be dealing with afirm that’sacross the ocean from the markets you have an interest in. Or you might find that afirm only makes its reps available for the length of the working day and that might not suit your own timing.
Speak personally with the reps at the firm because these are the people who are going to help you during the process of setting up your strategy. You want someone who is personable and knowledgeable—and, most importantly, who speaks in terms that you personally find easy to comprehend.
Take alook at the additional services the firm supplies. Many will offer learning materials, guides, and even classes or webinars to help you hone your strategies. Even if you feel that you already know what you need to know, there’sno harm in arefresher course or alittle nugget of inspiration every once in awhile.
Once you select afirm, you’ll then need to consider signing a “margin agreement” with that firm. That agreement allows you to borrow money from the firm in order to purchase your stocks, which is known as “buying on margin.”
Understandably, your brokerage firm is not going to allow you to buy on margin if you don’thave the financial status to pay them back. They will, therefore, run acredit check on you and ask you for information about your resources and your knowledge.
Amargin account is not anecessity for options trading—you don’tactually use margin to purchase an option because it must be paid for in full. However, amargin account can be useful as you graduate to more advanced strategies and, in some cases, it will be obligatory. If you opt to sign amargin agreement, talk it through thoroughly with the firm as there are certain restrictions on the type of money you can use that may apply to you.
Next, you’ll need to sign an “options agreement.” This time, it’san obligatory step. That agreement is designed to figure out how much you know about options and how much experience you have with trading them. It also aims to ensure that you are absolutely aware of the risks you take by trading options and it is to make sure that you are financially able to handle those risks.
By ascertaining those things, your firm can determine what level of options trading you should be aiming for. It will, therefore, approve your “trading level” and there are five levels.
Level 1: You may sell covered calls.
Level 2: You may buy calls and puts and also buy strangles, straddles, and colla


ascertaining those things, your firm can determine what level of options trading you should be aiming for. It will, therefore, approve your “trading level” and there are five levels.
Level 1: You may sell covered calls.
Level 2: You may buy calls and puts and also buy strangles, straddles, and collars. You may also sell puts that are covered by cash and by options on exchange-traded funds and indexes.
Level 3: You may utilize credit and debit spreads.
Level 4: You may sell “naked puts,” straddles, and strangles.
Level 5: You may sell “naked indexes” and “index spreads.”
Don’tworry if you’re not sure yet what each of those things means. You will understand them by the time you finish reading this book. For now, all you need to be aware of is that your firm will determine what level is appropriate for you. As abeginner, don’tbe surprised if you only reach the first two levels.
Once you’ve signed the option agreement, you’ll be handed abooklet that contains amine of information about the risks and rewards within options trading. Right now, if you were to read that booklet, it would seem to be in aforeign language. By the time you finish this crash course, it will be alot more understandable—and it’svery important for your success that you do read it.
Finally, your firm will present you with a “standardized option contract.” It’sthe same for every trader, which means you stand the same chance of success as every other person out there in the options market.
By trading an option, you are entering into alegal agreement that is insured by the Options Clearing Corporation, which guarantees the contract will be honored in full. Make sure you read that contract to be aware of not only the rights you have as atrader, but also the obligations you must follow in the same role.
Congratulations, you now have an options account. That is the conduit through which you will create and implement your strategies and begin your adventure in options trading.
Learning the Lingo
Options traders speak their own language. It’snot meant to confuse you, it’sjust the natural process of creating ashorthand by which one trader can converse with another more easily and thoroughly.
Of course, it does make it difficult to plunge into the waters of options trading if you can’tspeak the language. It is alot like trying to decipher road signs in aforeign country. It makes it hard to know the right direction—or even where you’re standing right now.
We’re going to take alook at the common terms you’ll be dealing with as you enter the world of options trading before we begin taking adeeper look at your strategies.
Don’tworry about trying to learn the terms by rote. They will all become clear as you forge onward. This glossary will always be available to you so that you can check on ameaning if you need to.
Strike Price:
Aprice per share agreed upon before an option is traded. At that price, stock may be bought or sold under the terms of your option contract. This price is also known as the “exercise price.”
Bid/Ask:
The latest price that amarket maker has offered for an option is its “ask” price. In other words, it’swhat the seller is willing to accept for the trade. The latest amount that abuyer has offered for an option is the “bid” price.
Premium:
The premium is aper-share amount paid to the seller in order to procure an option. The seller will keep that premium whether or not the buyer exercises their right to buy or sell the stock at the deadline.
In-the-Money:
Often shortened to ITM, that means that the stock price is above the strike price for acall or below the strike price for aput. In other words, it is now at the right price to be traded.
Out-of-the-Money:
Often shortened to OTM, that means the current price is below the strike price for acall or above it for aput. Such an option is priced according to “time value.”
At-the-Money:
The strike price is equal to the current stock price.
Long:
In this context, “long” is used to imply ownership. Once you purchase astock or option, you are “long” that item in your account.
Short:
If you sell an option or stock that you do not actually own, you are “short” that security in your account.
Exercise:
The owner of the option takes advantage of the right to buy or sell what they purchased with the option by “exercising” it.
Assigned:
When an owner of an option exercises it, the seller is “assigned” and must make good on the trade. In other words, the seller must fulfill their obligation to buy or sell.
Intrinsic Value/Time Value:
The intrinsic value of an option refers to how much it is ITM. Most options also include time value and that refers to how long is left until the option expires. That time has value because during that time the stock can still change in price. An OTM option has no intrinsic value because it’saloss but it does have time value because that loss might change.
Time Decay:
Linked to time value, that term refers to the fact that, as time ticks on, the amount of time value slowly d


ue because during that time the stock can still change in price. An OTM option has no intrinsic value because it’saloss but it does have time value because that loss might change.
Time Decay:
Linked to time value, that term refers to the fact that, as time ticks on, the amount of time value slowly decreases. At the expiration date of an option contract, the contract has NO time value and is worth only its intrinsic value.
Index Options/Equity Options:
Index options are settled by cash whereas equity options involve trading stock. The main difference between those two types of options is that an index option usually cannot be exercised before the expiration date while an equity option usually can.
Stop-Loss Order:
That is an order to sell either an option or astock when it reaches aparticular price. Its purpose is to set apoint at which you, as the trader, would like to get out of your position. At that price, your stop order is activated as amarket order. In other words, amarket order looks for the best available price at that moment in order to close out your position.
Those are the most common terms you will hear used as you venture into the world of options trading. It’sworth mentioning that, as you extend your understanding, you’ll encounter more terms. However, the above terms are enough in order to help you understand your first trades.
The Role of the Underlying Stock
It’svital to understand that stocks do play afundamental role in options trading—even though they may not be what you are buying and selling. Bear in mind that an option is only apiece of paper that gives you the right to buy or sell astock. Without the stock, you would have nothing to buy or sell.
You might say that the stock is Oz behind the curtain, changing and moving while your attention is fixed elsewhere. Letting Oz get up to his tricks without you is abad idea. You need to be keeping an eye on your stocks just as much as you follow the options themselves.
Not every stock is allowed to have its options traded on an options exchange. In total, you’ll find somewhere in the region of 3,600 stocks spread across twelve different exchanges, although that number changes all the time.
What does that mean? Well, the exchanges have in place some very solid rules that dictate which stocks may and may not participate in options trading. You’ll find some of the biggest business names on the planet have options, and you’ll also find what are known as “penny stocks” which buy and sell for less than $3.
In general, penny stocks won’tdo you much good for options trading. There simply isn’tenough liquidity in such asmall price for you to bother with the effort required to trade them.
Instead, Iwould recommend sticking with the big names—the recognizable companies such as Microsoft, Apple, Google, and McDonalds.
Another point to bear in mind is that there is afixed relationship between options trading and the underlying stock. One option contract will always be equal to 100 stock shares.
In other words, asingle contract will give you the right to buy or sell 100 shares of astock. Multiply the number of contracts involved in atrade by 100 and you’ll know how many shares are involved.
Athird factor of that relationship between an option and its underlying stock is that whenever the stock goes up or down, in most cases so, too, will the option contract.
Because astock and its options are so inextricably linked, you will need to study the stock market in detail to be awhiz at options trading. You will need to be able to predict which stocks are going to head in which direction and when—only if you get that right will your trading be truly successful.
For that reason, alot of options traders started with the stock market, itself, and gave themselves the experience of the market’swhims before taking astep up to the next level. If you haven’tdone that, it will be worth spending amonth or more trading on the stock market. Even atheoretical portfolio that you manage and never pay apenny to invest in is ahelpful step.
Doing that will allow you to get asense of how the market functions overall and it will familiarize you with some of the stocks you might be interested in for trading with options. The best options traders have almost asixth sense of how an underlying stock is going to perform. The only way to develop that uncanny ability is through exposure, research, and experience.
Understanding the Strike Price
We previously touched on the idea of the strike price, but it’ssuch afundamental aspect of options trading that it bears looking at in greater detail.
To review, the strike price is the fixed price at which the underlying stock can either be bought or sold. When you purchase acall option, what you are purchasing is the right to buy astock at acertain price. Selling acall option means that you are selling your buyer the right to purchase astock at acertain price.
The strike price is an aspect of every options trade and you will want to hone in on that


. When you purchase acall option, what you are purchasing is the right to buy astock at acertain price. Selling acall option means that you are selling your buyer the right to purchase astock at acertain price.
The strike price is an aspect of every options trade and you will want to hone in on that every time. It’sthat important. Never forget that, if the underlying stock never reaches the strike price, the trade is worthless because the option will simply expire on the expiration date.
The difference between the current market price of the stock and the strike price of the option also represents the profit-per-share you can expect to make if you are successful.
Let’ssay, for example, that you find two trades for astock that is currently worth $150. One has astrike price of $125 and the other has astrike price of $100.
In the first trade, the stock price will need to drop to $125 before you have the right to buy it or sell it (depending on whether the option is acall or abuy). In the second, it will need to drop to $100 before you have that right.
The value of the option is simple to calculate. It’sthe difference between the strike price and the current price of the stock. In the first of these examples, the trade has apotential worth of $25; in the second, the potential worth is $50.
At first glance, that would seem to mean that the second option is the one to go for because its value is so much higher. However, you also need to bear in mind that you cannot dictate what the market does.
That is where risk comes in. How confident are you, in this example, that the stock will plummet $50 before the expiration date of the option? If you’re as certain as it’spossible to be, it’sagreat investment. If you’re not, you stand to lose the premium you paid for the option because it will never reach the price at which you have the right to realize the trade.
The trade that has astrike price of $125 is, therefore, asurer bet because it’salways going to be more likely that astock will rise or fall by the smaller amount than the larger one. The trade-off, as you can see, is that you won’tmake nearly the profit you would on the riskier option, so, you have to ask yourself whether the premium you’dbe paying is worthwhile.
Basic Trading: Selling Covered Calls
As beginners, most people choose to dip their toes in the complicated waters of options trading by selling covered calls. It’sarguably the most basic level of options trading and, while also not the most adrenaline-inducing, it is agreat way to find your feet before moving on to more complicated strategies.
Selling covered calls is also likely to be an aspect of your options portfolio in the long-term. Many traders use it as asteady way of generating income and it is aconservative baseline for their account.
Athird benefit to starting with covered calls is that it includes the majority of the knowledge and strategies that you will use as an options trader, so, it’saperfect training ground.
Using that strategy, you are going to be selling the right to buy underlying stocks that you own. A “covered” call is when you own the shares and, therefore, you have the sale covered.
Before you can begin, therefore, you will need to own at least 100 shares of astock. By writing an option on those shares, you are offering buyers the right to buy them by the expiration date if the share price hits your strike price.
When abuyer takes advantage of your offer, you will receive apremium. That’syours to take home. You will never have to give it back whether the strike price is met or not and the buyer exercises their right or not. That, right there, is your reason for selling covered calls—the steady influx of cash from the premiums.
Covered calls are also agood way to sell your stock. Aclever trader will use that strategy to clear their portfolio of shares they no longer want to own. There is an advantage to owning astock in the interim, too, because you may receive adividend. You’ll receive capital gains (the difference between the price now and the increased price at time of sale) if the stock meets your strike price when the expiration date arrives.
One final advantage of covered calls is that the strategy can be used in atax-deferred account or an IRA. You won’tbe taxed on the revenue from your trade until you take out money at the time of your retirement. There are caveats to that rule, of course, so you may want to book an appointment with your accountant to make sure it works for you.
The downside? There is always the danger that your shares skyrocket before the deadline is up and you are forced to sell them to your buyer anyway, which means you’re losing out on apotential big win. That’sthe gamble and the truth is that even that risk will even out in the end because you’ll be making money on the premiums for those trades that didn’tturn out to be abad idea.
When the expiration date arrives, you will EITHER have the premium in your pocket and no shares or you will have both the


at’sthe gamble and the truth is that even that risk will even out in the end because you’ll be making money on the premiums for those trades that didn’tturn out to be abad idea.
When the expiration date arrives, you will EITHER have the premium in your pocket and no shares or you will have both the premium and the shares because the buyer didn’tchoose to purchase them after all. Either way, you’re always walking away with something.
So, let’swork through selling acovered call, step by step, and take alook at every aspect of the process.
First, choose astock that’salready in your portfolio and has been performing well recently. It also needs to be one that you are willing to no longer own if the buyer exercises their right to buy it.
In your account’sonline space, you will first bring up the underlying stock by entering its symbol. That will allow you to see its option chain—in other words, all the bids and calls currently on the table for those particular shares. Obviously, we’re interested right now in the calls. You’re going to be picking one of these offers to sell your shares.
First, take alook at the premiums on those calls. Take alook at the “bid price” column. These are displayed per share, so it’sthe amount you will receive for every share that you trade on. You’ll probably find that there is ahuge range of premiums for the same stock—that’safunction of the market. To be clear on your potential profits—for every option (100 shares of one stock), you will receive the premium for every share. If, for example, the premium is listed as $2.50, you’ll make that amount for every share of the stock. If it’sasingle stock, that’s $2.50 multiplied by 100 or $250.
You want to focus on pulling up options afew months from now, so pick adate range about two or three months down the line. That is because the premium will increase the later the expiration date. You want to be reasonable in your expectations, however, because there are downsides to going too far out, so, afew months is usually agolden spot.
Take alook at the other columns. Compare the “bid price” and “ask price” columns on that list of options. The bid price is the amount that atrader out there somewhere is prepared to pay to own the call option. The ask price is the amount that atrader somewhere has said they are prepared to sell that call option for. You can accept that bid price and you’ll sell your covered call instantly for that amount. Alternatively, you can instruct your broker to sell your option at acertain ask price or better. That won’tbe fulfilled immediately, but it will mean abetter return for you in the long-term if there’sabuyer out there who is willing to accept your price.
Take alook at the list for options that are currently “in the money.” Most lists will have amark of some kind to denote the ones that are. If an option is in the money, it means that exercising it instantly will yield aprofit—although it does not factor in the cost of buying that option in the first place, i.e., the premium. As an example to illustrate this, imagine that there is acontract with astrike price of $50 and the stock is priced at $52 right now. If the buyer of the option immediately exercises their right to buy that stock, they’dmake aprofit of $2 per share. However, if the premium per share for the option was also $2, the buyer wouldn’tactually gain any net profit.
What you should be looking for is acovered call contract with astrike price that’sslightly “out of the money.” You want to unload your shares at aslightly higher price than they are currently worth to make it agood purchase for your buyer and because you will make aprofit on the actual sale as well as on the premium. If the shares never reach that price, you won’thave to sell them, of course. If that happens, you can simply pocket the premium and list the shares again.
You can also consider acontract slightly “in the money” if the premium is high enough to offset the loss you would make on the sale. You should be calculating overall profits rather than relying on just the sale price or the premium alone. The bottom line is that you will need to calculate astrike price you’re happy to sell astock at, whether it’saloss or again, with apremium that makes the sale worthwhile.
Once you’ve chosen the contract that best suits your needs, you can simply enter into it and wait for the expiration date. At that time, though sometimes before, your broker will let you know whether the buyer exercised their right or that you still own the stock. Keep in mind that, if your buyer does NOT exercise their right, you have generated acertain amount of money because of the premium. When you repeat the exercise, you can factor that overall profit into your thinking to help guide you toward the next contract.
To sell acall option on your stock, select the “Action” that says “Sell to Open” because that is the one that applies for selling acovered call. Now, enter the number of contracts you want to sell—and rememb


an factor that overall profit into your thinking to help guide you toward the next contract.
To sell acall option on your stock, select the “Action” that says “Sell to Open” because that is the one that applies for selling acovered call. Now, enter the number of contracts you want to sell—and remember that one contract equals 100 shares.
Now, you must choose between amarket order or alimit order. Amarket order allows the market makers to figure out the price to fill your order while alimit order allows you to choose your own price. The latter is usually the better option. Once you’ve selected it, you can decide on your price. The risk is that you might not sell for the price you pick.
Now, enter the information for how long you want the option to appear in the marketplace. Iwould recommend selecting “day” rather than “until cancelled” because you want to be able to relist with new information if it isn’tpurchased.
Next, set your bid price, which will likely appear under the heading “Limit Price.” Ignore the information about last sale when you are doing this as there is no way to tell when that last sale actually happened, so, it may not reflect the current bid and ask prices you should be using as aguide.
That’sit. Hit the order button. Your first covered sell is now in the marketplace and awaiting abuyer.
Strategy for Selling Covered Calls
We’ve covered the process but what about the strategy behind covered calls? In the last chapter, we looked at the absolute basics of that strategy but an experienced trader knows there’salways going to be more to an option than meets the eye.
There’sawhole list of considerations that you will eventually want to bear in mind as you expand your knowledge and develop your own personal strategy. Every trader has adifferent attitude toward what works and what doesn’t. There are plenty of ways to make selling acovered call work but you’ll probably find yourself preferring one or two strategies.
We’ll take alook now at those considerations in more detail in order to guide you as you delve into covered calls more deeply:
The Market Environment:
You are no doubt aware that traders of stocks are happy in abull market and disgruntled in abear market. You may also know that such traders hate aflat market most of all because very little is happening and there aren’tmany big profits to be made. For you, as aseller of covered calls, the opposite is true. Ihighly recommend waiting for the market to temporarily flatten before embarking on aspate of covered call sales. That is because you’re only really interested in small changes to your share prices. If they are skyrocketing, you’re losing money on your contract. There also isn’tas much danger of the bottom falling out of the market with your stock prices plummeting at the same time which would be problematic.
Your Underlying Stock:
There is nothing more important to your success than choosing the right stocks to invest in. Icannot stress strongly enough that your success will be heightened if you pick stocks that move up very slowly. You don’twant stocks that rise and fall very quickly, especially as abeginner, because they have ahabit of making surprising moves that ruin your strategy. If they drop too far, you stand to lose alot of money if you sell. If they rise too high, you lose the money you could have made if you’dsold them at the higher price. Traders who deal in risk often enjoy those stocks because they have higher premiums and achance for huge profits but that goes against the idea of selling covered calls. You’re looking for asteady income that will underpin your riskier strategies elsewhere. By all means, go for the riskier stock elsewhere in your strategy but avoid it like the plague for covered calls.
The Premium:
Always remember that the premium is your guaranteed profit. Whatever else happens, you’re going to walk away with that cash. When you factor in the cost to list the option and any commission you will lose to your broker, you’ll be able to calculate the actual profit you’ll make on apremium. Set yourself aminimum premium—anumber that you consider to be enough to provide aprofit you’ll be happy with on the assumption that it’sthe only profit you make. When you move ahead on setting the strike price, you’ll likely adjust that base figure up or down based on what you think the underlying stock is going to do before the expiration date. Remember that the premium is only one component of the overall profit you will make. If you set astrike price that means you lose the same amount of cash on selling the shares as you made with the premium, the trade wasn’tworth doing in the first place.
The Expiration Date:
There’sareason that the premiums on covered calls get higher when the expiration date is further out. It’sbecause, much like the weather forecasts we all deride on adaily basis, it gets harder and harder to predict what’sgoing to happen to ashare price the further out you go. Also, bear in mind that your money is


that the premiums on covered calls get higher when the expiration date is further out. It’sbecause, much like the weather forecasts we all deride on adaily basis, it gets harder and harder to predict what’sgoing to happen to ashare price the further out you go. Also, bear in mind that your money is going to be tied up until the expiration date, so, the premium will increase as anod to that sacrifice. Most investors believe that atime span of between amonth and three months works best.
The Strike Price:
You might think that the strike price you set should be based on what you, as the seller, are comfortable with but actually it’sthe opposite. You’re looking for astrike price that your buyer will feel comfortable with because otherwise they aren’tgoing to buy. That, in turn, is going to be dictated by the expiration date you set as well as the premium you’re asking for and how stable or volatile the underlying stock is. Your best bet is to put yourself in the shoes of your buyer. Would you purchase that contract? How much would you stand to gain? Set your strike price accordingly and then take alook at it from your own point of view. Would that be an acceptable profit for you? If so, you’ve hit the nail on the head.
With all of those factors in mind, you are likely starting to see that there is no single “correct decision” when it comes to selling covered calls. It’sgoing to take practice and concentration to figure out which ones work best for you.
It’salso important to note that your strategy is probably going to change as you gain experience. The more options you sell, the more you will see new and more advanced ways to take advantage of the market. For now, Iurge you to be conservative in your approach and accept that selling covered options is not going to win you your fortune but it is going to help you increase the seed money you have available to do just that.
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Outcomes of a Covered Sell
As we’re using the idea of selling covered calls as atrade example to help you learn the basics of options trading overall, let’snow take aclose look at what is going to happen to your option once you’ve listed it.
The stock increases in value:
If the stock moves up and hits your strike price, that means that your buyer can now exercise their right and buy the shares. The more the stock rises, the more likely it is that the buyer will do exactly that. When your goal is to sell shares, that is what you want to happen. You will pocket the premium as well as the difference between the shares as they were valued when you listed them and the value they are at on the expiration date. In other words, you will have capital gains in addition to the premium you received.
The stock value doesn’tmove:
If the shares don’tchange either up or down during the time the option is open, then they won’thit the strike price and you won’thave to sell. You will pocket the premium and can factor that into your overall profits when you relist the stock. Many options traders actually count on that outcome. It’sthe one they are hoping for because it means they make aprofit AND keep the shares. Feel free to follow the same logic but make sure your entire plan doesn’thinge on it. You don’tcontrol the market, so, you could find yourself with anasty surprise.
The stock drops in value:
If that happens, the outcome is very similar to the share price not moving at all. The difference is that you are losing money on the shares themselves all the time they are dropping. They might bounce back but, if they don’t, then the expiration date will arrive and you’ll be holding shares that are now worth alot less than they used to be and that constitutes aloss in value. If, while monitoring your option contracts, you see that astock is starting to drop, you need to prepare to take emergency action. Do that by calculating your “breakeven” price. Subtract the premium per share from the price of the share at the time you listed it. For example, if the share was worth $50 and the premium per share is $1.50, your breakeven price per share is $48.50. If it falls below that price, you can buy back your option. That is not something you should rely on or do often but it is good as an emergency action. To do that, go back to the order entry and select “Buy to Close.” Enter either the current ask price or something lower, depending how risky you want to be. Once the trade goes through, you are back in control of your shares and can either keep or sell them as you deem fit.
As an aside, you should know that buying back your options is actually adeliberate strategy used by some people who trade in covered calls. Doing so allows you to manage your own


be. Once the trade goes through, you are back in control of your shares and can either keep or sell them as you deem fit.
As an aside, you should know that buying back your options is actually adeliberate strategy used by some people who trade in covered calls. Doing so allows you to manage your own risk and to end trades that are likely to be disadvantageous for you so that you can list those stocks again at alater date.
For instance, let’ssay that your underlying stock is rising fast and you think you’re going to lose out on alot of potential profit as it continues to skyrocket. You could “roll up” your options by buying back your call at the current ask price or lower and then selling it again at ahigher strike price.
Simply setting your stock to sell is enough to garner you aregular income with your options trading but there are other ways you can make the most of the market.
Atypical strategy for aperson who deals in selling covered calls is to purchase astock and sell acovered call on that stock at the exact same time. It’scalled a “Buy-Write Strategy.” Your brokerage firm will almost certainly allow you to do that and may even have it listed on their online order screen for you to select.
So what would you be looking for if you did that?
Astock that you would be happy to have in your share portfolio, assuming that the buyer never realized their right to purchase it.
Astock that is showing apremium rate in the marketplace you would be happy to accept.
Astock that is predictable in that it is rising or dipping in worth slowly over time.
Keep your eyes firmly on the stock market over time and you will start to see those trends. You’ll also develop an eye for spotting good trades—the ones where you can make aquick profit by selling afew contracts at agood premium price.
Asecond advanced strategy is to use options trading to get rid of stocks you don’twant to own any more. Maybe, for instance, they’ve been flat for along time and you aren’tseeing enough movement to make them worthwhile. You can set up asell that would return agood premium while allowing you to get rid of your stock at close to its current price. Instead of simply unloading them, you’dwalk away with apremium and apotentially tidy profit.
Third, you can choose to use the “half and half” strategy. Keep some of your shares in aparticular company and sell the rest. That works well if you aren’treally sure whether you should sell them all but make sure you are keeping records of what you have done.
Stepping Up a Tier: Buying Calls
We’re ready to move on to the more sophisticated areas of options trading. You have tested the waters, made alittle cash, and you feel comfortable with the mechanics of the market. Now, you can start actually buying calls and begin to hopefully make some real money.
It’sactually simple to buy acall in terms of physically going ahead and doing it. However, it’snot quite so easy to make aprofit. You’re going to need to start small and dedicate yourself to alearning curve—and you need to understand that there is arisk involved in buying calls, so, you don’twant to stake your life savings on your efforts.
My advice is that you build up slowly over time rather than jumping straight in with several buys in asingle day. Be circumspect about your actions. Asmall profit is better than no profit at all. Save your riskiest ideas for when you’ve set up anest egg with your sells and you feel confident enough in your own judgment that you’re as sure as it’spossible to be that your risk will pay off.
As areminder, what you are actually doing when you buy acall is purchasing the right to buy the underlying stock if it reaches the strike price before the deadline. You aren’tobligated to buy it. If you choose not to, all you have lost is the premium you paid for that right.
The best case scenario for you, as the buyer, is that the stock suddenly starts rising at ahigh speed before the expiration date arrives. You want it to go beyond the strike price so that, when it comes time to exercise your right, you are purchasing your stock at alower price than it is now worth. Obviously, you then have the option to instantly list that stock as acovered sell, which would allow you to realize more profit in real money.
That final piece of the puzzle is the important one. As an options trader, you are not in the business of building astock portfolio. You don’treally want to actually own shares—you want to make aprofit on them as they pass through your hands. You want to buy them for less than they are worth and then sell them for more than they are worth if you are lucky. It’swithin those transactions that your money will be made.
Buying calls has several advantages for you as an options trader.
It doesn’tcost much to get involved in the movement of aparticular stock. You only need fork out the amount for the premium. You can sit back and wait to see what the stock does before making your purchase decision based on actual information rather than o


al advantages for you as an options trader.
It doesn’tcost much to get involved in the movement of aparticular stock. You only need fork out the amount for the premium. You can sit back and wait to see what the stock does before making your purchase decision based on actual information rather than on speculating what the market will do.
It allows you to make use of the kinds of “tips” that market experts have abad habit of swearing by. You read the news, you’re watching the markets, and you have information that makes you think acertain stock is about to rise fast and hard. You want to take advantage of that, obviously, and options trading allows you to do so in asafe way rather than simply buying the stock. If you’re wrong, you’ll only lose your premium and you may even make asmall profit. If you purchased the stock and then it plummeted rather than rose, you stand to lose awhole lot more cash.
Buying calls also allows you to consider shares that would ordinarily be out of your price range. You can play around with the big boys, like Walmart and Apple without putting asecond mortgage on the house. Buying options on those stocks is awhole lot less expensive than buying the stocks themselves, so, if you see something on the horizon that makes you think the trade would be worthwhile—like anew product or service, for instance, or achange in leadership—you can use call buying to get in on the game. That is called “leverage” which is the ability to control thousands of dollars in stock for just hundreds of dollars in premiums.
One thing to note before you start buying calls is that you’ll want to wait for the right time. You are no longer interested in aflat market. This time, you want abull market where stock prices are rising.
What you are looking for is an underlying stock you have faith in. You think it’sgoing to rise in value over the next few months. Let’ssay you’ve found astock that’scurrently at $50 and you believe it will continue to rise steadily. Predicting the rate of its growth, you think it will be at $80 in two months’ time.
What you would be looking for in that scenario is acall contract that would allow you to purchase shares for LESS than the $80 you think they will rise to in two months. You must also juggle the math to make sure that you will not be paying apremium that would wipe out the profit you would make.
For example, you might find acontract option that will allow you to buy the stock at $80 per share on the expiration date with apremium of $1 per share. You think the stock is actually going to be worth $85 on that date, so, you would actually be making aprofit of $4 per share. You would make no profit at all if the premium had been $5.
Bear in mind, of course, that you won’twalk away from acall option with cash in hand. The profit we are talking about in this case is “intrinsic value.” You can now take that stock and write acovered call on it, hopefully selling it, and making atangible profit in the process. That was what we were discussing in the previous chapter. As an options trader, you’re not looking to hold astock portfolio. You’re purchasing stocks with call contracts in order to turn around and sell for aprofit.
Strategies for Buying Calls
Ihave urged you several times throughout this book to start paying attention to the stock market and learn how to spot trends in the ups and downs of particular shares. As you become increasingly familiar with that part of your options trading experience, you can also make use of acolumn in the trading screen itself to guide you.
That column is titled “Open Interest” and it represents the total amount of open contracts on aparticular underlying stock that are still running at the time you are viewing the page.
What you are looking at is the supply and demand on the stock. The more open interest there is on aparticular contract, the more people believe it’sasure bet. You can also watch for sudden changes. If acall contract has 500 in that column one day and 2000 the next, it means that asignificant number of traders believe that stock is going to move in that price direction.
Those people aren’tnecessarily right, so, it’sup to you to use your judgment. Nevertheless, it can be avery helpful addition to your tool kit when it comes to predicting the movement of the stock market and making the right decisions in your own trading.
At the same time, there are anumber of factors that should be guiding you as you choose the right contract. The following factors can help you:
In or Out of the Money:
As acall seller, you were mostly interested in the premium. As abuyer, you want abargain. You’ll find that the premium is cheaper the more out of the money acontract is. In other words, the further the stock needs to climb before you can call in your option, the cheaper the premium will be. That doesn’tmean it’sthe best bet. If you don’tbelieve the stock will climb that high, it doesn’tmatter how cheap the premium is as you’re not going to be able to purch


tract is. In other words, the further the stock needs to climb before you can call in your option, the cheaper the premium will be. That doesn’tmean it’sthe best bet. If you don’tbelieve the stock will climb that high, it doesn’tmatter how cheap the premium is as you’re not going to be able to purchase that stock. Calls that are slightly in the money are agood option for beginners and more likely to bring you amodest or sometimes larger profit.
Stock Movement:
There is absolutely no point buying abargain call that has astrike price higher than you believe it will go. If it never reaches that price, you’ve lost the premium you paid. Sometimes it can be worth the risk if you are reasonably sure the stock has achance of rising that high but that doesn’thappen very often.
Time Value:
If you’re purchasing acontract that would require the stock to rise above aprice, it stands to reason that you need to give it enough time to do that. Premiums also are lower on short term contracts but that’sbecause there’sprobably not enough time for the stock to reach its target. Be circumspect when looking for contracts with cheap premiums. The lowest price is often not the best one. It’simportant to give your strategy breathing room, so, lean toward the calls with long enough expiration dates to allow the stock to do what you hope it will.
Spread:
This is the difference between the bid and ask price and it has adirect impact on the price you will pay. Afair price usually falls somewhere between the two. The higher you pay, the more you are taking from your profit. Bear in mind that you will usually begin at aloss in your trade. If you pay $1.50 when the bid price is $1, that’sa $0.50 loss on each share. Because the whole idea is that the stock will rise in value, that’snot necessarily abig issue although it can be. As ageneral rule, if there is awide spread, you should aim for somewhere in the middle. If it’snarrow, you can probably pay the ask price without too much concern.
To make aprofit buying covered calls, you have to be right on all of these fronts. You need to choose the right time, the right direction, and the right contract price if you’re going to be successful. If you get one of those things wrong, you will likely lose that profit. Be aware that buying calls is where the risk comes in for options traders. That is why Ihighly recommend balancing your activity and relying on covered sells for your steady income while keeping your buying activity relatively modest.
Understanding Time Value
At this stage, let’stake adeeper look at one of the factors influencing the price of the options you are considering. Time value, as we’ve mentioned before, is what’sleft after you take the intrinsic value away from the premium.
In other words, if your option is priced at $2 and the intrinsic value is $1.50—the premium minus the stock price will give the time value of $0.50. The time value will slowly bleed away as you get closer to the expiration date.
Time value is your friend as abuyer but, as aseller, it’squite the opposite. You are on atimer from the moment you buy acall because, the closer you are to the expiration date, the less time there is left for the underlying stock to do what you want it to do and for your option to increase in its value.
The closer you get to the deadline, the faster the time value will trickle away. Be very aware of the time value, because it’sfar more important than alot of beginners realize. That is why you will want to factor it in very carefully to any decision you make.
Too far out and your contract could start moving in the opposite direction again and the premium will be dauntingly high. Too close and you simply won’thave enough time to watch your stocks head for the magic value you were hoping for, leaving you out of pocket on the premium.
Aim for two to three months, plenty of time for your strategy to see fruition without risking it heading in the opposite direction or paying afortune in premiums.
Understanding Volatility
There’sone final factor that affects the prices of contracts on afundamental basis and it’snot really something we’ve touched on so far. The volatility of acontract is, however, an incredibly important concept to grasp for an options trader.
Volatility refers to the movement of the underlying stock. Some stocks will slowly wend their way up and down in apredictable manner and those stocks are not very volatile. Others change up and down on aday-to-day basis.
To sum up the effect of volatility in asingle sentence—the more volatile the stock, the more that an options trader is willing to pay for it. Avolatile stock has abetter chance of reaching astrike price and perhaps shooting far beyond it before the expiration date.
However, volatility is also the most dangerous of the factors that you need to bear in mind because it’sarguably the most likely one to force you into abad decision. Avolatile stock, for example, can lead to amuch higher premium and, therefore, ahigher cont


far beyond it before the expiration date.
However, volatility is also the most dangerous of the factors that you need to bear in mind because it’sarguably the most likely one to force you into abad decision. Avolatile stock, for example, can lead to amuch higher premium and, therefore, ahigher contract price. Unless that stock shoots through the roof, you could actually end up losing money even when you should be making it.
One way to estimate the volatility of astock is to take alook at what it has done in the recent past. That tells you how much it has moved up and down already, which is what some use as an indicator of how much it will move up and down in the future.
Unfortunately, it’snot always true that the past repeats itself and you can’tpredict the future based on what’salready happened. Instead, options traders use “implied volatility” to make their guesses and that is the value that the market believes the option is worth.
You can see that reflected in the activity on the options for that stock. Buyers will be keen to get their hands on options before acertain event takes place, such as the announcement of anew product or arelease about the company’searnings. Because of that, options increase in price because there is implied volatility. The market thinks the stock is going to shoot up.
You’ll see lower demand on astock that’sflat or moving gently because there is no implied volatility and, therefore, no hurry to get in on the action. You’ll also see correspondingly low prices for options on that stock.
Volatility is obviously agood thing. As abuyer, you want the stock to be volatile because you need it to climb to the strike price and beyond. However, there is also such athing as too much volatility. It’sat that point that contracts become popular, the prices rise, and you stand to pay more for acontract than you will ultimately profit from.
Your broker will likely be able to provide you with aprogram that will help you determine implied volatility by asking you to enter certain factors and then calculating it for you. However, it’sonly with experience that you’ll learn how to spot astock that’sjust volatile enough to justify its higher price. Again, practice is key.
It’salso worth noting that alot of the risk in options trading comes from volatility largely because it’simpossible to be accurate in your estimates. What happens if an earthquake destroys acompany’sheadquarters? That stock will plummet and you had absolutely no way to see it coming.
That’swhy options traders are forced to accept that their fancy formulas are not going to be perfect predictors. They will help but you should still be conservative in your trading and avoid the temptation to sink everything into atrade that you believe could make your fortune thanks to its volatility.
Keeping an Eye on Your Calls
Once you’ve purchased acall contract, your job is not over. In fact, it has only just begun. From now until the expiration date, you need to keep an eye on what your stock is doing to see whether it goes up, down, or nowhere at all.
Down:
If the stock unexpectedly begins to move down, it’smoving further and further away from the strike price. If that trend continues, it’sgoing to mean that you can’texercise your right to buy at the expiration date and you’ve lost out. You could choose to try to sell your option to regain some of that potential loss if there’sstill time value enough to justify someone taking it off your hands. If you choose to keep it, remember that you don’tactually have to buy the stock. You are only going to lose the premium on the expiration date.
No Movement:
The stock is hovering around the strike price and is losing time value as it does. Again, you may want to think about selling the call option to reap back some of the premium. However, if you think there’sachance that things will change before the expiration date and the stock will start moving up, that’snot always agood idea. It’satough call to make because you could end up losing out on atidy profit if you don’tgive the stock breathing room to start moving. Again, remember you’ll only lose the premium if it doesn’treach the strike price or you decide not to buy.
Up:
Here’swhere options traders have ahabit of getting antsy. You’re watching the stock rise and it’sgone far beyond the strike price. Naturally, you want to call in the contract right away and you hit the “sell to close” button so you can sell it and bank that profit. If the stock has indeed reached the top of its curve and is about to start dropping again, that can indeed be the right call. However, you also have the option to “roll up” your call by closing out your position and moving it to one with ahigher strike price. You can also “roll over” to astrike price with alater expiration. There is athird option which is to actually exercise the right to buy that you purchased in the first place.
Exercising Your Right to Buy the Stock
Bearing in mind that an option is all about the right to


e with ahigher strike price. You can also “roll over” to astrike price with alater expiration. There is athird option which is to actually exercise the right to buy that you purchased in the first place.
Exercising Your Right to Buy the Stock
Bearing in mind that an option is all about the right to buy or sell astock, it might seem strange that most traders are not looking to do that. Instead, they are looking to immediately pass the stock on as asell and make aprofit by taking the premium along with the increased price of the stock from what they paid for it.
That’swhat you should be basing your strategy around—the idea of gaining stocks and instantly selling them back into the options market and making your profit in the process. In most cases, that’swhat you will be aiming to do.
It is also worth noting that some traders who buy call options never want to own the underlying stock. They are only interested in making money on the options which they can do by buying and selling options without ever owning the stock.
Nevertheless, there are still going to be times when you want to exercise your right in order to purchase the underlying stock itself. Usually, that is when you genuinely want to add aparticular stock to your portfolio. It’sup to you to decide when those times arrive.
First things first. Be very aware that you will automatically exercise your right at the expiration date if the option is in the money unless you tell your broker not to take that action. That won’thappen if it’sout of the money but it’sstill imperative that you keep acalendar of your trades so that you aren’tsurprised by the sudden arrival of stocks in your portfolio that you’dcompletely forgotten about.
If and when you decide to exercise your right, you should almost always do it at the expiration date and not before because you’ll lose the time value if you exercise early. When you alert your broker to that decision, it’salso important to know that you cannot then change your mind—the decision is permanent.
How to Buy and Sell Puts
Buying puts can be awinning strategy if done right. The stock market wouldn’tbe the stock market if it only moved in one direction. By buying puts as well as calls, you’re making the most of the market by profiting no matter which direction it’sheading. Puts are your ally during abear market.
Buying aput means that you are going to make aprofit with astock declining in price. Just as you’re looking for astock to skyrocket in acall, you’re looking for one that will plunge in aput. The strategy is, therefore, very similar and it’sjust that you’re looking in the opposite direction.
Most traders buy puts either because they’re speculating on astock and think they can make aprofit in the short term as that stock plummets, or because the puts can function as insurance for your overall portfolio. If you actually own astock in question, you can buy puts on it if you believe it’sat risk of heading downward.
For instance, let’ssay you own stock in acompany and you think the share price will drop because of the business environment. You aren’tsure, but you can make an educated guess. Simply leaving that stock sitting in your portfolio means potentially watching as its value bleeds away.
On the other hand, you could buy aput and give yourself the option to offload that stock if it does drop to acertain value. As the buyer, you are not obligated to sell your stock when the deadline arrives. You’re just giving yourself the option to do so. Of course, as always, you’ll lose the premium.
The biggest difference between buying calls and puts is that the stock market has ahabit of falling much faster than it rises. Astock can drop through the floor in just asingle day whereas it can take weeks or months to climb to magical figures.
To buy puts for the sake of speculation, you’ll need to master the art of spotting weaker stocks—the ones that are likely to fall. That is easiest during abear market and when the overall economic outlook is poor.
Even the most successful companies have down times and, if you own aput contract when that happens, you stand to make money.
When buying aput, you’ll need to think in reverse. The lower the strike price, the cheaper the option will be. In other words, it is the opposite of buying acall. You should also factor in the speed of the market when looking at expiration dates. If you think the stock is going to drop hard and fast, you probably want ashorter deadline. If you think it will take awhile for the full effects of the drop to realize, then you will want alonger one.
The most successful put strategies, at least at first, will probably be slightly in the money because you can profit from asmaller change in the underlying value. Conversely, you’ll make more money on asmaller premium with an out of the money put but you have less chance of actually making that money.
Selling puts can be agamble. The idea behind it is that, by selling your promise to buy stocks, you are earning asteady


smaller change in the underlying value. Conversely, you’ll make more money on asmaller premium with an out of the money put but you have less chance of actually making that money.
Selling puts can be agamble. The idea behind it is that, by selling your promise to buy stocks, you are earning asteady premium but you’re choosing contracts that you believe will never hit the strike price. That way, you walk away having been paid for the contract without having to actually own the underlying stock.
It’salso away to increase your stock portfolio and get paid for doing so. That can be useful if you think astock’sdropping price is temporary and you want to snap up afew of them before they start to rise again and you can sell them.
Be aware, of course, that when selling aput you are obligating yourself to buy that stock if it does reach the strike price, so, it’sabad gamble if you lack the funds to do that when the expiration date arrives.
Strategies for New Options Traders
Now that you know the basics of options trading, you’re no doubt raring to get started with your first trades. All that remains is to introduce you to some of the strategies you now have open to you.
First up is the Greeks. You’re going to see of those all over the place and they can really help you understand your chances with aparticular trade, so, it’simportant to understand what they are.
Delta:
That stands for the change in price of the option when compared to the change in price of the underlying stock. For call options, it will be between 0 and 1; for put options, it will be between 0 and -1. The closer to 1 or -1, the more likely that the price of that option will increase or decrease dollar for dollar as the stock price changes. If it’sat 0.5 or -0.5, it will increase or decrease by 50 cents for every dollar of change on the stock. The further in the money the option is, the higher its delta will be. The higher the delta, the more likely your option is going to finish in the money.
Gamma:
That stands for the change in the delta of an option relative to the change in the price of the underlying stock. It tells you, therefore, what the rate of increase of the delta is. As abuyer, ahigh gamma is good assuming that your assumptions about what the underlying stock is going to do are correct. If you’re wrong, it can be very bad indeed because your mistake is going to work against you more quickly.
Theta:
That stands for the change in the price of an option relative to how much time is left until it expires. It is directly related to the time value and will decrease as that value does. You want alow theta risk with options more than 90 days before expiration if you are long on your position because you don’twant the time value to drop. You want ahigh theta if you are short with options less than 30 days to deadline.
Vega:
That stands for the change in price relative to the option’schange in volatility. Premiums increase with volatility so vega will, too. Specifically, it will tell you how every 1 percent point change in the implied volatility affects the premium. If the volatility drops or disappears altogether, it’spossible that your option could lose value, so, vega is important to keep an eye on.
Now, for some of those all-important strategies you’ve been waiting for.
Straddling a Stock:
If you are good at spotting market trends, this strategy is for you. Let’ssay that you think acompany is about to have abig event or release an announcement, but you don’tknow exactly what that will do to its shares. You just think that it’sbound to affect them. You could use astraddle strategy to purchase both aput and acall option at the same strike price, setting the expiration shortly after the date of the event in question. Your breakeven point on that is going to need to factor in both trades. You need to be doubling your profit, in other words, to justify the spend on two contracts. Therefore, you’ll need to include that thought in your choice of strike price and you’ll need to watch out for volatility. You need higher implied volatility for that to work. You should also be aware that you won’tbe the only one who sees the change coming, so, the contracts could be pricey.
The Strangle:
That can be abetter way to tackle the situation we just looked at. It’sthe same idea except that the call and the put are set to different prices with the put strike price usually lower. When you do that, you will break even if the stock rises above acertain price OR drops below acertain price, “strangling” the possibilities from both ends.
Bull and Bear Spreads:
That strategy again tackles the question of, “What is going to happen to this stock?” It gives you asure-fire way to see some cash but with the possibility of trading away aserious profit. Again, it’sall about flexibility. In an example, for astock that’snow trading at $50, you could buy acall with astrike price of $55 and sell acall with astrike price of $60. You’ll likely pay more to buy your call than you gai