Learn Options foe Beginners

Learn Options Option Trading

eBook

Written By - Adam Beaty

Table of Contents

BACK TO BASICS

3

HISTORY OF OPTIONS

3

WHAT DOES AN OPTION LOOK LIKE?

4

COMMON OPTION DEFINITIONS

5

7 FACTORS THAT AFFECT AN OPTION'S PRICE

8

OPTION STRATEGIES

12

LONG CALL

12

LONG PUT

14

SHORT CALL

16

SHORT PUT

18

COVERED CALL

20

COLLAR

22

BULL CALL SPREAD

24

BEAR PUT SPREAD

26

BEAR CALL SPREAD

28

BULL PUT SPREAD

30

LONG STRADDLE

32

SHORT STRADDLE

34

LONG STRANGLE

36

SHORT STRANGLE

38

LONG COMBINATION

40

SHORT COMBINATION

42

RATIO VERTICAL SPREAD WITH CALLS

44

RATIO VERTICAL SPREAD WITH PUTS

46

BACK SPREAD WITH CALLS

48

BACK SPREAD WITH PUTS

50

LONG CALENDAR SPREAD WITH CALLS

52

LONG CALENDAR SPREAD WITH PUTS

54

DIAGONAL SPREAD WITH CALLS

56

DIAGONAL SPREAD WITH PUTS

58

LONG BUTTERFLY SPREAD WITH CALLS

60

LONG BUTTERFLY SPREAD WITH PUTS

62

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IRON BUTTERFLY

64

SKIP STRIKE BUTTERFLY WITH CALLS

66

SKIP STRIKE BUTTERFLY WITH PUTS

68

INVERSE SKIP STRIKE BUTTERFLY WITH CALLS

70

INVERSE SKIP STRIKE BUTTERFLY WITH PUTS

72

CHRISTMAS TREE BUTTERFLY WITH CALLS

74

CHRISTMAS TREE BUTTERFLY WITH PUTS

76

LONG CONDOR SPREAD WITH CALLS

78

LONG CONDOR SPREAD WITH PUTS

80

IRON CONDOR

82

ADVANCED TOPICS

84

THE GREEKS

84

THE GREEK CHEAT SHEET

89

USING OPTIONS TO PICK UP STOCK

90

TOP 8 MISTAKES PEOPLE MAKE TRADING OPTIONS

93

(SET) AND INDEX OPTION EXPIRATION

99

Back to Basics

History of Op ons The US op ons exchange started with the founding of the CBOE (Chicago Board Op ons Exchange) in 1973. At the beginning there were a total of 16 equi es that had only call op ons. In 1977 they began to trade put op ons. There are now over 5 different exchanges ac vely trading op ons. In 1975 the SEC (Securi es and Exchange Commission) approved the OCC (Op ons Clearing Corpora on) with the sole purpose of clearing all US based op ons. A clearing firm’s job is to facilitate execu on by transferring funds, assigning deliveries, and guaranteeing the contracts. Op ons were a hit when they first appeared. In 1975 18 million contracts traded. By 1978 that number had more than tripled to 60 million contracts. The increase in contracts con nued to climb un l the 1987 stock market crash. A er the stock market crash investors were s ll uneasy. In 1991 only 2/3 of the peak level contracts were traded. In 1983 we saw the first op ons traded on an index, the S&P 500. This was a big development since it was from this that led to the forma on of the VIX. The VIX is the vola lity index, fear index, based on the prices of S&P 500 op ons. Enthusiasm for the op ons market didn’t return un l the 1990s. During these mes we saw the introduc on of LEAPS (Long-term An cipa on Securi es) which allowed investors to buy op ons that expired over a year. We also saw the forma on of the OIC (Op ons Industry Council) which is a non-profit organiza on developed to educate people on the risk and benefits of op ons.

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What Does An Op on Look Like? An op on gives the buyer the right to buy or sell the underlying at a specified price and me. At the same me, the seller has the obliga on to take the opposite side and fulfill the op on upon exercise. That means that the buyer can choose if they want to exercise the op on, but the seller has to live up to the contract if the buyer does exercise. A typical op on:

Let’s analyze: XYZ is the underlying instrument. This can range from equi es (companies), indexes, futures, and currency. In this case we are using the company XYZ. January is the expira on month and sets the life of the op on. Expira ons are always given in terms of a month. It is understood that op ons expire on the third Friday of every month. In this example, a er the third Friday in January this op on will no longer exist. 170 is our strike price. The strike price sets the price of the underlying if it were exercised. This is not the price you would pay to buy the op on. Call specifies if this is a call or put. A call is the right to buy or call the stock away from someone else. Too long a call you are making a bet the underlying will appreciate in price. A put is the right to sell or put the stock to someone else. Too long a put you are predic ng deprecia on in price. A put and call can be traded long and short or also in combina on with other puts/calls to create spreads (more informa on on combina ons to follow).

Back to Basics

Common Op on Defini ons

In-the-Money (ITM): For a call op on this means that the underlying is trading above the strike price. For example ABC is trading at 30 and the call op on has a strike price of 25. This call op on is ITM. For a put op on this means the underlying is trading below the strike price. For example ABC is trading at 45 and the put op on has a strike of 50. This put op on is ITM.

At-the-Money (ATM): This indicates the underlying price is around the strike price. For example ABC is trading at 50 and the op on strike is 50. This goes for both puts and calls. If you cannot tell which strike is closer than look for the strike with a delta closer to .50.

Out-of-the-Money (OTM): For a call op on this means the underlying is trading below the strike price. For example ABC is trading at 15 with the call op on strike at 20. This call op on is OTM. For a put op on this means the underlying is trading above the strike price. For example ABC is trading at 75 and the put op on has a strike of 70. This put op on is OTM.

Intrinsic Value: The amount the op on is in-the-money. Only In-the-Money (ITM) op ons carry intrinsic value.

Time Value: Sets the value of me ll expira on. An op on that is Out-of-the-Money (OTM) only has me value. If an op on is In-the-Money (ITM) it is made up of both Intrinsic Value and Time Value.

Exercise: To exercise an op on contract means you are fulfilling the contract and closing it out. If you exercise a call op on you are buying the shares at the strike price. If you exercise a put you are selling the shares at the strike price.

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Assignment: An op on assignment is the other side of the op on being exercised. In this case you are not the buyer of the op on instead you are the seller or writer of the op on. When a buyer exercises an op on the writer gets assigned. If you are a writer of a call op on that gets exercised then you have to give the buyer your shares. If you are a writer of a put op on then you will receive the shares when assigned.

Op on Chain: An op on chain displays all the necessary informa on for the underlying asset. The op ons are listed by the expira on month and then broken down by all the strikes available. Usually Calls are listed on the le side and Puts listed on the right side. Op on Chains can provide a wide variety of informa on from something basic such as the bid/ask to more specific informa on such as the op on Greeks.

Back to Basics

Example of an op on chain:

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7 Factors That Affect An Op on's Price 1. Stock Price If a call op on allows you to buy a stock at a certain price in the future than the higher that price goes the more the op on will be worth. Which op on would have a higher value: A call op on allows you to buy The Op on Prophet (sym: TOP) for $100 while it is trading at $80 OR A call op on allows you to buy TOP for $100 while it is trading at $120 Obviously no one is going to pay $100 for something they can buy on the open market for $80, so our op on in Choice 1 will have a low value. What is more appealing is Choice 2, an op on to buy TOP for $100 when its value is $120. In this situa on our op on value will be higher.

2. Strike Price Strike price follows along the same lines as stock price. When we classify strikes we do it as in-themoney, at-the-money or out-of-the-money. When a call op on is in-the-money it means the stock price is greater than the strike price. When a call is out-of-the-money the stock price is less than the strike price. A TOP call has a strike of 50 while TOP is currently trading at $60, this op on is in-the-money. On the flip side of that coin a put op on is in-the-money when the stock price is less than the strike price. A put op on is out-of-the-money when the stock price is greater than the strike price. A TOP put has a strike of 20 while TOP is currently trading at $40, this op on is out-of-the-money. Op ons that are in-the-money have a higher value compared to op ons that are out-of-the-money.

Back to Basics

3. Type Of Op on This is probably the easiest factor to understand. An op on is either a put or a call and the value of the op on will change accordingly. A call op on gives the holder the right to buy the underlying at a specified price within a specific me period. A put op on gives the holder the right to sell the underlying at a specified price within a specific me period. If you are long a call or short a put your op on value increases as the market moves higher. If you are long a put or short a call your op on value increases as the market moves lower.

4. Time To Expira on Op ons have a limited life span thus their value is affected by the passing of me. As the me to expira on increases the value of the op on increases. As the me to expira on gets closer the value of the op on begins to decrease. The value begins to rapidly decrease within the last thirty days of an op on's life. The more me an op on has ll expira on, the more me the op on has to move around.

5. Interest Rates Interest rates have a very small effect on an op on's value. When interest rates rise a call op on's value will also rise and a put op on's value will fall. To drive this concept home let's look at the decision making process of trying to invest in TOP while it is trading at $50. We can buy 100 shares of the stock outright which would cost us $5,000. Instead of buying the stock outright we can long an at the money call for $5.00. Our total cost here would be $500. Our ini al outlay of cash would be smaller and this would leave us $4,500 le over. Plus, we will have the same reward poten al for half the risk. Now we can take that le over cash and invest it elsewhere such as Treasury Bills. This would generate a guaranteed return on top of our investment in TOP.

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The higher the interest rate the more a rac ve the second op on becomes. Thus, when interest rates go up calls are a be er investment so their price also increases. On the flip side of that coin if we look at a long put versus a long call we can see a disadvantage. We have two op ons when we want to play an underlying to the downside. You can short 100 shares of the stock which would generate cash into the brokerage and allow us to earn interest on that cash. You long a put which will cost you less money overall but not put extra cash into your brokerage that generates interest income. The higher the interest rate the more a rac ve the first op on becomes. Thus, when interest rates rise the value of put op ons drops.

6. Dividends Op ons do not receive dividends so their value fluctuates when dividends are released. When a company releases dividends they have an ex-dividend date. If you own the stock on that date you will be awarded the dividend. Also on this date the value of the stock will decrease by the amount of dividend. As dividends increase a put op on's value also increases and a calls' value decreases.

7. Vola lity Vola lity is the only es mated factor in this model. The vola lity that is used is forward vola lity. Forward vola lity is the measure of implied vola lity over a period in the future. Implied vola lity shows the "implied" movement in a stock's future vola lity. Basically it tells you how traders think the stock will move. Implied vola lity is always expressed as a percentage, nondirec onal and on an annual basis.

The higher the implied vola lity the more people think the stock's price will move. Stocks listed on the Dow Jones are value stocks so a lot of movement is not expected, thus, they have a lower implied vola lity. Growth stocks or small caps found on the Russell 2000, conversely, are expected to move around a lot so they carry a higher implied vola lity.

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Name: Long Call Descrip on: The long call gives the buyer the right to buy the underlying at the strike price. The long call is used to simulate buying the underlying since you try to profit from the underlying going up in price. Unlike buying the underlying outright the long call gives you a cap for losses since you can only lose the price of the call. Be careful though, it is easy to overleverage yourself using calls. Setup: Buy (long) a call Bias: Bullish Break-Even: Strike A + Price paid for call Max Profit: Unlimited: Looking for the underlying to go as high as the sky

Option Stategies

Max Loss: Limited: Price paid for the call Margin: No margin needed since call is bought outright Time Decay: As me passes the call will drop in value. To offset rapid me decay typically call op ons are purchased 60-150 days from expira on. Implied Vola lity: Over the life of the op on you want implied vola lity to increase, thus increasing the price of your op on. A decrease in implied vola lity will lower the price of your op on. Notes: Purchasing calls deep out-of-the-money because they are cheap will typically result in losses.

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Name: Long Put Descrip on: The long put gives the buyer the right to sell the underlying at the strike price. This is the equivalent to selling a stock short. The buyer of the long put will profit if the underlying drops in price. Unlike selling stock short, which can have unlimited losses, a long put has a cap on the losses since you can only lose the price of the put. Setup: Buy (long) a put Bias: Bearish Break-Even: Strike A - Price paid for put Max Profit: Limited: Underlying cannot fall below $0.00 Max Loss: Limited: Price paid for the put Margin: No margin needed since put is bought outright

Option Stategies

Time Decay: As me passes the put will drop in value. To offset rapid me decay typically put op ons are purchased 60-150 days from expira on. Implied Vola lity: Over the life of the op on you want implied vola lity to increase, thus increasing the price of your op on. A decrease in implied vola lity will lower the price of your op on. Notes: Purchasing puts deep out-of-the-money because they are cheap will typically result in losses. The purchase of puts is also used as protec on against long stock. If you are currently long stock and want to protect or lock in gains from future decline you can purchase a put that will cover any downward movement below the strike price.

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Name: Short Call Descrip on: The short call obligates you to sell the stock at the strike price. If the underlying finishes below the strike price your call will expire worthless allowing you to keep the credit. This play carries unlimited risk so cau on is advised when pu ng this play on. Setup: Sell (short) a call Bias: Neutral to Bearish Break-Even: Strike A + Credit received for the sale of the call Max Profit: Limited: To credit received Max Loss: Unlimited: If the underlying rises above your strike price - loses will occur as long as the underlying con nues to rise

Option Stategies

Margin: Short call requires no cash outlay so margin is used. Margin is calculated by taking the greater of: 25% of the underlying security value minus the out-of-the-money amount plus the premium received or 10% of the underlying security value plus the premium received Time Decay: As me passes the call will drop in value which is what you want. You want your short call to lose value so it expires worthless or allows you to buy it back (close it) for a lower price. Implied Vola lity: Over the life of the op on you want implied vola lity to decrease, thus decreasing the price of your op on. An increase in implied vola lity will increase the price of your op on. Notes: Short calls can profit no ma er which direc on the underlying moves. Losses will only occur above break-even. Selling deep out-of-the-money calls can return high probability plays

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Name: Short Put Descrip on: The short put obligates you to buy the underlying at the strike price. If the underlying finishes above the strike price your put will expire worthless allowing you to keep the credit. This play carries high risk so cau on is advised when pu ng this play on. Setup: Sell (short) a put Bias: Neutral to Bullish Break-Even: Strike A - Credit received for the sale of the put Max Profit: Limited: To Credit received Max Loss: Limited: If the underlying falls below your strike price losses will occur - but are limited due to the fact the underlying cannot fall below $0.00

Option Stategies

Margin: Short put requires no cash outlay so margin is used. Margin is calculated by taking the greater of: 25% of the underlying security value minus the out-of-the-money amount plus the premium received or 10% of the underlying security value plus the premium received Time Decay: As me passes the put will drop in value which is what you want. You want your short put to lose value so it expires worthless or allows you to buy it back (close it) for a lower price. Implied Vola lity: Over the life of the op on you want implied vola lity to decrease, thus decreasing the price of your op on. An increase in implied vola lity will increase the price of your op on. Notes: Short puts can profit no ma er which direc on the underlying moves. Losses will only occur below break-even. Selling deep out-of-the-money puts can return high probability plays. Short puts can also be turned into cash-secured puts. This is setup by holding enough cash to buy the shares if the underlying falls below the strike price. This is a good way to pick up shares at a reduced price. For example if the underlying is currently trading at $65 and you are willing to purchase the stock at $60 then you could sell the put on the 60 strike. If the underlying falls below 60 you will be assigned the shares and now have a long stock posi on. This is more typical for picking up long-term holdings.

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Name: Covered Call Descrip on: A covered calls means you are buying or already own shares of the underlying and you are going to sell a call on it. People will do this because this posi on is rela vely safe. If the underlying increases in price you will sell the shares and keep the premium. If the underlying drops then you will keep the premium. Setup: Sell (short) a call and Own or Buy (long) equal amount of shares Bias: Neutral to Slightly Bullish (If the underlying sky rockets in price you will be forced to sell at the strike price missing out on the extra gains) Break-Even: Underlying Price - Credit received for the sale of the call Max Profit: Limited: To credit received; if the underlying price goes above strike price then profit increases to premium received + sale of the underlying

Option Stategies

Max Loss: Downside risk happens only if the stock price falls to low Margin: The short call is covered by the purchase or ownership of the stock - no margin needed Time Decay: As me passes the call will drop in value which is what you want. You want your short call to lose value so it expires worthless or allows you to buy it back (close it) for a lower price. Implied Vola lity: Over the life of the op on you want implied vola lity to decrease, thus decreasing the price of your op on. An increase in implied vola lity will increase the price of your op on. Notes: Covered Calls are typically referred to as beginner plays because the op on cannot take a loss so the posi on is rela vely safe. Selling calls on shares already owned is a good way to increase/boost profit on long-term posi ons. Only establish covered calls if you are comfortable with ge ng assigned, if you are okay with losing the shares because they are called away. Pu ng on a covered call when you are not willing to give up the shares will only bring headaches and future losses.

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Name: Collar Descrip on: This strategy creates security around your underlying posi on. When you long the put you use the short call to pay for it. With this play you have protected your downside movement and capped your upside poten al. Setup: Own the stock and Sell (short) a call and Buy (long) a put Bias: Neutral to Slightly Bullish (If the underlying sky rockets in price you will be forced to sell at the strike price missing out on the extra gains) Break-Even: Two breakeven points could exist: If the play is established for a net credit (cash inflow) the break-even is the current underlying price - the credit received If the play is established for a net debit (cash ou low) the break-even is the current underlying price + the debit paid

Option Stategies

Max Profit: Limited: The strike of the short call - the current underlying price + the credit or - the debit paid Max Loss: Losses will equal the current underlying price - the strike of the long put + the debit paid or the credit received Margin: The short call is covered by the purchase or ownership of the stock - no margin needed Time Decay: As me passes the call will drop in value and the put will also drop in value. This is a neutral effect. Implied Vola lity: Movement in implied vola lity will also be neutral.

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Name: Bull Call Spread or Ver cal Spread Descrip on: The bull call spread has the same intent as the long call. However, instead of just buying the long call you also short a call. This short call reduces your cost, reduces your risk, but also reduces your profit poten al. Setup: Buy (long) Strike A call and Sell (short) Strike B call - same expira on month for both Bias: Bullish with a target at the short strike Break-Even: Strike A + debit paid Max Profit: Limited: Strike A - Strike B - Debit Paid Max Loss: Limited: Equal to the debit paid Margin: No margin required

Option Stategies

Time Decay: A neutral effect - the passing of me hurts the long call and the passing of me helps the short call Implied Vola lity: The effect of implied vola lity depends on where the underlying is in rela on to the strikes. If the underlying is trading near the short call then you want implied vola lity to decrease. If the underlying is near the long call then you want the implied vola lity to increase.

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Name: Bear Put Spread or Ver cal Spread Descrip on: The bear put spread has the same intent as the long put. However, instead of just buying the long put you also short a put. This short put reduces your cost, reduces your risk, but also reduces your profit poten al. Setup: Buy (long) Strike A put and Sell (short) Strike B put - same expira on month for both Bias: Bearish with a target at the short strike Break-Even: Strike B - debit paid Max Profit: Limited: Strike A - Strike B - Debit Paid Max Loss: Limited: Debit paid

Option Stategies

Margin: No margin required Time Decay: A neutral effect - the passing of me hurts the long put and the passing of me helps the short put Implied Vola lity: The effect of implied vola lity depends on where the underlying is in rela on to the strikes. If the underlying is trading near the short put then you want implied vola lity to decrease. If the underlying is near the long put then you want the implied vola lity to increase.

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Name: Bear Call Spread or Ver cal Spread Descrip on: The bear call spread has the same intent as the short call. However, instead of just shor ng the call you also long a call. The long call reduces your risk, but also reduces your credit received. Setup: Sell (short) Strike A call and Buy (long) Strike B call - same expira on month for both Bias: Neutral to bearish Break-Even: Strike A + credit received Max Profit: Limited: Credit received Max Loss: Limited: Strike A - Strike B - Credit received Margin: Margin is equal to the Max Loss: Strike A - Strike B - Credit received

Option Stategies

Time Decay: Time decay is a posi ve effect as you want both sides of the spread to expire worthless Implied Vola lity: The effect of implied vola lity depends on where the underlying is in rela on to the strikes. If the underlying is trading near the short call then you want implied vola lity to decrease. If the underlying is near the long call then you want the implied vola lity to increase.

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Name: Bull Put Spread or Ver cal Spread Descrip on: The bull put spread has the same intent as the short put. However, instead of just shor ng the put you also long a put. The long put reduces your risk, but also reduces your credit received. Setup: Buy (long) Strike A put and Sell (short) Strike B put Bias: Neutral to Bullish Break-Even: Strike B - credit received Max Profit: Limited: Credit received Max Loss: Limited: Strike A - Strike B - Credit received Margin: Margin equal the Max Loss: Strike A - Strike B - Credit received

Option Stategies

Time Decay: Time decay is a posi ve effect. You are looking for both sides of your spread to expire worthless. Implied Vola lity: The effect of implied vola lity depends on where the underlying is in rela on to the strikes. If the underlying is trading near the short put then you want implied vola lity to decrease. If the underlying is near the long put then you want the implied vola lity to increase.

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Name: Long Straddle Descrip on: The long straddle gives you the opportunity to profit if the stock goes up or goes down. While this may seem like an ideal play the underlying has to move enough to cover the cost of both op ons. Setup: Buy (long) Strike A put and Buy (long) Strike A call Bias: Bullish and Bearish - expec ng a big move but unsure of direc on Break-Even: Two break-even points: Strike A + Debit paid Strike A - Debit paid Max Profit: Unlimited

Option Stategies

Max Loss: Limited: Debit paid Margin: No margin required Time Decay: Time decay is an extreme nega ve effect since it will drop the value of both of your op ons Implied Vola lity: A er you establish the posi on you want implied vola lity to increase so the value of your op ons increase and to make the necessary move you originally planned for Notes: Long straddles can be hard to profit from due to the wide move the underlying needs to make before your posi on gets beaten down by me decay. Even if you are expec ng move such as an earnings announcement or report coming out the op ons could already be priced so high that it cannot capture the move. Always make sure you find the price of an at-the-money (ATM) straddle to see how big of a move the market is expec ng. You can use gamma scalping to protect and increase your gains with long straddles

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Name: Short Straddle Descrip on: The short straddle is a good play if you think the underlying will remain neutral or a decrease in vola lity. This play has the advantage of bringing you double the credit. However, you will be exposed to a lot of risk. Risk will be unlimited on the upside and substan al on the downside. Setup: Sell (short) Strike A put and Sell (short) Strike A call Bias: Neutral Break-Even: Two break-evens exist: Strike A - Credit received Strike A + Credit received Max Profit: Limited: Credit received

Option Stategies

Max Loss: Unlimited Margin: Margin is the greater out of the Short Put or the Short Call + the premium received from the other side Time Decay: Time decay is a posi ve effect. You are looking for both sides of your spread to expire worthless. Implied Vola lity: A er the posi on has been put on you want implied vola lity to decrease thus lowering your op on prices. Notes: This posi on carries a lot of risk since you are naked two op ons in either direc on. Playing direc on is not as important as playing the implied vola lity here. Look for the underlying to have a lot of vola lity and put the posi on on when you believe it will decrease.

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Name: Long Strangle Descrip on: The long strangle gives you the opportunity to profit if the stock goes up or goes down. The op ons you buy will be out of the money which reduces the cost over the long straddle. However it will split the strikes apart which increase your breakeven levels. The underlying has to move enough to cover the cost of both op ons. Setup: Buy (long) Strike A put and Buy (long) Strike B call Bias: Extreme Bullish and Extreme Bearish Break-Even: Two break-even points: Strike A - Debit paid Strike B + Debit paid

Option Stategies

Max Profit: Unlimited Max Loss: Debit paid Margin: No margin requirement Time Decay: Time decay has an extreme nega ve effect since it will lower the value of both of your op ons. Implied Vola lity: A er the posi on has been established you want implied vola lity to increase. This will increase the value of your op ons plus help make the an cipated move. Notes: A Long Strangle posi on is a hard posi on to profit from. You will need a big move that the market hasn't accounted for in a quick period before me decay eats the value from your op ons.

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Name: Short Strangle Descrip on: The short strangle allows you to make a neutral bet on the underlying. By selling both a put and strike you receive a larger credit. However, there is s ll substan al risk involved because you can incur unlimited losses to the upside and substan al losses to the downside Setup: Sell (short) Strike A put and Sell (short) Strike B call Bias: Neutral Break-Even: Two break-even points: Strike A - Credit received Strike B + Credit received Max Profit: Limited: Credit received Max Loss: Unlimited

Option Stategies

Margin: The margin requirement is the greater margin between the short put or the short call plus the credit received Time Decay: Time decay is a posi ve effect. You are looking for both sides of your spread to expire worthless. Implied Vola lity: A er the play has been established you want implied vola lity to decrease thus lowering the value of your op ons. This will also lower the chance of seeing a large move in either direc on. Notes: Short Strangle is a good play to put on when you expect a decrease in implied vola lity. Be careful when placing this play because you are exposed to unlimited risk.

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Name: Synthe c Long Descrip on: This is called a synthe c long because the profit graph is iden cal to going long on the underlying. The advantage of choosing this posi on over the underlying is the increase in leverage. You can pick up more op ons than stock. The disadvantage is that the op ons have expira on while the underlying does not. Setup: Buy (long) Strike A call and Sell (short) Strike A put - same expira on month for both Bias: Bullish Break-Even: Strike + Debit paid Max Profit: Unlimited Max Loss: Limited - Even though it is limited it can s ll be substan al in that the underlying can fall to $0.00

Option Stategies

Margin: Margin requirement equals the short put requirement Time Decay: Time decay is a neutral effect. It will lower the value of your long call and lower the value of your short put which is a good thing Implied Vola lity: Implied vola lity is also a neutral effect. An increase in vola lity will increase the value of your long call and it will increase the value of your short put which is not a good thing Notes: This play replicates a long posi on in the underlying

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Name: Short Combina on or Synthe c Short Stock Descrip on: This play replicates going short on an underlying. This play has several advantages over shor ng the underlying. With op ons you will have be er leverage and the margin will not be less than shor ng the underlying. The disadvantage here is that the op ons have expira on when the underlying does not. Setup: Sell (short) Strike A call and Buy (long) Strike A put Bias: Bearish Break-Even: Strike A + Credit received or - Debit paid Max Profit: Limited: Underlying can only go to $0.00

Option Stategies Preface

Max Loss: Unlimited if the underlying climbs Margin: Margin equals the requirement for the short call Time Decay: Time decay is a neutral effect. It will have a posi ve effect on the short call but a nega ve effect on the long put Implied Vola lity: The effect of implied vola lity is neutral. It will have a posi ve effect on the long put but a nega ve effect on the short call

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Name: Front Spread With Calls or Ra o Ver cal Spread With Calls Descrip on: The front spread with calls, also known as ra o ver cal spread, is a neutral strategy. This play is a good play if you are looking to take advantage of a decreasing vola lity. The cau on with this trade is the unlimited risk to the upside. Setup: Buy (long) Strike A call and Sell (short) 2 Strike B calls Bias: Neutral to Slightly Bullish Break-Even: Strike B + Max Profit Max Profit: Limited: Strike B - Strike A + Credit Received Max Loss: Unlimited if the underlying climbs Margin: Margin equals the requirement for the short call

Option Stategies

Time Decay: Time decay is a posi ve effect. As me goes on it will lower the value of your long call but also lower the value of your short calls which outweigh the long Implied Vola lity: A er the play is put on you want vola lity to decrease as it will have a greater posi ve effect on the short calls

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Name: Front Spread With Puts or Ra o Ver cal Spread With Puts Descrip on: The front spread with puts, also known as ra o ver cal spread, is a neutral strategy. This play is a good play if you are looking to take advantage of a decreasing vola lity. The cau on with this trade is the substan al risk to the downside. Setup: Sell (short) 2 Strike A puts and Buy (long) Strike B put - contracts will have the same expira on Bias: Neutral to Slightly Bearish Break-Even: Strike A - Max Profit Max Profit: Limited: Strike A - Strike B + Credit received Max Loss: Limited: Capped if the stock goes to $0.00 Margin: Margin equals the requirement for the short put

Option Stategies

Time Decay: Time decay is a posi ve effect. As me goes on it will lower the value of your long put but also lower the value of your short puts which outweigh the long Implied Vola lity: A er the play is put on you want vola lity to decrease as it will have a greater posi ve effect on the short puts

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Name: Back Spread With Calls Descrip on: The back spread is used when you are bullish on vola lity and on direc on. There are s ll gains to be made when the direc on goes down but the poten al to the upside is unlimited. Setup: Sell (short) Strike A call and Buy (long) 2 Strike B calls Bias: Very Bullish Break-Even: Two break-even points: Strike B - Strike A - Credit received Strike B - Credit received Max Profit: Unlimited Max Loss: Strike B - Strike A - Credit received Margin: Margin requirement equals the difference between the strikes of the short call spread

Option Stategies

Time Decay: Time Decay is mixed on this play and depends where the underlying price is rela ve to the strikes. If the underlying is below Strike A then me decay is a posi ve effect as it will allow your op ons to expire worthless and to collect the credit. If the underlying is above Strike A me decay is a nega ve effect as it will eat away at the long calls value. Implied Vola lity: An increase of implied vola lity will be a posi ve effect on this play. It will increase the value of your op ons plus it will set your play up for a big move which is what you want

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Name: Back Spread With Puts Descrip on: The back spread is used when you are bullish on vola lity and bearish on direc on. There are s ll gains to be made when the direc on goes up but the poten al to the downside is substan al. Setup: Buy (long) 2 Strike A puts and Sell (short) Strike B put - contracts will have the same expira on Bias: Very Bearish Break-Even: Two break-even points: Strike B - Strike A - Credit received Strike B - Credit received Max Profit: Limited - Max profit if stock goes to $0 Max Loss: Strike B - Strike A - Credit received

Option Stategies

Margin: Margin requirement equals the difference between the strikes of the short put spread Time Decay: Time Decay is mixed on this play and depends where the underlying price is rela ve to the strikes. If the underlying is above Strike B then me decay is a posi ve effect as it will allow your op ons to expire worthless and to collect the credit. If the underlying is below Strike B me decay is a nega ve effect as it will eat away at the long puts value. Implied Vola lity: An increase of implied vola lity will be a posi ve effect on this play. It will increase the value of your op ons plus it will set your play up for a big move which is what you want

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Name: Long Calendar Spread With Calls Descrip on: The calendar is established over two different expira on periods. These periods can be week vs month, month vs month, month vs year, or any combina on you can think of. The idea is to capture neutral movement by the near term expira on. Rolling the short strike out in calendars is a popular strategy. Setup: Sell (short) Strike A call (front month) and Buy (long) Strike A call at a later month (back month) Bias: Neutral Break-Even: Due to the fact that it is played over two different expira on months determining an exact breakeven point is difficult Max Profit: Limited - Credit received from short call minus the me decay lost on the long call Max Loss: Limited - Debit paid

Option Stategies

Margin: No margin required Time Decay: Time decay is your friend in this play since it will speed up the decline of the short front month op on faster than the back month op on Implied Vola lity: Implied vola lity's effect is mixed in this case. On one hand you want vola lity to increase because it will drive up the price on the long back month op on. However, you do not want the stock to move a lot as this is a neutral play.

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Name: Long Calendar Spread With Puts Descrip on: The calendar is established over two different expira on periods. These periods can be week vs month, month vs month, month vs year, or any combina on you can think of. The idea is to capture neutral movement by the near term expira on. Rolling the short strike out in calendars is a popular strategy. Setup: Sell (short) Strike A put (front month) and Buy (long) Strike A put at a later month (back month) Bias: Neutral Break-Even: Due to the fact that it is played over two different expira on months determining an exact breakeven point is difficult Max Profit: Limited - Credit received from short put minus the me decay lost on the long put Max Loss: Limited - Debit paid

Option Stategies

Margin: Since the trade is paid for no margin is required Time Decay: Time decay is your friend in this play since it will speed up the decline of the short front month op on faster than the back month op on Implied Vola lity: Implied vola lity's effect is mixed in this case. On one hand you want vola lity to increase because it will drive up the price on the long back month op on. However, you do not want the stock to move a lot as this is a neutral play.

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Name: Diagonal Spread With Calls Descrip on: Diagonal spreads are more difficult because it involves the combina on of several plays. Diagonal spreads typically involve the combina on of a me spread (calendar spread) and a ver cal spread. This is because you are buying and selling over different strikes and different expira on months Setup: Sell (short) out-of-the-money Strike A call (front month) and Buy (long) Strike B call at a later month (back month)and When the short call expires sell another call at Strike A Bias: Neutral to Bearish Break-Even: Due to the fact that it is played over two different expira on months determining an exact breakeven point is difficult Max Profit: Limited: Credit received from both short calls minus the debit paid for the Strike B call Max Loss: Limited: Strike A - Strike B + Net Debit Paid

Option Stategies

Margin: Margin equals the difference between strike prices Time Decay: At the beginning me decay will be on your side as your short call will lose value quicker. This is the equivalent to a calendar spread w/ calls. However, a er the first short call expires and you sell another call me decay will be neutral as it will eat away at both the long and short op ons. Implied Vola lity: Implied vola lity's effect is mixed in this case. On one hand you want vola lity to increase because it will drive up the price so you will receive a greater amount on the 2nd short call. However, you do not want the stock to move a lot as this is a neutral play

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Name: Diagonal Spread With Puts Descrip on: Diagonal spreads are more difficult because it involves the combina on of several plays. Diagonal spreads typically involve the combina on of a me spread (calendar spread) and a ver cal spread. This is because you are buying and selling over different strikes and different expira on months Setup: Sell (short) out-of-the-money Strike B put (front month) and Buy (long) Strike A put at a later month (back month)and When the short put expires sell another put at Strike B Bias: Neutral to Bullish Break-Even: Due to the fact that it is played over two different expira on months determining an exact breakeven point is difficult Max Profit: Limited: Credit received from both short puts minus the debit paid for the Strike B put Max Loss: Limited: Strike A - Strike B + Debit paid

Option Stategies

Margin: Margin equals the difference between strike prices Time Decay: At the beginning me decay will be on your side as your short put will lose value quicker. This is the equivalent to a calendar spread w/ puts. However, a er the first short put expires and you sell another put me decay will be neutral as it will eat away at both the long and short op ons. Implied Vola lity: Implied vola lity's effect is mixed in this case. On one hand you want vola lity to increase because it will drive up the price premiums so you will receive a greater amount on the 2nd short put. However, you do not want the stock to move a lot as this is a neutral play.

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Name: Long Bu erfly With Calls Descrip on: The bu erfly combines two ver cal spreads where the Strike B is the same in both. This is a neutral strategy where you hope the underlying finishes at Strike B. The profit in these posi ons can be a plus; however, ge ng the underlying to fall on Strike B is difficult Setup: Buy (long) Strike A call and Sell (short) 2 Strike B calls and Buy (long) Strike C call Bias: Neutral Break-Even: Two breakeven points: Strike A + debit paid Strike C - debit paid Max Profit: Limited: Strike B - Strike A -Debit paid Max Loss: Limited: Debit paid Margin: No margin required

Option Stategies

Time Decay: Time decay is a posi ve effect as you want the underlying to remain trapped between the strikes. You are looking for all op ons but the long call on Strike A to expire worthless Implied Vola lity: If the underlying is within Strike A and Strike C you want implied vola lity to decrease. This will decrease the value of your op ons so they expire worthless but it will also reduce the possibility of a large movement (something you don’t want). If the underlying is outside Strike A or Strike C then you want implied vola lity to increase so it will increase the value of your op ons. Notes: This is typically a neutral play but you can place direc onal bias on it by picking strikes that are out of the money.

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Name: Long Bu erfly With Puts Descrip on: The bu erfly combines two ver cal spreads where the Strike B is the same in both. This is a neutral strategy where you hope the underlying finishes at Strike B. The profit in these posi ons can be a plus; however, ge ng the underlying to fall on Strike B is difficult Setup: Buy (long) Strike A put and Sell (short) 2 Strike B puts and Buy (long) Strike C put Bias: Neutral Break-Even: Two breakeven points: Strike A + debit paid Strike C - debit paid Max Profit: Limited: Strike C - Strike B- Debit paid Max Loss: Limited: Debit paid Margin: No margin required

Option Stategies

Time Decay: Time decay is a posi ve effect as you want the underlying to remain trapped between the strikes. You are looking for all op ons but the long put on Strike A to expire worthless. Implied Vola lity: If the underlying is within Strike A and Strike C you want implied vola lity to decrease. This will decrease the value of your op ons so they expire worthless but it will also reduce the possibility of a large movement (something you don’t want). If the underlying is outside Strike A or Strike C then you want implied vola lity to increase so it will increase the value of your op ons. Notes: This is typically a neutral play but you can place direc onal bias on it by picking strikes that are out of the money.

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Name: Iron Bu erfly Descrip on: The bu erfly combines two ver cal spreads where the Strike B is the same in both. This is a neutral strategy where you hope the underlying finishes at Strike B. The profit in these posi ons can be a plus; however, ge ng the underlying to fall on Strike B is difficult Setup: Buy (long) Strike A put and Sell (short) Strike B put and Sell (short) Strike B call and Buy (long) Strike C call Bias: Neutral Break-Even: Two breakeven points: Strike B + credit received Strike B - credit received Max Profit: Limited: Credit Received Max Loss: Limited: Strike B -Strike A - Credit received

Option Stategies

Margin: Greater of the following: Short call spread requirement Short put spread requirement Time Decay: Time decay is a posi ve effect for this posi on. Ideally you want all of your op ons to expire worthless so you can keep the ini al credit. Implied Vola lity: If the underlying is within Strike A and Strike C you want implied vola lity to decrease. This will decrease the value of your op ons so they expire worthless but it will also reduce the possibility of a large movement (something you don¡¦t want). If the underlying is outside Strike A or Strike C then you want implied vola lity to increase so it will increase the value of your op ons.

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Name: Skip Strike Bu erfly With Calls or Broken Wing Bu erfly With Calls Descrip on: The broken wing bu erfly has the characteris cs of a bu erfly play but with direc onal bias on it. In this case you open your posi on when the underlying is around Strike A. You want the underlying to move up in price and remain there. Setup: Buy (long) Strike A call and Sell (short) 2 Strike B calls and Buy (long) Strike D call Bias: Slightly Bullish Break-Even: Strike C + Credit received Max Profit: Limited: Strike B – Strike A + Credit received Max Loss: Limited: Strike C – Strike D – Credit received Margin: Difference between strike prices of the short call spread

Option Stategies

Time Decay: Time decay is your friend as you want all of your op ons to expire worthless except the call at Strike A Implied Vola lity: If the underlying is trading near or outside Strike A or Strike D you want implied vola lity to increase. This will increase the value of your op ons but also suggest a large move to get your towards Strike B. If the underlying is trading near Strike B you want vola lity to decrease. Strike B is your max profit area so a move outside of this range would be a bad thing.

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Name: Skip Strike Bu erfly With Puts or Broken Wing Bu erfly With Puts Descrip on: The broken wing bu erfly has the characteris cs of a bu erfly play but with direc onal bias on it. In this case you open your posi on when the underlying is around Strike D. You want the underlying to move down in price and remain there. Setup: Buy (long) Strike A put and Sell (short) 2 Strike C puts and Buy (long) Strike D put Bias: Slightly Bearish Break-Even: Strike B - Credit received Max Profit: Limited: Strike D – Strike C + Credit received Max Loss: Limited: Strike A – Strike B – Credit received

Option Stategies

Time Decay: Time decay is your friend as you want all of your op ons to expire worthless except the put at Strike D Implied Vola lity: If the underlying is trading near or outside Strike A or Strike D you want implied vola lity to increase. This will increase the value of your op ons but also suggest a large move to get your towards Strike C. If the underlying is trading near Strike C you want vola lity to decrease. Strike B is your max profit area so a move outside of this range would be a bad thing.

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Name: Inverse Skip Strike Bu erfly With Calls or Inverse Broken Wing Bu erfly With Calls Descrip on: This play is looking for an extreme bullish move. Typically at the start of the play the underlying will be at Strike A. You can establish this play for a credit so if you are wrong and the underlying moves lower then you can s ll make money. You will need a large move to the upside to make this play profitable Setup: Sell (short) Strike A call and Buy (long) 2 Strike B calls and Sell (short) Strike D call Bias: Extremely Bullish Break-Even: Two break-even points: Strike A + Credit received Strike C - Credit received Max Profit: Limited: Strike D - Strike C + Credit received Max Loss: Limited: Strike B - Strike A - Credit received

Option Stategies

Margin: Difference between prices of the short call spread Time Decay: Time decay is your friend as you want all of your op ons to expire worthless except the call at Strike A Implied Vola lity: If the underlying is trading near or outside Strike A or Strike D you want implied vola lity to increase. This will increase the value of your op ons but also suggest a large move to get your towards Strike B. If the underlying is trading near Strike B you want vola lity to decrease. Strike B is your max profit area so a move outside of this range would be a bad thing.

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Name: Inverse Skip Strike Bu erfly With Puts or Inverse Broken Wing Bu erfly With Puts Descrip on: This play is looking for an extreme bearish move. Typically at the start of the play the underlying will be at Strike D. You can establish this play for a credit so if you are wrong and the underlying moves higher then you can s ll make money. You will need a large move to the downside to make this play profitable Setup: Sell (short) Strike A put and Buy (long) 2 Strike C puts and Sell (short) Strike D put Bias: Extremely Bearish Break-Even: Two break-even points: Strike D - Credit received Strike B + Credit received Max Profit: Limited: Strike B - Strike A + Credit received Max Loss: Limited: Strike D - Strike C - Credit received

Option Stategies

Margin: Difference between prices of the short put spread Time Decay: Time decay works both ways in this play depending on where the underlying is currently trading. It will be your friend if the underlying is trading below Strike B or above Strike D. At these levels you want the calls to drop in value to capture your profit. If the underlying is trading around Strike C me decay becomes your enemy. At this level you will receive the max loss. Implied Vola lity: Again vola lity works in two ways on this play. If the underlying is trading around Strike D or Strike B then you want it to decrease to increase the overall value of the posi on. If the underlying is trading around Strike C then you want implied vola lity to increase for two reasons. First it will raise the value of your Strike C op ons plus it will hint at a strong move in either direc on.

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Name: Christmas Tree Bu erfly With Calls Descrip on: This play is more like running the tradi onal bu erfly play except you put a slight bias on it by skipping over Strike B. Typically you will run this with the underlying trading around Strike A. You are looking for a slight move higher before it stops. With this play you will have profit over a wider range from break even to Strike C. However if you were wrong you would lose profit quicker once the underlying makes it over Strike C Setup: Buy (long) Strike A call and Sell (short) 3 Strike C calls and Buy (long) 2 Strike D calls Bias: Slightly Bullish Break-Even: Two break-even points: Strike A + Debit paid Strike D - Debit paid Max Profit: Limited: Strike C - Strike A - Debit paid

Option Stategies

Margin: No margin required Time Decay: Time decay is your friend as you want all op ons except Strike A to expire worthless. Implied Vola lity: A er the underlying reaches Strike C you want vola lity to decrease. A decrease here will increase the value of your posi on, and also decrease the chance you will see a big move outside

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Name: Christmas Tree Bu erfly With Puts Descrip on: This play is more like running the tradi onal bu erfly play except you put a slight bias on it by skipping over Strike C. Typically you will run this with the underlying trading around Strike D. You are looking for a slight move lower before it stops. With this play you will have profit over a wider range from break even to Strike B. However if you were wrong you would lose profit quicker once the underlying makes it under Strike B Setup: Buy (long) 2 Strike A puts and Sell (short) 3 Strike B puts and Buy (long) Strike D put Bias: Slightly Bearish Break-Even: Two break-even points: Strike A + Debit paid Strike D - Debit paid Max Profit: Limited: Strike D - Strike B - Debit paid Max Loss: Limited: Debit paid

Option Stategies

Margin: No margin required Time Decay: Time decay is your friend as you want all op ons except Strike D to expire worthless. Implied Vola lity: A er the underlying reaches Strike B you want vola lity to decrease. A decrease here will increase the value of your posi on, and also decrease the chance you will see a big move outside Strike B.

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Name: Long Condor Spread With Calls Descrip on: Like the bu erfly the condor is a neutral play looking to capture profits on a lack of movement. Unlike the bu erfly there is a wider range the underlying can fall in and s ll be profitable. The trade of here is that the profit will be lower. Setup: Buy (long) Strike A call and Sell (short) Strike B call and Sell (short) Strike C call and Buy (long) Strike D call Bias: Neutral Break-Even: Two break-even points: Strike A + Debit paid Strike D - Debit paid

Option Stategies

Max Profit: Limited: Strike B – Strike A – Debit paid Max Loss: Limited: Debit paid Margin: No margin required Time Decay: Time decay is your friend as you want Strike C and Strike D to expire worthless. Implied Vola lity: If the underlying is between Strike B and Strike C you want vola lity to decrease. Ideally you want the underlying to end up between these strikes for max profit. A decrease in vola lity will increase the value of your posi on and make the chances of a move outside of these strikes less likely.

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Name: Long Condor Spread With Puts Descrip on: Like the bu erfly the condor is a neutral play looking to capture profits on a lack of movement. Unlike the bu erfly there is a wider range the underlying can fall in and s ll be profitable. The trade of here is that the profit will be lower. Setup: Buy (long) Strike A put and Sell (short) Strike B put and Sell (short) Strike C put and Buy (long) Strike D put Bias: Neutral Break-Even: Two break-even points: Strike A + Debit paid Strike D - Debit paid Max Profit: Limited: Strike D - Strike C - Debit paid Max Loss: Limited: Debit paid

Option Stategies

Margin: No margin required Time Decay: Time decay is your friend as you want Strike A and Strike B to expire worthless. Implied Vola lity: If the underlying is between Strike B and Strike C you want vola lity to decrease. Ideally you want the underlying to end up between these strikes for max profit. A decrease in vola lity will increase the value of your posi on and make the chances of a move outside of these strikes less likely.

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Name: Iron Condor Descrip on: The iron condor is traded for a credit. Like the bu erfly the condor is a neutral play looking to capture profits on a lack of movement. Unlike the bu erfly there is a wider range the underlying can fall in and s ll be profitable. The trade of here is that the profit will be lower. Setup: Buy (long) Strike A put and Sell (short) Strike B put and Sell (short) Strike C call and Buy (long) Strike D call Bias: Neutral Break-Even: Two break-even points: Strike B - Credit received Strike C + Credit received Max Profit: Limited: Credit received Max Loss: Limited: Strike B - Strike A - Credit received

Margin: Greater of the following: Short call spread requirement Short put spread requirement Time Decay: Time decay is your friend as you want all of the op ons to expire worthless. Implied Vola lity: If the underlying is between Strike B and Strike C you want vola lity to decrease. Ideally you want all the op ons to expire worthless to collect the full credit. A decrease in vola lity will increase the value of your posi on and make the chances of a move outside of these strikes less likely.

Advanced Topics Trade Smart Win Smart

The Greeks Delta: The measure of how much exposure your op on posi on has to the underlying is Delta. Delta lets you know how much your op on posi on will change for a 1-point move in the underlying. Call deltas range from 0.0 to 1.0 and Put deltas range from 0.0 to -1.0. The underlying always has a delta of 1. For example: Delta of a call: .60 Price of call: $1.00 Price of underlying: $52.00 If the underlying increases to $53.00 your op on is now worth $1.60. If the underlying decreases to $51.00 your op on is now worth $0.40 The further out of the money the op on the lower the delta. Deep out of the money op ons have deltas closer to 0.0 (for calls and puts). Deep in the money op ons will have a delta closer to 1.0 (for calls) or 1.0 (for puts). We can use this same logic to apply probability to our posi on. You can use delta to give you a rough es mate of probability for an op on finishing in the money. So in our example above, our calls has a 60% (.60 delta) chance of finishing in the money. You can always find the strike that is at the money by looking for the delta closest to .50. Deltas are not constant as they will move over the life of the op on as me, price, and vola lity change. If you are trading a posi on comprised of more than one op on than you can total up the deltas to figure out the total delta for the posi on. Posi on Delta = Delta x Shares per Contract x # of Contracts

Advanced Topics

For example: Posi on

Delta

Short 50 XYZ

1.0

Short 20 XYZ November 115 Calls

.55

Long 30 XYZ November 118 Calls

.46

Total Delta

Posi on Delta 1 x 50 =

+50

.55 x 100 x 20 = -1100

.46 x 100 x 30 = +1380

+330

From here we can see the posi on is delta long 330. This is equivalent of owning 330 shares of the underlying stock. If the delta was around 0.0 we would call it delta neutral. Delta short is a nega ve overall delta. From this example we can also see that Long Calls and Short Puts have a posi ve delta (they both benefit from an increase in the underlying). Short Calls and Long Puts both have nega ve deltas (they both benefit from a decrease in the underlying). Gamma: To figure out how fast the delta is going to move we look at Gamma. Earlier we talked about how delta is not a consistent number and how it will change over the life of an op on. Gamma gives us the tool to measure that change. Again, we can think of the change in terms of a 1point move in the underlying. For example: Delta of call: .60 Gamma of call: .05 Underlying: $46.00 If the underlying increases to $47.00 then the delta will now be .65. If the underlying decreases to $45.00 then the delta will be .55.

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Like delta, gamma will also change over the life of the op on. This is because a delta cannot go beyond 1.0 or -1.0. A gamma must change to slow down the movement of delta. The gamma of at the money op ons will be the highest. Deep in the money and deep out of the money op ons will have the smallest gamma. Gammas are always expressed as posi ve numbers, and will increase drama cally near expira on. This factor is what makes the Weekly op ons desirable. Even a small move so close to expira on can change the op on price greatly. Like delta gamma can be calculated for an en re posi on consis ng of more than one op on. We will use our previous example on delta. Posi on Delta Posi on Delta Gamma Posi on Gamma

Posi on

Delta

Posi on Delta

Gamma

Posi on Gamma

Short 50 XYZ

1.0

+50

0.0

0.0

Short 20 XYZ November 115 Calls

.55

-1100

.04

.04 x 100 x 20 = -80

Long 30 XYZ November 118 Calls

.46

+1380

.03

.03 x 100 x 30 = +90

Totals

+330

+10

As you can see this posi on is posi ve gamma at +10. So if the underlying moves up by 1-point our new delta will be +340 (330 + 10). If the underlying moves down 1-point our new delta will be +320 (330 – 10). We also no ce that the underlying has a gamma of 0.0. The underlying has a 1.0 delta and thus cannot change so we get a 0.0 gamma. We also no ce Long Calls and Long Puts have posi ve gammas and Short Calls and Short Puts have nega ve gammas. Later we will show you how to make your posi on both delta and gamma neutral. As we will discover it is not enough to be delta neutral as that only last un l the underlying moves. Theta: The measure of me decay comes from theta. One thing all op on traders need to be aware of is an op on’s me decay. Time decay is the enemy of the op on buyer and friend of the op on seller. Theta is expressed as a nega ve number of cents of decay for each day. So a theta of -.06 means the op on price will drop 6 cents each day if everything else remains the same.

Advanced Topics

Time decay is not linear and will increase rapidly when the op on nears expira on. Also near expira on most brokerages, op on chains, and models will report theta that is not accurate. The majority of the me thetas near expira on that will report a number that will take the op on price below 0 before expira on.

Unlike delta, gamma, and vega me decay cannot be hedged against so it is usually not of major concern to overall posi ons.Understanding that it is there and how it will affect your posi ons is more important. However, you can figure out the overall theta of posi on that has more than one op on. Posi on Theta = Op on Theta x Shares per Contract x # of Contracts Vega/Tau/Kappa: Vola lity always gets a wide variety of names because Vega is not actually a Greek le er, so in some cases you will see it referred to as Tau or Kappa.In our case we will also refer to it as Vega since that is the generally accepted name.Vega measures the change in op on price according to the change in vola lity.Vola lity is always the X- Factor in op ons pricing. That is because it is always a guess, always misunderstood, and usually not taken into major account. Unlike all other inputs into an op on pricing model, vola lity is the only one that is not a concrete number.With that being said,vola lity is the most important factor in op ons. A high vola lity means higher op on prices.This is because people expect the underlying to move more so therefor op on prices are higher to reflect that.That means if vola lity goes up your op on price will rise. That means if vola lity goes down, your op on price will go down.

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This may seem like an elementary concept; however most beginner op on traders will ask the ques on, “Why did my stock go in the right direc on, but my op on lose money”. Learning vola lity and how it moves and affects op ons will put you way ahead of the pack when you being op on trading. Rho: This is the poor forgo en Greek. Rho tracks interest rates and how they affect op on prices. With an increase of interest rates we have an increase in call prices and a decrease in put prices. When interest rates decrease we see a rise in put prices and a decrease in call prices. Rho measures this movement.

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The Greek Cheat Sheet The Greeks can get very complicated especially when you really start to dive into the plays. This cheat sheet is what helped me when I first started in op ons. Long Straddle is a neutral delta, posi ve gamma, nega ve theta, and posi ve vega. This means it is not direc onal (delta), needs movement (gamma), decays with me (theta), and looks for increasing vola lity (vega) This is a great worksheet to keep around when pu ng on op on posi ons to make sure you are aligning the right strategy with the situa on. Strategy Long Stock Short Stock Long Call Long Put Short Call Short Put Long Straddle Long Strangle Short Straddle Short Strangle Bull Spread Bear Spread Calendar Spread

Delta + + + N/A + N/A N/A + N/A

Gamma N/A N/A + + + + -

Theta N/A N/A + + + + +

Vega N/A N/A + + + + +

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Using Op ons to Pick Up Stock Most people will use op ons as a means of specula on or a means to hedge. Both of these strategies have their place; however what people tend to not use op ons for is to pick up stock. Using op ons to go long on a posi on is a great way to make extra money without a real risk. How is it done? Well there are a couple of different methods, this is one. We will go over the other at a later date. Let's start with a company (AAPL) (this is not a recommenda on - just used for demonstra on)

At the end of today these are AAPL's numbers, Last Price is $383. This is a bit overpriced for my liking but if Apple were to come down to 370 I would pick up a 100 shares in a heartbeat. Maybe I see 370 as a fair valua on of the company or at that price it will be pulling back to a strong support level. So now that I have the price I want it at I could sit on my hands and wait for it to drop or I could sell puts to make some money while I wait. Here is our op on chain for October:

(calls on the left - puts on the right) For our purpose we will only look at the right side. When you short puts to pick up the stock you look for the stock to drop in price under the strike and you will be assigned (given) the shares. So as you can see there just so happens to be a 370 strike which is the price I want Apple for. The last price traded on the 370 puts was 12.15. If we sell 1 contract (100 shares) we collect (12.15 x 100) $1215 while we wait for Apple to drop. Sounds simple, right? Well it is, but we are not done yet. We still need to discuss how far out we sell our premium, what happens when we get assigned, what happens if we don't get assigned, and what the pitfalls of this strategy are.

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How far out do we sell premium? To answer this ques on we have to level the playing field. Obviously an op on expiring in a couple of weeks can't compete on premium to an op on expiring 6 months from now. First we need to find out the annual return of our premium. The formula we will use is: (( 1 + (Premium) / (Cost of Shares) / (Days to Hold)) ^ 365) - 1 looks like a complicated formula but it is really simple so for our example: (( 1 + (1215 / 37000) / 44) ^ 365 ) - 1= (( 1 + .032837838 / 44 ) ^ 365 ) -1 = (( 1 + .000746314 ) ^ 365 ) - 1 = (( 1.007463145 ) ^ 365 ) - 1 = 1.312985029 - 1 = .312985029 = 31.30% annualized return Yes that is right. You have the op on of si ng and wai ng for the stock to come down to 370 before you buy it, or you can sell puts to collect a 31.30% return while you wait. Use this method of figuring out the annualized return for different expira on months so you can find out which month is offering a be er return. Keep in mind that you don't want to get crazy with the holding period. You will have to keep this cash si ng aside just in case your op on gets assigned. Typically 1 - 3 month holding periods work the best, but try a couple out to find out for sure. If selling puts becomes a normal habit of yours, go ahead and make an excel spreadsheet to make these calcula ons quick and efficient. Let me know if you require help crea ng a spreadsheet. What happens if we get assigned? Ge ng assigned is having the stock fall below your strike and forcing you to buy the shares. This is the scenario you should be coun ng on if you are selling cash-secured puts. If at expira on Apple is .01cents below 370 you will be assigned the shares, and have to pay out $37,000. However, since you sold puts your average price is not 370 for the shares but is actually 370 - 12.15 = 357.85.

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Now that you have the stock you can start thinking about selling calls to generate extra cash. We will describe this strategy at a later date also. What happens if we don't get assigned? If we don't get assigned then the puts will expire worthless and we keep the premium. This has its advantageous because we s ll make the $1215 premium, which is a 3.28% return, and we will not have to pay another commission to close out the posi on. What are the pi alls of this strategy? Every strategy has its pi alls and this one is no different. Let's say you sell the puts but the stock does not come down and begins to move higher. At this point you would not be able to take advantage of this run up since you only have puts and not the stock. What you can do in this situa on is buy back the puts for a cheaper price, thus making a profit, and then sell more puts at a higher strike. Another scenario is if the stock falls below your strike and keeps falling. This will assign you shares at your price, in our example 370 with a breakeven of 357.85. If the stock falls below that point you will have a loss. One way to think about this scenario is that you were planning on buying Apple at 370 anyways, at least this way you have lowered your breakeven.

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Top 8 Mistakes People Make Trading Op ons 1. Buying out of the money op ons because they are cheap The Problem: A lot of new traders like to start out by buying near term out of the money op ons. Why? They are the cheapest so it seems like a great idea at the me. The problem is that these op ons are cheap for a reason. They have a small probability of finishing in the money so they are not going to be worth anything to begin with. Think of these op ons as lo ery ckets. You will have to buy lots of them just to get one to pay off and breakeven. When you purchase these op ons you HAVE to be right on both ming and direc on. Now that seems easy and obvious at first but if you are si ng on these op ons for too long then a move in the right direc on s ll won't help you out. The closer those op ons move to expira on the lower the probability becomes that they will finish in the money which means they will s ll be worth very li le. The Fix: When purchasing straight long calls and long puts try to get them at the money or in the money. The op ons will be more expensive than their out of the money counterpart but the probability of success and the leeway they afford will be worth the money. If you s ll want to go out-of-the-money shoot for one strike out 2. Ge ng overleveraged The Problem: When star ng into the world of op ons you will undoubtedly come from trading stock first, this is just the natural progression. As a stock trader you probably have rules for how big of a posi on you are going to trade. Typically, traders will buy in blocks of shares: 100 shares a posi on, 200 shares a posi on, etc... and spend anywhere between $1,000 - $5,000 on a posi on. The problem forms when they try to make this move into op ons. Op ons, by their nature, are cheaper than stock so it will allow you to take on more shares for less money then you are used to. This leads to ge ng over leveraged in these posi ons. If you are used to spending $1,000 for a posi on buying the same amount in op ons will leave you will much more leverage and risk. The swings in op ons can make or break a posi on very quickly and if you are not use to the swings then you can end up in a lot of pain.

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The Fix: When you start op ons try to keep you posi on size small. In fact, one of the best things about op ons is that you can s ll be profitable by trading only one contract. Commissions are typically so cheap you don't need to trade large posi ons to break even. Any me you are learning a new op on strategy or play always start small so you keep your risk low. Use small posi ons to learn how op ons move with the market, vola lity, and me. Once you have a clear understanding of the types of plays you are running then you can begin to build your posi on size. bigger loss. If the spread is 20cents or 30cents that means you already begin $20 to $30 down. 3. Not Having A Plan The Problem: Op on trading is a lot more complex versus trading regular stock posi ons. There are a lot more factors to watch and there are a lot more op ons to take when you are already in a posi on. The nice part about op ons is that you will rarely want to simply enter and exit a posi on. There are a lot of adjustments that can be made that will allow you to capture some profit or reduce your risk. When you trade without a plan you will enter a posi on and then have it move against you which will leave you frozen like a deer in the headlights. When trading without a plan you let emo on take over your decision making. It is impossible to leave emo on out of trading but le ng it make the decisions for you is a great way to blow out your por olio. The Fix: With all trading, stock or op ons, you need to set a plan before you enter the posi on. This plan should include when you are ge ng in, the strategy you will use, what your profit target is, adjustment levels are, the adjustments you are going to make, and your max loss. Now this may seem like a long list to prepare before even making the trade but having this plan ready will keep you in the game longer. Kirk at Op onAlpha.com reaffirms that the three numbers you need to know before you click send on a trade are: the percentage profit target, adjustment points, risk and maximum loss. Have you thought about when you are going to adjust a posi on? Will you adjust when a stock reaches a certain point, when you are a percentage away from your max loss, like we describe in our Iron Condor Trade, or will you do it when the deltas reach a certain point? These are the things that need to be planned before you reach that level. Let me tell you from experience, if you wait un l you are already underwater on a posi on your emo on will take over and you will make poor decisions about the trade. As you progress in your trading and learn more about op ons some parts of this plan will just natural fill in itself. Certain types of trades lend themselves to having the same types of adjustments done at various levels, but when you are first star ng these items need to be detailed out.

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4. Limi ng Yourself To Simple Long Call and Long Put Strategies The Problem: When you first start trading op ons you will, inevitably, start with long calls and long puts for stocks you want to trade long and short. There is nothing wrong with that. Your first trade should not be an Iron Condor. The problem is that traders will allow themselves to get pigeon-holed into this strategy and never venture out into other strategies, which is a real shame because op ons allow for so many unique strategies that you cannot get with stock. The Fix: Only with op ons can you trade an upward move, downward move, a move in either direc on or no move at all, an increase in vola lity, drop in vola lity, or just a passing of me. To not explore these strategies would be a tragedy because you will be short a lot of useful tools in your trading toolbox. Now, not all op on strategies will be for you. There are some plays that we simply do not enjoy running or have no luck with, looking at your calendar spreads, so don't run them but it doesn't hurt to know about them and have tried them in the past. Begin your journey into new op on strategies by first studying them and then trying them out in small sizes. As we men oned in the Ge ng Over Leveraged fix, op on commissions are cheap and they allow you to trade small sizes without raising your breakeven point. You never know when you will find your next favorite op on strategy. 5. Trading Op ons Without Fully Understanding Them The Problem: Here is the story we hear from most new traders, "I bought a call on XYZ and then XYZ moved up in price but my call lost money. I don't understand, what went wrong?" Most beginning op on traders will find themselves in this situa on and the answer is always the same, "vola lity dropped". This is a perfect example of the pains involved in not knowing about the inner workings of op ons. The Fix: You don't have to know every minute detail about every op on trade before you start trading but you be er know something. Start by Downloading Our Op on Trading eBook. This will give you a good start as it details out every op on strategy available and how they react to vola lity, me, and direc on. Now when you place a trade you can use it as a quick reference to make sure you are not surprised a er the trade is already on. Once you have a good idea of how the strategies work start to dive into the Greeks. The Greeks can and will be confusing but a basic understanding is needed to understand how your strategy will move. The Greeks should be learned in this order: delta, gamma, theta, and vega.

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6. Le ng Short Op ons Go Unmonitored The Problem: Short op ons carry with them several interes ng proper es. One of the most notable and usually the head scratcher is the fact that short op ons have limited rewards and unlimited risk. Now this is usually a turnoff to most op on traders, but don't let it stop you from exploring these strategies. Short op ons can be a great way to generate income but you have to stay on top of them. This doesn't just relate to monitoring the downside. The upside needs to be monitored too. Op on traders will push to squeeze every dime of profit out of a trade only to have it turn on them and have it end up a loss. The Fix: Remember when we talked about Not Having A Plan well this is not where you want to break that rule. Your first and most important rule is to never let short op ons go in the money unless you are trading covered calls or using puts to pick up stock. If you are not running those strategies and let the op on go in the money you run the chance of ge ng assigned and this is not a good situa on if you are not seeking it. Before you begin to trade short op ons set your get out points whether that is dependent on a technical analysis or a max loss number.

7. Not Being Informed The Problem: Not being informed of market events is a problem not only for op on traders but for all traders in general. What happens is they find this perfect trade, dot their i's cross the t's, but forget to account for one variable that ruins the whole trade. With op on trading these mistakes can be magnified and can cause a play that should profit to turn a loss instead. Most traders are aware that company earnings will affect a trade but what about dividends? A company coming up on their ex-dividend date can cause short op ons to be assigned. The Fix: When you are in the market you need to be dialed into what is going on both from a macro and a micro standpoint. For a macro perspec ve you should always keep your eye on an economic calendar and look for any major economic news releases that could affect the overall market. A couple of items you want to keep your eye on are employment numbers, GDP numbers, and whenever the Federal Reserve talks.

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Looking more into the company, the micro level, we want to focus on any scheduled announcements. As men oned above, short op ons have a higher probability of being assigned when a company reaches its ex-dividend date. This is due to the fact that op on traders have no rights to the dividend so they must convert to stock to get that dividend. You will want to keep an eye on earnings announcements too. When a company releases earnings it can send the stock roaring or tanking. This uncertainty causes vola lity to increase which in turn increases op on prices. This will also lead you to experience vola lity crush a er the announcement which can drop the op on price drama cally. It is okay to trade around these events but you need to understand what they are and the affect that they could have on your strategies.

8. Trading Illiquid Or Low Volume Op ons The Problem: Liquidity is how fast you can get in and out of a posi on at a desirable price. The lower the liquidity the higher the chance you won't get a price you like or you will have to wait an excessive amount of me before you do. This also has the effect of increasing the spread size between the buy price and the sell price. If you purchase an illiquid op on you could begin the trade down 10-20% right from the start. That is not something you want to have to work back from just to turn a profit. Not all op ons are created equal. Unlike straight stock where you always trade just the company common stock, op ons have a wide variety of choices. Just on one company you are faced with several expira on dates that could venture out three years (as is the case with LEAP Op ons) and a mul tude of strikes both on the put and the call side. A lot of op ons are simply not going to trade and you don't want to get caught in that posi on. The Fix: Just because the op ons are listed on the screen doesn't mean they are liquid or good to trade. Most op ons won't be traded. The smaller the company the more illiquid op ons it will have. The further out of the money and in the money you go the more illiquid the op on will be. There are two numbers you want to focus on before you decide to purchase or sell an op on. The first is Open Interest which will let you know how many open contracts are on that strike. Each strike will have its own separate open interest and it will fluctuate daily depending on the trades placed. Avoid strikes with li le to no open interest.

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The next number is Volume which is exactly like stock volume in that it tells you how many shares have been traded that day. Again, you will want to focus on op on strikes that actually carry some volume. The higher these numbers are the more liquid that strike is and the easier it will be to trade at prices you desire.

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(SET) and Index Op on Expira on A lot of investors like to incorporate index op ons into their strategies because they are more stable and easier to predict. These are usually be er for using neutral strategies like iron condors. An index op on is simply an op on based on one of the major indexes such as: S&P 500, Russell 2000, NASDAQ, etc… Most investors also know that index op ons are AM se led. Typical op on expira on occurs at the close on the 3rd Friday of each month. However, index op ons expire that Friday morning giving investors one less day to worry about. Now AM se lement might seem like a good idea but it carries with it one major drawback, which is SET. SET is the se lement value given to the indexes on Friday morning. Let's look at an example: October 21, 2011 was op on expira on The day before, that Thursday the SPX (S&P 500) closed at 1215 Friday Morning the SPX opened at 1215 SET Value is 1228 a 1.06% difference. Why does this ma er? Let's say you are short the 1225 calls and you see the market close at 1215 on Thursday. You can now go to bed happy because your op ons will expire worthless and you will collect a nice premium. Unfortunately, when the market opens that Friday the CBOE (Chicago Board of Op on Exchange) calculates all the opening prices for every component in that index and uses that as the se lement value. Some stocks gap higher, gap lower, or don't even trade in the morning but all of these values are taken into account. Through this process we can get a big swing in SET value over the close/open price of that index. The real crummy part is that your op ons stop trading Thursday at the close, and if you are s ll holding then you are at the mercy of SET. So now those 1225 calls you had a profit on are now showing a loss. You should not hold index op ons into the close on Thursday if they are around the closing value. Go ahead and close it out early to guarantee you get the price you want. Don't get caught looking at a profit on Thursday only to have it turn to a loss on Friday morning.