Manual Trading in Options

Guide to Options Strategies TM

Guide to Options Strategies ©2010 Tigrent Brands Inc. All rights reserved. Tigrent Learning is a trademark of Tigrent Brands Inc.

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Guide to Options Strategies

Table of Contents

Table of Contents Introduction: The Options Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 History of Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 How Options Symbols are Assigned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Chapter 1: How Options Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Basic Requirements to Trade Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Commissions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Basic Option Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Leverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Expiration Date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 In-the-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Out-of-the-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Exercise. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Why Use Calls? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 The Good and Bad About Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Timing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Chapter 2: Options Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Elements of an Option and the Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Intrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Time Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Time Decay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Open Interest and Volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Theoretical Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Technical Analysis and Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Guide to Options Strategies

Trading Rules and Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Trading Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Chapter 3: Call Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Review – What is a Call? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Why Trade Calls? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Fundamental Analysis and Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Technical Analysis and Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Duration of the Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Finding Stocks to Trade with Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 Call Option Trading Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Choosing a Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Determining Your Time Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Applying Reward-to-Risk Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 Planning Your Exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Call Strategies and Setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Strategy I – Swing Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74 Strategy II – Trend Breakout and Reversal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Available Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Chapter 4: Put Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Review – What is a Put ? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 Why Trade Puts? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 Fundamental Analysis and Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 Technical Analysis and Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Deciding How Much Time to Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Finding Stocks to Trade with Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 Your Broker’s Website . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 Your Watch List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 Seeker Scans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 Put Options Trading Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 Choosing a Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 Determining Your Time Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

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Planning Your Exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Put Strategies and Setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Stocks Beginning New Downward Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102 Threshold Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Duration of the Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Stocks in Current Downtrends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Confirmation Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 Warning. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 Duration of the Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 Trendless Stocks at the High End of a Trading Range . . . . . . . . . . . . . . . . . . . . . . 112 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Chapter 5: Covered Calls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 What is a Covered Call? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 Downside Protection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 Stocks to Use with Covered Calls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Covered Calls Trading Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Direction of the Trend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122 Selling Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 Choosing a Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Developing Your Exit Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129 About Stop Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Income Strategies and Setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Growth Strategies and Setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Chapter 6: Option Strategies with LEAPS . . . . . . . . . . . . . . . . . . . . . . . . . . 139 LEAPS Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Strategies for Using LEAPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 Strategy I – Using LEAPS as a Stock Alternative . . . . . . . . . . . . . . . . . . . . . . . . . . 142 Strategy II – Using LEAPS Options Instead of Short-Term Options . . . . . . . . . . . . 146 Measuring Time Decay. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 Leverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149 Strategy III – LEAPS Puts on Stocks You Own . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

Guide to Options Strategies

Determining Which LEAPS Put to Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 Important Conditions to Success . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154 Using Calendar Spreads for Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 Strategy IV – Calendar Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 Calendar Spreads to Enhance Growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

The Options Market

Options can be a terrific place to realize potential profits from your winning trades and should be considered in your long-term trading system.

The purpose of this material is to help you understand how the options market works and how you, as an individual investor, can take advantage of it. Many investors look at the options market with a sense of trepidation and fear, and this is unfortunate. Options can be a terrific place to realize potential profits from your winning trades and should be considered in your longterm trading system. The objective of this material is to help you understand how you can use options to your benefit and to familiarize you with how some of the most powerful option strategies work. Here, we will cover the following topics: • Option basics — We will discuss the basic principles behind any option transaction and what they mean to both the buyer and seller. 3

Guide to Options Strategies

Notes • Option dynamics — There are significant differences between stock trading and option trading that most investors who venture into this arena aren’t aware of. Time decay, leverage, and implied volatility are just a few factors that can dramatically impact the success or failure of any option trade. • Buying call options — We will cover the specific methods you need to follow as you develop a trading system to take advantage of the potential profits offered by call options. • Buying put options — We will discuss why every trader should understand how to trade the downside of the market. • Covered calls — Generating income is a major objective of many people that trade options. We will outline the different reasons a covered call can work in your favor, how to identify stocks that provide good call opportunities, and the specifics of how to effectively manage each covered call trade you make. • Long-Term Equity Anticipation Securities (LEAPS) — We will discuss how to use long-term option contracts, or LEAPS, to take advantage of extended stock trends and minimize risk on short-term trades. We will also introduce the calendar spread, a powerful, yet conservative type of spread trade. It is important to note that this material is built on the assumption that you already have some experience in stock trading and are familiar with basic trading concepts, such as fundamental analysis and technical analysis. Fundamental knowledge is needed to advance to the options strategies discussed here. Specifically, make sure you are comfortable with identifying the trend of any stock, drawing trend lines, and finding support and resistance levels to identify specific entry and exit points on a trade. You should also be familiar with the basic types of orders you can place as you trade. And you need to know when to use a market order or a limit order as well as how to place a stop loss.

History of Options Before we dive into what an option is, how a call or put option works, or any of the specific strategies that apply to options trading, you will find it interesting, and useful, to understand some of the history behind options trading and how it has evolved over the years. 4

Chapter 1: The Options Market

Notes Options have been used for literally hundreds, even thousands of years. It is a well-known and established fact that the ancient Greeks and Romans used contracts that were very similar in concept and application to modern options in shipping. One of the earliest known cases of options is that of a Greek philosopher named Thales. Anticipating a plentiful olive harvest, Thales used options during the off-season when demand for olive presses was nearly nonexistent to secure rights for use of the presses at a very low initial cost. When the harvest was in and the presses were needed, he rented the equipment he had secured with his options at a premium in relation to his original cost. The Dutch used options in the 1600s to negotiate prices for tulips. Initially, tulip dealers used call options to secure tulips at a rate that would help them meet demand. Meanwhile, tulip growers used put options to ensure an adequate selling price. Speculators saw the opportunity to trade tulip call and put options for profit only and joined the fray; however, when the tulip market crashed, these speculators refused to meet the obligations they held, sending the Dutch economy into a tailspin. The British economy saw similar problems a hundred years later when they began using options. These horrendous experiences led to a tainted view of options by many people, and in many cases were even declared illegal. Options came into existence in America around the same time as stocks in the early 1800s, but they didn’t exist in the ordered, regulated manner they do today. The terms for each contract—also called a “privilege”—varied according to the agreement between the interested parties. Such variance meant that there wasn’t much of a secondary market, so options weren’t listed on any exchange. Instead, buyers and sellers had to find each other, usually through the newspaper when firms advertised specific call and put offerings. Options trading came under intense scrutiny after the Great Depression. Options were legitimized by the Investment Act of 1934, which put option and stock trading under the careful scrutiny of a new government agency, the Securities and Exchange Commission (SEC). However, options trading continued to see slow growth. By 1968, the volume of options trades was still less than 300,000 contracts per year.

5

Guide to Options Strategies

Notes One of the reasons investors and institutions didn’t use options as regular investment vehicles was because they were still trading strictly as over-the-counter instruments. In addition, orders were placed over the phone, and buyers and sellers alike had no notion of what price they would actually get for their contract; the call-put dealer simply matched buyers with sellers. Options investments were very liquid because a dealer was under no obligation to provide both the buy and sell side of a transaction, so if you had an option contract you wanted to sell, you had no assurance of finding a buyer. With no fixed commission percentage attached to each transaction, the dealer kept the difference between the buying and selling prices for each contract, with no restriction or standard on what the spread should be. If you wanted to exercise an option, it had to be done in person by 3:15 p.m. Eastern time. If you missed the deadline, the option simply expired worthless without regard to any intrinsic value it might have. In the late 1960s, the commodities market was seeing a significant decline in trading volume, so the Chicago Board of Trade (CBOT) began looking for ways to diversify their market offerings. Joseph W. Sullivan, who at the time was the Vice President of Planning for the CBOT, studied the over-the-counter nature of the options market and identified two key elements that a successful, robust, and growing options market would need: a standardization of terms relevant to options contracts and an intermediary organization that would facilitate contract issuance and guarantee contract settlement and performance. His solution to address these needs was to standardize the strike price, expiration date, and size of options contracts and to create the Options Clearinghouse Corporation (OCC). Under the old system, dealers acted only as intermediaries between buyers and sellers, but these dealers were under no obligation to provide a two-sided market. The dealer kept the difference between the buying and selling prices, but there was no system in place to prevent the dealer from widening this spread beyond reasonable levels. The CBOT decided it would be necessary to create a system where dealers became market makers, providing for both the buy and sell side of any security they dealt with. This requirement resulted in multiple market makers for any given contract, creating a competitive pricing environment in which buyers and sellers could both receive the best possible price for their trade. 6

Chapter 1: The Options Market

Notes In April of 1973, the CBOT put all of their research and planning into effect by launching the Chicago Board Options Exchange (CBOE). Initially, the CBOE offered options on only 16 stocks, and then doubled the number to 32 approximately a year later. By the end of 1974, daily volume on the CBOE reached an average of 200,000 contracts. Up to this point, the CBOE had been forced to purchase ad space to list option prices in major publications such as the Wall Street Journal. This newfound popularity attracted the attention of newspapers, which began voluntarily listing option prices. For the first few years of the CBOE’s operation, option trading was restricted only to call options due to SEC concerns about the risk of put option trading. In 1977, the SEC allowed the CBOE to list put options for five stocks only; this narrow perspective has been expanded since so that all optionable stocks offer both call and put options. In the years since, volume on the CBOE has continued to rise, with more than 1.3 billion contracts traded during 2009. And as of February 2010, the CBOE offered more than 2,300 equity options, which means many of the stocks you are already used to looking at offer options as an additional means of investment. Liquidity, or how quickly you can place a buy or sell order and get to your money, is a critical issue in any financial market. With so many publicly traded stocks on the American stock exchanges, investors can find a huge variance between how frequently a stock trades. Some large companies, such as Intel or General Electric may trade several million shares per day. Other stocks, usually smaller companies, may only trade a few thousand per day at best. Smart stock traders pay attention to how much volume a stock has because they know that if the stock only trades a thousand shares per day and they want to buy in, their order could shift the price of the stock in dramatic fashion, which probably won’t work in the trader’s favor. The advantage options traders have over stock-only traders is that this doesn’t happen with options. Of the approximately 10,000 stocks that are publicly traded, there are just over 2,000 that offer options trading. This means that just because a company is publicly traded, you shouldn’t assume options are available for it. In fact, the CBOE typically won’t offer options on a stock until it has demonstrated a significantly active trading history with a high level 7

Guide to Options Strategies

Notes of investor interest and demand. This is a large part of how the liquidity of the options market is assured; by only offering options on stocks that already have a high level of trading activity with high volume, the CBOE can make sure that there will be a market for the option contracts it offers. In addition, there are specific guidelines in place that market makers are required to follow to assure an organized and prompt order to how buyers are matched with sellers, how much of a spread between the bid and ask price of a single contract the market maker can take, and so on.

How Options Symbols Are Assigned Have you ever looked at an options chain? The symbols for the contracts any stock offers can look confusing and even convoluted sometimes. Some symbols are clearly a variation on the symbol for the underlying stock, while others just seem to have been pulled at random from a bowl of alphabet soup. In reality, there is a logic and order to how option symbols are assigned, and being familiar with how this works can help you know what you are looking at. The option root symbol consists of three letters and is derived from the symbol of the underlying stock; however, it usually looks at least slightly different from the underlying stock’s ticker symbol. This is done simply to maintain a clear delineation between the stock and its options. The expiration date symbol is a single letter and has specific letters assigned to each month of the yearly calendar, as follows: Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Calls A B C D E F G H I J K L Puts M N O P Q R S T U V W X

The strike price symbol is also a single letter and is staggered in $5 dollar increments; each letter used repeats itself at higher dollar levels, as follows: Suppose that you are looking to buy an option on XYZ stock while the stock was priced at $52. If you wanted to purchase a May 50 call, the symbol for the option could be something like: XRY EJ 8

Chapter 1: The Options Market

Notes While a May 50 put could be something along these lines: XRM QJ You won’t need to actually memorize the letters that correspond to each month or strike price, since this information is displayed in the options chain screen of any software or website you use for price quotes. However, it is useful to understand the framework that is used for the option contracts you will be looking at. Now that you know some of the background and terminology of the options market, you’re ready to take the next step. In Chapter 1, we will discuss some of the basic concepts behind options, and build your knowledge from there. Let’s get started!

9

Guide to Options Strategies

How Options Work

The mapping process is detailed and specific and it reads: “Make Money! And lots of it!” You can build on your knowledge of stock trading by applying the common principles of technical analysis—support, resistance, and trends—to options trading. For many people, options are an area of the stock market they’ve never heard of. Many others have heard of options, but have heard more about all of the money people have lost trading options, so they are consequently afraid of them. Still others have traded options in the past and are familiar with most of the basic concepts around them, to one level of success or another. Although the volume of trading in options has been growing over the last several years, the fact remains that options are a strange, complex financial vehicle to most people. Most options traders fall into the category of reasonably experienced investors who have been trading for many years. Just because you may be new to the options market, however, doesn’t mean

13

Guide to Options Strategies

Notes that you can’t be successful in trading them. You simply need to give yourself the proper education and knowledge of the various techniques and strategies associated with trading options. Options in general are an aggressive investment and trading strategy. If you cannot afford to tolerate a high level of risk, you shouldn’t trade options. It is worthwhile to note, however, that if you can accept a higher level of risk, there are a variety of methods and strategies you can use to minimize and manage the risk you take. There are also options strategies that in reality are very conservative. Options can be an effective way to manage risk in stock trades. In addition, covered calls give you a way to generate income on stocks you already own. In this material, we will outline several different strategies as they apply to options and the risks associated with each. A common mistake that many investors who are new to options make is to attempt to master every strategy they learn. Indeed, there are many strategies available to you, and you should make sure to spend enough time on each one to become familiar with them all. However, you don’t have to master them all. As you work to learn each strategy, you will identify strategies that appeal to your investment style, tolerance for risk, and attitude more than others. That is perfectly natural; in fact, the most effective options traders identify only the strategies that work best for them and then use them again and again over time. You may decide that covered calls are the thing to do, while buying calls and puts might be more risky than you are willing to deal with. That’s fine! You can trade options and create profit potential with just one or two strategies if that is all you are comfortable with. This chapter will cover the following topics: • How to gain broker approval to trade options • The basic components that make up an option • The principles of leverage and risk as they relate to options contracts

14

Chapter 1: How Options Work

Notes

Basic Requirements to Trade Options Anybody can trade options, provided a few conditions are met. First, in order to trade options, your broker needs to give you permission. Just because you have a brokerage account doesn’t mean that you can trade options right away. In addition to setting up your brokerage account, you also have to fill out an Options Authorization application. You can call your broker to have this mailed to you, visit their local branch office if they have one, or you can likely download the application from their website. Some brokerages will also allow you to fill out the application and submit it online. This application will ask for similar information that you provided when you established your brokerage account, such as your investment experience and objectives, but the questions will be options-specific. Depending on your answers to those questions, your broker will assign you a level of options permission. These levels are fairly standardized as follows: • Level 1 — Options trading is limited to writing (selling) covered calls only • Level 2 — Options trading is limited to level 1, along with buying call or put options • Level 3 — Options trading is limited to levels 1 and 2, along with the use of options spread strategies • Level 4 — Options trading is limited to levels 1, 2, and 3, along with the selling of naked equity options • Level 5 — Options trading is limited to levels 1, 2, 3, and 4, along with the selling of naked index options Levels one and two are the levels that most traders start with. If you are only approved for level one, don’t worry; you can still create profit potential as an options investor using covered calls. If you are approved for at least level two, however, you will be

15

Guide to Options Strategies

Notes able to utilize every options strategy discussed here. Levels three, four, and five all include much more sophisticated strategies that are advantageous to those who can use them, but are best suited to experienced traders who know how to manage a margin account effectively. These types of trades are outside the scope of this book; however, after you have established a familiarity and confidence in the strategies discussed here, you may want to examine these advanced strategies in greater detail.

Commissions We assume that you have been trading stocks now for some time and are used to the idea of paying a commission on your stock trades. Commissions apply to options just as well as stocks, but you will want to make sure to check with your broker, because options commissions are usually slightly different than those for stocks. They are typically charged at a rate of around $1.50 per contract, with a minimum commission fee for small contract numbers. Your broker can give you their exact commission structure. This commission will play a factor in evaluating your break even and profit points in your options trades, so make sure you understand it completely.

Basic Option Terms An option gives the buyer the right, but not the obligation, to buy or sell the stock that option is tied to at a specific price for a specific period of time. It is an instrument that you can use to reserve the right to buy or sell the stock at the price you want, if the stock moves in the direction you thought it would in the time frame of the contract. Option securities are called contracts. Each contract controls 100 shares. Thus, you immediately have control of 100 shares of the stock when you buy a single-option contract. This may sound like a completely foreign concept to you at first glance. Options and their structure are not readily known or understood by the general investing public, so don’t let any confusion you may feel right now dissuade you from pushing into this in more detail. Let’s try to simplify the concept and relate it to 16

Chapter 1: How Options Work

Notes something that may seem more logical. It is usually helpful to think about the same concept as it applies to a different business. Let’s use real estate: Suppose you have found a home you would like to buy, but you don’t have the cash to buy the home outright, your credit doesn’t qualify you for a mortgage to buy the home with, and interest rates are high. So you sit down with the current owner and propose to lease the property from the current owner for three years, after which, you will purchase the house for $100,000. If the owner agrees, you both win. You get to move into the house right away while the lease contract gives you the time to rebuild your credit to get a loan for the house. The owner keeps the rights to the house and the title remains in his name. He will also receive income from your lease payments, with a lump sum at the end of the contract when you buy the house. To show him you’re serious, you give him a nonrefundable deposit of $5,000 up front. As part of the lease contract, you stipulate that at any time during the contract, you can purchase the house by giving him the lump sum you have agreed to or sell your lease contract to someone else. Two years later, you are ready to buy the house. But now the house is worth $150,000. Now you are really excited to get the deal done because your lease contract stipulates your purchase price is only $100,000. Sounds like a great deal, right? Of course it is! Before you jump on the opportunity to buy the house, think about the terms of your lease contract. You also have the ability to sell your lease contract to somebody else if you decide you don’t want to buy the house. Maybe you want to find somewhere else to live. The house is now worth $150,000, so your lease contract should also be worth more than the $5,000 deposit you paid to secure the contract. To figure how much the contract is worth, subtract the purchase price in the contract ($100,000) from the current value of the house ($150,000), which gives you $50,000. Subtract the deposit you paid of $5,000, and you could sell your lease option to somebody else for a total net profit of $45,000. You could either make $50,000 by purchasing the house and selling it at the going market value or $45,000 by selling your lease

17

Guide to Options Strategies

Notes option. In the first case, you would have to pay $100,000 to make your $50,000 profit; in the second, your only cost is the $5,000 you paid when you first entered into the contract. Options on stocks work in essentially the same manner as our real estate example. They allow you to make an investment based on the direction you think the stock is likely to move in with a smaller amount of money than it would take to buy the stock outright. If you are right about the move, you can either exercise your option to buy the stock or sell the option to another investor. Just as the lease contract in our example increased in value proportionally more than the house did, options also give investors the opportunity to realize greater gains than if they bought the stock outright provided the stock moves in their favor. This is a powerful concept you should make sure to remember. Options cost considerably less than would be required to buy the stock outright. If the stock moves in the direction you want, the amount of the move in your option will be greater as a percentage of your initial investment than if you paid for the stock up front. This is called leverage. For any given stock move, options move more. There are two types of options. We’ll describe them briefly here and give a more detailed example of each later in this chapter. • Call — The right to buy a stock at a set price for a set period of time • Put — The right to sell a stock at a set price for a set period of time The question is, when should you use a call and when should you use a put? When the market or stock you are interested in is going up, call options will work for you, while put options give you the opportunity to take advantage of pullbacks and downtrends. Each of these types of options will be covered in more depth in Chapters Three and Four. 18

Chapter 1: How Options Work

Notes Just as stocks trade on a stock exchange, options trade on an options exchange. For stocks, you have the New York Stock Exchange (NYSE), the NYSE Amex, the NASDAQ, and so on. Options are listed on the Chicago Board of Options Exchange (CBOE). The CBOE operates on the same schedule as the stock market.

Leverage Leverage is the reason most people get excited about options, but remember that leverage can work against you just as well as for you. Remember that options decrease in value faster when the stock moves opposite to the contract just as they increase in value faster when it moves in favor of the contract. This is why you should be very careful about taking large positions in any given option trade. Although you stand to make superior gains when you are right, you also could experience dramatically more severe losses when you are wrong. The higher volatility associated with options means that they don’t fit every type of investor. If you intend to invest in options, you need to understand this concept thoroughly and make sure your trading system is structured effectively around it. Options are aggressive and risky, but that doesn’t mean that you can’t create profit potential in them. You have learned how to use threshold zones to identify possible failure points to get out of a stock, as well as how stop losses can help you manage that downside risk. These same principles apply in options. Your stop loss ranges are generally wider for options than they would be in stock, but you are still going to be using them. The point with options is the same as it is for stocks: cut your losses short and let your profits ride. Before we go further, there are some very important terms to understand about options. Let’s look at them now.

Strike Price Every option includes a strike price. This strike price is the price at which you will buy or sell the stock. Strike prices are usually listed in $5 increments, although more active options contracts will sometimes be listed in $2.50 or even $1 increments. 19

Guide to Options Strategies

Notes The strike price is always listed on any options quote. For example, if you wanted a quote on a call option for General Electric, you might see it listed by your broker in a manner similar to this: GE HZ Aug 32.5 Call Bid 1.05 Ask 1.10 The strike price of this option is $32.50. That means that if you bought this call, you would reserve the right to buy 100 shares of GE stock for $32.50. You will get a similar quote for put options: GE TZ Aug 32.5 Put Bid .30 Ask .40 This put has the same strike price of $32.50. The difference with this option is that since it is a put, buying it would give you the right to sell 100 shares of GE stock for $32.50.

Expiration Date Every option also includes an expiration date. All stock options expire the third Friday of the month, each month. That month is listed in your option quote as well, and can be easily seen from an options pricing table. In our GE call example, its expiration is in August, so we will have to make sure to take some type of action on the option before the third Friday of August. If you take no action prior to the expiration date, all the money you put into that option will be lost.

Premium An option’s premium is the amount you have to pay to buy it. Just as with stocks, you will always buy at the ask price and sell at the bid price. Looking at our GE call option again, we can see how much we have to pay for it. GE HZ Aug 32.5 Call Bid 1.05 Ask 1.10. Our premium for this call is $1.10. Just as when you buy stock, you have to multiply the ask price by 100 for the total dollar cost of the trade, in this case $110 minus commissions.

20

Chapter 1: How Options Work

Notes How about the put we looked at earlier? Remember that you always buy at the ask, regardless of whether you are buying a call or put option. GE TZ Aug 32.5 Put Bid .30 Ask .40 Our premium for this put is $.40, so it would cost you $40 to purchase one put contract.

In-the-Money An option becomes in-the-money when the price of the stock moves past the strike price of the option. If the price of GE went to $35, for example, our call with a strike price of $32.50 would be in-the-money since we can now buy GE much cheaper than its current price. Puts are a little different. Since you reserve the right to sell the stock at the strike price, put options become in-the-money when the stock drops past your strike price. Our GE put would be inthe-money if the price of GE dropped below $32.50 since we could sell the stock at a higher price than it is at now. Figure 1.1 demonstrates the relationship between a stock’s price and in-themoney call and put options.

Figure 1.1 The further the price of a stock moves above a given strike price, the deeper in-the-money the call option with that strike price will

21

Guide to Options Strategies

Notes be. By the same token, the further the price of a stock moves below a given strike price, the deeper in-the-money the put option with that strike price will be.

Out-of-the Money An option becomes out-of-the money when the price of the stock fails to move past the strike price of the option. If the price of GE were below $32.50, for example, our call with a strike price of $32.50 would be out-of-the money since the strike price we could buy the stock at is higher than the current price. The reverse is true for a put option. If the price of GE were higher than $32.50, our GE put would be out-of-the money since the price we could sell the stock is lower than the current price. Figure 1.2 gives an illustration.

Figure 1.2

Exercise If you have bought an option and the stock has moved in the direction you anticipated, you may decide to exercise your option. Exercising your option means that you will buy or sell the stock at the strike price of the option, depending on whether you have bought a call or put option.

Call Options 22

A call option gives you the right, but not the obligation, to buy 100 shares of the stock you are interested in at the option’s strike price.

Chapter 1: How Options Work

Notes This is a bullish trade. If you have identified a stock in your analysis that you think is poised to go up, you can find its options by adding the stock symbol to your quote sheet, and right clicking on the stock symbol. A drop-down menu appears. Click on “option chain” near the bottom of the menu, as illustrated in Figure 1.3.

Figure 1.3 Your software will then populate the fields in the Options tab with all of the currently available options. This list is shown in Figure 1.4. Not all stocks have options; if the stock you are looking at doesn’t have options, you will simply get no results when you move to the Options tab.

Figure 1.4 The available calls will be on the left side of the option table and the puts are on the right.

23

Guide to Options Strategies

Notes Let’s look at your General Electric Options again. GE HF Aug 30 Call Bid 2.90 Ask 3.00 Suppose that your analysis of GE leads you to believe that GE is likely to increase in value in the near term. In fact, your analysis of support and resistance zones indicates that it could move up by several dollars. This would be a terrific reason to buy shares in GE’s stock, right? Of course! It is also a terrific reason to buy a call option.

Why Use Calls? Whether you buy the stock or the call option, you are placing the same bet. The call option, however, gives you a wider range of choices to make at a lower cost than buying the stock. Suppose that GE was priced right now at $32. If you wanted to buy 100 shares of this stock, you would pay $3,200, plus commissions. That is a significant amount of money for most investors. That doesn’t mean it’s a bad idea, but it does lock you in to a specific course of action. You have plunked down $3,200 of your hardearned money to buy 100 shares of stock in GE. Your choices at this point are limited and depend completely on which direction the stock actually moves, but regardless of which direction the stock moves in, you have $3,200 at risk. Now suppose that GE drops in price to $28, a drop of $4 per share. Your $3,200 purchase is now worth only $2,800; you’ve lost $400 and now you have to decide if you are going to stay in the stock, hoping that it comes back to your purchase price, or sell and cut your loss short. If the stock goes up to $36, of course, you are much happier since now you have a $400 profit in the stock, which is a handsome return of 12.5%. Now you need to decide whether to take the profit by selling the stock or try to let the stock continue its upward run and increase your profits even more. Now let’s use your GE FF Aug 30 call. At the point where GE is $32 and you think it is going to go higher, you could buy this call option at $3, a total investment of $300 for a single contract (you could buy more contracts if you wanted to, but we will work off of the idea of a 24

Chapter 1: How Options Work

Notes single contract for the time being), plus commissions. You still want the same thing as if you bought 100 shares of the stock, but you have paid a dramatically lower price for your bullish bet. Rather than placing $3,200 at risk, you risk only $300. If GE drops to $28, you aren’t going to be very happy about the trade since your option is probably not even worth the commission you would pay to sell it, but how much have you really lost? $300. This is a much smaller loss than the $400 you would have lost by buying 100 shares of the stock. You still have most of your money in your account and can keep trading. Of course, if GE suddenly climbs to $36, your options trade will look much better. Your option gives you the right to buy the stock at $32, and since it is now at $36, you would immediately be in the black on your trade if you decided to exercise this option. All you had to do to give yourself this ability was to pay $3 per share up front, rather than paying everything up front. That’s not a bad price to pay to give you this kind of flexibility. There is another choice, however, that may be even more attractive. Since the stock has increased in value by $4 per share, your option will likely have a comparable move in price. Suppose that the bid price of your option is now $5.15 per share. You could sell your option back to your broker and pocket $2.15 per share, a total return of a little more than 120%.

Put Options What if your analysis of GE led you to believe that the stock was likely to drop significantly in the near term? Certainly you’re not going to buy the stock, but is that the end of the story? Not if you buy a put option. Since a put option gives you the right to sell the stock at the strike price, you want the stock to drop below the strike price. This is a bearish trade, and a counterintuitive idea for most investors, because human beings are naturally wired to think optimistically in most respects. It makes all kinds of sense to make money when a stock goes up: you buy low and sell high. Most people trip on the idea of a put option because you actually want the stock to go down, but in reality, the reason you want the stock to go down is the same as the reason you want a stock to go up when you buy it or a call option: you want to buy low and sell high. 25

Guide to Options Strategies

Notes You will get price quotes for put options in the same table as call options. The put options are listed on the right hand side of the Equity Options page. Figure 1.5 shows a list of put options for GE, shaded in blue:

Figure 1.5 Let’s look at your GE put option again: GERZ June 32.50 Put Bid 1.78 x 1.80 Hoping to make a profit on a downward move in a stock is the most common reason people buy put options. This is a pretty aggressive play, however, and if you aren’t accustomed to reading negative patterns in a stock, you will want to ease into this kind of trade gradually. Let’s walk through a trade on this option to establish the concept. We will cover this in more detail in Chapter Four. Our asking price for this put option is $1.80 per share, so it costs you $1.80 total for a single put contract. Let’s suppose that GE is at $32 when you buy the option.

26

If the stock starts to climb, your put contract is going to be worth less than what you paid for it, but since you only paid $180, you

Chapter 1: How Options Work

Notes aren’t putting a major amount of money at risk. But if the stock drops the way you forecast, your put option will increase in value. Let’s suppose GE falls to $28 per share, a drop of $4, or 12%. You could exercise your right under the put contract to sell the stock at $35. Since you don’t own the stock, you make the sale possible by simply first buying the stock at $28, and then selling the stock, giving you a tidy profit of $7 per share right away, minus the $235 you paid to buy the contract. Remember that exercising the option isn’t the only choice you have. Now your option, which only cost $1.80 per share, will be worth considerably more. In this case, let’s suppose the value has increased to $8.50 per share, giving you a net profit, not counting commissions of $6.70 per share, of $670. Put options have the same element of leverage as call options, making them an attractive way to play the downside of a stock or the market and realize significant profits if you are right about a breakdown in price. Again, remember that this is an aggressive way to trade options; it has the potential to be a major drain on your capital if you aren’t very familiar and comfortable with identifying and trading negative trends.

The Good and the Bad about Leverage In both of the examples from the previous section, we saw significantly more price percentage movement from the option contracts than we did from the stocks themselves. This phenomenon is the primary reason investors trade options; they move faster, percentage wise, than stocks. In other words, if you are right about which way a stock is going to move, you will be able to make larger profits as a percentage of your investment in a shorter amount of time than you would by buying or selling the stock. It is exciting to think about buying an option to control 100 shares of stock for only a few hundred dollars rather than the thousands of dollars it usually takes to buy or sell the stock itself. Many beginning investors draw the natural conclusion from this that they can use their investment capital to control more shares and make even more money. If you bought the call option on GE we used earlier, for example, buying three contracts would increase your total profits from $310 to possibly $930. This is a correct assumption, but it comes with a critical downside element that must be recognized.

27

Guide to Options Strategies

Notes As we mentioned earlier, leverage cuts both ways. Just as an option will increase in value more quickly than the stock, it will also drop faster if the stock doesn’t move the way you wanted. What if you bought the June 32.5 Put option on GE we discussed earlier, and instead of dropping, GE increased in value to $35? Will anybody be willing to pay you anything close to the $1.80 per share you paid for that option? Not at all. In fact, in an example such as this, that option will only be worth a small fraction of what you paid for it originally. Many investors, new to options, lose significant portions of their investment capital because they don’t correctly understand how leverage can affect them, and they place too much money in their first-options trades. Even if your first few options trades are successful and you see significant profits from them, don’t get caught in the trap of thinking, “If I had bought more contracts, I would have made more money.” Beginning traders who put large portions of their capital into options trades will generally reduce the value of their trading account significantly, even if they start out with profitable trades. This is because they don’t account for the downside of leverage and fail to plan adequately to deal with an option trade that has gone against them. They were so excited when they made money; options trading seemed easy. Then when a trade went against them, they stayed in it thinking they needed to make the same kind of profit. Frame the successful, profitable trades in the context of the money you put into that trade to avoid trying to “hit a home run” every time. Frame the losing trades in the same context so you can identify the points in price when you need to get out of the trade without being emotionally tied to it. Don’t think, “I only have a couple hundred dollars in this trade. It’s only a little bit of my total capital. If I lose it, that’s okay.” The reason to avoid this mindset is that if you start thinking in these terms, your winning trades won’t make up for your losing ones, and you will gradually deplete your account. It is much more effective to think about a loss in the context of the money you have in the trade: “I put $200 in this trade, and now I’m down $80, or 40%. I should get out now so I can use that $120 in a better trade.” Think of options trading as a gradual process. Not only are there a lot of different strategies you can use, but there are also a lot of dynamics you have to understand before you can correctly 28

Chapter 1: How Options Work

Notes interpret how much risk you are taking. Understanding those dynamics takes time and experience. Start your options trading small; buy one or two contracts at a time at the most. As you build experience, familiarity, and confidence, you can begin to use larger allocations as you deem appropriate.

Timing The leveraged aspect of options is part of what makes the timing of an option so critical to the success or failure of your trades. Remember, options have a finite life; in other words, they disappear after their expiration date. If you bought an August option and the stock didn’t move the way you wanted before the third Friday of the month, any money you had left in the option would disappear as of the third Saturday. Because of this, your success will depend more on your ability to be right on time than on simply being right about the direction of a stock. Let’s think about this idea for a minute. You already have had some experience in performing technical analysis, identifying reversal points in a stock pattern, and determining support and resistance thresholds before delving into options trading. This should mean that you can often identify which direction a stock is likely to move in the future. This is a critical skill for successful stock trading and for options trading, but the time sensitive nature of options gives you a much smaller window of opportunity. Maybe your analysis leads you to conclude a stock is bouncing off of a support level and should begin a new rally. Your analysis leads you to buy a call option that is two months away from expiration. After a month, however, the stock still hasn’t rallied. In fact, suppose it has begun to drift sideways as stocks sometimes do. Even though the price of the stock may not have changed, your option is going to be worth less because now you only have a month left before it expires. Suppose that a week after the option expires, the stock does in fact rally as you had originally predicted. Unfortunately, it doesn’t help you because your option has expired. You were right about which way the stock would move, but you weren’t right about when it would happen. As you gain experience and familiarity with options, you will find that the timing of your trade, and how much time you buy, will sometimes do more to dictate success or failure than any other single factor. That doesn’t change the fact that you have to perform your normal analysis; it just underscores the importance of learning how to handle the timing of a trade.

29

Guide to Options Strategies

Notes

Summary Options are a powerful way to achieve aggressive growth in your investments and to diversify your portfolio. However, options do represent a higher level of risk depending on how they are used, so it is still critical to make sure that you understand the dynamics of options and the risks involved. Options require smaller capital investments than are needed to buy stocks. This leads many people to try to “hit home runs” on their options trades; in other words, they often try to achieve maximum results on every trade they make. This is a dangerous mindset and should be avoided in your trades. Effective management of your trades means cutting your losses on bad trades and maximizing your profits on good ones. This can be a difficult skill to master, but successful implementation of a trading system in options will greatly impact your long-term investment results. Timing is critical in options trades. Options expire on the third Friday of each month, so it is critical to know when to take profit and when to cut a loss. Holding an option contract through its expiration date means losing all of the money you spent buying the contract.

30

2

Options Greeks

“Cut your losses short and let your profits ride.”

Now that you have an understanding of some of the basic components of options, we will examine some critical elements that impact how much an option will move, how those moves can be measured, and how options pricing is based on some of that information. We will also discuss how that information can be included to develop a trading system specific to your options trades. As you know, it is critical to develop a trading system that you can apply to each stock trade you make, and that can respond and adjust to the changes that take place in the stock market. The same holds true for options trading. Just as you established trading rules for your stock trades, you should take the time to establish trading rules for your options trades. Some of these rules will be similar to the rules you set for your stock trades, perhaps even exactly the same. There

33

Guide to Options Strategies

Notes will be other issues that your rules will need to address in options trading, which we will discuss in this section. By now you have heard the maxim “cut your losses short and let your profits ride” many times. This is because the principle this statement emphasizes applies to every kind of trade you make, regardless of whether you are trading stock or options. Your trading system and trading rules must reflect your determination to do this consistently. If they don’t, your success rates in options trading will be extremely haphazard and will ultimately take away significant amounts of your trading capital.

Elements of an Option and the Greeks There are various elements of options pricing and valuation that are measured and tracked by investors, market makers, and institutions alike. These elements are designed to reflect the volatile nature of options and to underscore both their upside and downside risk. Understanding these dynamics and how they are used will help you identify the contracts in an options chain that give you the best combination of reward and risk and increase the probability of achieving success.

Intrinsic Value Intrinsic value refers to the dollar amount the stock price has moved beyond the strike price of a given options contract. For a call option, intrinsic value is calculated by subtracting the current stock price from the strike price of the option. For a put option, subtract the strike price of the option from the current price of the stock. If your result is a negative number, the intrinsic value is zero. Intrinsic value is like equity in a home. If you bought a home for $150,000 and it is now worth $200,000, you have $50,000 of equity, or intrinsic value in the home. Intrinsic value is the difference between the current value of an asset and its purchase price. Intrinsic value is a quick way to determine whether a contract is in-themoney or out-of-the money. Simply put, an in-the-money option always has intrinsic value, while an out-of-the-money option never has intrinsic value. The moment an out-of-the-money option has intrinsic value, it is in-the-money. 34

Chapter 2: Options Greeks

Notes As you evaluate the different options contracts available for any given stock, whether or not the stock has intrinsic value can tell you a lot about the prospects for that contract. If an option has no intrinsic value, the entire value of the option is tied to the term of the contract. If the stock doesn’t move past the strike price of the option before expiration, it will never have any real value and will simply expire worthless. This is why out-of-the-money options are so risky; when you buy out of the money, you are betting that the stock is going to reach your strike price and continue past it. If it doesn’t, you will quickly lose most, if not all, of the money you put into the trade. The intrinsic value of in–the-money options provides a conservative means to buy option contracts. Although the stock price can still move quickly and change from being an in-the-money option to an out–of-the-money option in a short period of time, the intrinsic value of the option provides a cushion, or buffer, that can help you manage downside risk. If the stock moves against the direction of your contract, the intrinsic value you bought at the beginning will likely leave a larger portion of your money in the trade, so if you need to get out, you have more money to walk away with.

Time Value We alluded to time value in Chapter One. Every options contract has a finite life. Options expire on the third Friday of the month they specify. Options contracts can have durations of one month to a couple of years in many cases; this duration translates into a realdollar value called time value. Time value is calculated by simply subtracting the intrinsic value (if there is any) from the price of the contract you are looking at. The number that is left is how much time value that contract has. If a contract has no intrinsic value, then the entire price of the option is time value. You can also think about time value as “possibility value;” it is an expression of the likelihood the stock will move in the direction you want in the time the contract has. Let’s put it into literal terms: Suppose that in August, you bought a September call on IBM. In addition to that, you decide to buy a December call on IBM with the same strike price as the September call.

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Guide to Options Strategies

Notes Under which time frame does IBM have the greater likelihood of going up—one month or four? Since stocks tend to go up over time, the December contract has better odds of increasing in value than the September contract. Therefore, December calls will have greater time value reflected in their price than September. Let’s look at an example.

Figure 2.1 Let’s use the $20 strike price. The last trade for INTC was at $20.85, giving us a total of $.85 in intrinsic value for any of the call options with a $20 strike price. Look at the April 20.00 calls (Figure 2.1). Its ask price is listed at $1.22. If we subtract the $.85 in intrinsic value from $1.22, we see that this contract has $.37 of time value.

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Figure 2.1a

Chapter 2: Options Greeks

Notes How about May (Figure 2.1a)? The October 20 call has an ask price of $1.48, which means that its time value is $.63. We have to pay a higher price to add a month of time to our contract, but we get almost twice as much time value. The principle to remember about time value is that the closer to the expiration date you are, the smaller the time value will be. If you were to buy the April call, you would only have $.37 of time value to work with. If the stock doesn’t move up for you right away, you will probably have a hard time making money in this trade because you are going to have to do something before the option expires. You have the intrinsic value acting as a buffer, which means you probably won’t take a huge loss, but the small time value equates to a very small window of opportunity. On the other hand, if you bought the May call, you would have $.63 of time value to work with on top of the $.85 in intrinsic value. This gives you a larger window of opportunity to work with. If the stock doesn’t move in the next few weeks, the time value will be less, but probably not to the point that it will hurt your trade. When you buy options with longer expiration dates, you can usually afford to let the stock run for a longer period of time.

Time Decay Time value and time decay both are borne out of the fact that options have a finite life. Time decay refers to the decline of an option’s time value as it gets closer to its expiration date. Time decay occurs in every option contract, regardless of whether the option is in the money or out-of-the-money. The truth is that time decay is less visible with in-the-money options because as they become deeper in the money, they are more profitable. Remember, though, that time decay is still there. Time decay affects out-of-the-money options far more dramatically than it does in-the-money options. Remember, if an option is outof-the money, it has no intrinsic value. In that case, the entire cost of the option is tied to time value. As the contract gets closer to the expiration date, time decay will accelerate, eating away at the time value on an increasing basis every day until there is nothing left.

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Guide to Options Strategies

Notes An effective analogy when thinking about the concept of time decay is an ice cube. If you hold an ice cube in your hand, the heat from your hand and the air around it will cause the ice cube to begin to melt and shrink in size. As it becomes smaller, the heat being generated on the cube is working on less mass, which forces the cube to melt even faster until eventually all you’re left with is water. This is precisely what happens to options as they get closer to expiration and also why the option simply disappears after the expiration date. If you bought an October call right now and the stock didn’t move for the next three weeks, the option wouldn’t be worth as much as you paid for it because of the loss of three weeks of time value. By the same token, if the stock continued to hover in the same range through October, time decay would continue to erode the overall value of the option until after the third Friday of October when there is no time value and the option ceases to exist. As you gain experience in your options trading, you will find that keeping track of time value and monitoring the effect of time decay will be a critical part of your risk management strategy. It will often do more to differentiate between profitable and losing trades than guessing correctly which way the stock is going to move.

Open Interest and Volume Open interest refers to the net amount of outstanding open positions on a given option contract. This number is displayed in any options chain for each contract listed. This is an important number; it gives traders a sense for how much interest there is in a given option. As a minimum, you may want to look for at least 50 contracts in open interest for any options trade you consider. If the contract you are looking at has less than 50 contracts available, there may not be enough interest to maintain liquidity in the option, which you will need to have when it’s time to get out. The daily activity in that option is reflected by its volume. Just as volume on a stock tells you how many shares were traded in a given day, volume describes how many contracts have changed hands on any given option during that day. You will rarely see a correlation between open interest and volume; in terms of measuring liquidity in a contract, open interest is a better indication than volume. 38

Chapter 2: Options Greeks

Notes This may sound counterintuitive, but the reasoning behind this statement lies in the way options trades are processed. When you place an options trade with your broker, that order is sent to a market maker. The market maker’s role is to maintain and update a list of buyers and sellers for any option contract throughout the day, and find matches for each. If your option order specifies that you want to buy 10 call contracts, the market maker will try to find an order to sell 10 contracts to match you with. The market maker’s job is to maintain liquidity for the options contracts he deals with, and so in addition to matching buyers and sellers, he will frequently assume some of those contracts as well. Market makers make money by taking the difference between the bid and ask prices of the contracts they deal with, which is why they are willing to take on the occasional contract to maintain liquidity. This is different than stock trading, where market makers primarily match buyers and sellers, but rarely take any positions themselves. The role the market maker fills makes the options market one of the most liquid of all of the various financial markets—even more so than the stock market! This is why, despite the fact that volume describes how many contracts have been traded during the day, it is more important to pay attention to open interest. If there is adequate open interest, the market maker will be able to match your order to buy or sell with another trader on the opposite side of the coin quickly.

Volatility If you have not already done so, be sure to learn how to evaluate the volatility of a stock to determine whether a stock meets or exceeds your risk tolerance. Options traders use measurements based on volatility to identify contracts that are overvalued or undervalued. It is important to remember that an overvalued options contract isn’t automatically bad and an undervalued options contract isn’t automatically good. Even fairly priced options aren’t always the most desirable options to use. Depending on your approach and what your objective is for a given options trade, any of these types of options could work for you. Implied volatility (IV) represents the expected volatility of a stock over the life of the option. As expectations change, option premiums reflect this change. Supply and demand of the underlying option also influence the market’s expectation of the direction of the price of the underlying stock.

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Guide to Options Strategies

Notes IV is also used as a surrogate value of the option itself. More simply put, if the implied volatility is above the midpoint of a volatility graph, it is said to be overpriced. If IV is below the midpoint of a volatility graph, it is said to be underpriced. Because there is no standard value of implied volatility, both historical volatility and implied volatility must be charted. The 90-day IV is a very valuable indicator regarding the expected change in the price of the stock or option. In Figure 2.2, implied volatility is the column highlighted in red.

Figure 2.2 However, it is of little worth unless it is applied to a volatility chart. In Figure 2.2, the 90 IV is 42.25. On first glance, it would seem that this is below the 50th percentile and therefore just underpriced. When this is charted on a volatility chart the initial perception of being underpriced is radically changed.

Figure 2.2a

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Chapter 2: Options Greeks

Notes In Figure 2.2a, we see that both the HV and the IV are at the top of the volatility chart signifying that both of these values are overpriced. Still, volatility, like all technical indicators is subjective, meaning it is not absolute. The price of Google could continue to go up, remain overpriced and people betting against it could lose. Like all technical indicators, volatility should be used in conjunction with other indicators and information. The general rule of thumb states that stocks with high-implied volatility numbers will have inflated option prices. This is a logical conclusion, since options traders look for stocks that can make significant price swings in short periods of time so as to maximize their opportunity. Experienced options traders will often use implied volatility values as a way to identify potential reversal opportunities. An option with high-implied volatility is overvalued and may well be at the top of its increase; for option sellers, this could provide an opportunity to generate significant income. By the same token, an option with low implied volatility would be considered undervalued, which could be an indication of an early opportunity. Don’t rely on volatility measurements alone as buying and selling indicators; the same rules for buying and selling signals apply to options as to trading stocks. Make sure that technical analysis of the underlying stock confirms the opportunity you are looking at.

Delta Delta is a percentage that describes how much the option will change in value as its underlying stock price changes. Delta is not constant. As the value of a stock price changes the value of delta will change as well. The further out-of-the-money an option strike price is, the lower the delta. Deep in-the-money strike prices have a progressively higher delta.

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Guide to Options Strategies

Notes

Figure 2.3 Delta is also described as the ratio comparing the change of the price of a stock to the corresponding change in the price of the option. It does not have values higher than 1.0 Let’s use an example from Figure 2.3. The May 145 call option for Apple (AAPL) has a delta value of $.58. If AAPL moves up or down by one dollar in the near term, this option will likely experience a $.58 move. This may not sound like much at first, but be careful to take this information in its proper context. We are looking at a call option, so let’s suppose that AAPL goes up by $5, from $147.56 to $152.56. This would equate to roughly a 3% return if you owned the stock which isn’t bad for a short-term trade. Remember that the price of the May 145 call for AAPL is $11.25. With a delta of .58, the price of the May 145 call would go up $5 x .58 = 2.90.* Seeing this option suddenly increase in value to $14.15 on a $5 stock move would certainly give you a greater return on investment than if you bought the stock outright. The option returns 25%. *Note: As the stock moves up, the delta on the options increases as well. Therefore, the $.58 would not be the actual amount the option increased. All other factors being equal, the delta would have a sliding value. The actual rate of return on a $5 stock move would be somewhere around $3.50.

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Be careful about getting too excited about the information you get from the delta. Many investors see the upside of leverage but fail to consider the downside. Leverage cuts both ways: Just as delta describes how much the May 145 call option would likely increase if the stock goes up, it also describes how much this contract would

Chapter 2: Options Greeks

Notes likely decrease if the stock goes down in the short term. If AAPL dropped from $147.56 to $142.56, your option would also drop, to around $8.35, an unrealized loss of more than 25%. This is a critical part of the leveraged nature of options to remember: You can make greater profits faster than is possible in ordinary stock trades, but you can also experience dramatic, steeper losses. You have very high-upside potential, but also increased-downside risk. This is why we emphasize using options as just one component of an overall investing strategy. It can be an effective means of diversification and supplementing the growth side of that strategy, but using too much of your investment capital in options will usually increase your risk profile beyond reasonable levels. Anytime you look at making an options trade, make sure you check the delta so you can gauge both sides of the equation. Also remember that delta is not a hard-and-fast number; it can and usually does change daily. One of the biggest factors that impacts the delta is whether a given options contract is in-the-money or out-of-the-money. As an option goes deeper in-the-money, the delta will increase as the premium (the ask price) increases. As an option goes further out-of-the-money, the delta will decrease as the premium decreases. So while the delta can help you evaluate reward and risk, make sure you don’t depend on delta too much. It can give you a sense of potential upside or downside, but those numbers aren’t fixed or guaranteed. You can also use delta to sort through the various options that are available based on potential reward for the amount of capital required. Generally, there are three rules to follow which will increase the probability of a winning trade. They are (1) buy an option one strike price in-the-money; (2) buy more than one month’s period of time and; (3) don’t exercise the option. Buy the option to sell the option. Options are a personal thing; however, each investor or trader should pursue them with regard to their own comfort level. There are no absolute rules. Many investors try to find the option contract in a chain with a delta closest to $1, and if that is your preference, that’s fine. When it comes to sorting through an options chain, use delta to evaluate potential reward versus cost and to begin to assess overall risk. If you want to be aggressive, options that are closer to at-the-money have lower deltas and greater total upside potential that will probably suit you better, while if you prefer a more conservative approach, you should look at deeper in-themoney options with a higher delta.

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Guide to Options Strategies

Notes

Theoretical Value As with the stock market or any other market in a supply-anddemand economy, options prices can be impacted not only by buying and selling, but also how much demand for a given contract there is. In other words, options prices can inflate or deflate depending on how much interest there is in a contract. Let’s use an example we all deal with on a daily basis to illustrate: gas prices. Gas prices fluctuate widely depending on a wide variety of factors. One of the more interesting factors that can impact how much you pay at the pump is where you fill your car. If you use a station on a busy thoroughfare, it isn’t unusual to pay five to ten cents more per gallon than at stations on less busy roads. You also usually pay higher prices for gas in large metropolitan areas than in rural communities, again by around five to ten cents per gallon. In other words, where interest (or demand) is high, gas prices are more inflated than in other areas. The options market works in a very similar manner. Where interest in a specific option contract is high, the price of that option will usually be inflated to higher levels than for contracts that aren’t receiving much attention. Many professional traders use this dynamic to gain an edge in their trades—they will look to buy options with deflated prices and sell those with inflated prices. Theoretical value, also called t-val, gives options traders like you the ability to look for the same kinds of opportunities. On any table showing theoretical value, this value can be compared with the actual buy-sell price of the option. If the option price is less than the t-Val, the option is under priced. In such cases, if the stock is trending upward, you may wish to buy a call. If the stock is trending downward, a put may be a wise choice Be careful about relying on t-val exclusively to identify good opportunities; make sure you combine evaluation of t-val with solid technical analysis of the short-term prospects for the stock. Remember that if your technical analysis doesn’t lead you to believe the stock is going to move the way you want, it doesn’t matter what the t-val tells you.

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Chapter 2: Options Greeks

Notes Overvalued options are another dilemma that can be viewed from different perspectives. The implication of an option contract with a t-val that is less than the current trading price of the option is that the option is overvalued; therefore, you would be paying a higher than “fair” price for the option. Many traders stay away from overvalued options on the assumption that the opportunity for profit in the trade may be limited—it has already extended itself far above its fair value. This is often true, but can also be viewed in exactly the opposite light. Think for a moment about a stock that is riding along a strong upward trend and setting new high prices every couple of weeks. Although these kinds of stocks will certainly run out of steam at some point and begin to go down, these stocks often simply continue their impressive upward run. This is because in order for a stock to make a new high, it has to overcome a previous high. The market often reads this action as a bullish indicator and continues to push the stock even higher. Although call options for this kind of stock will likely be significantly overvalued, there is often still ample opportunity for significant profits in these types of trades. This is just one more reason why you should use technical analysis as the overriding indicator in your decision making about whether or not to place a trade. The t-val is helpful in knowing that the call option is overvalued because it essentially provides confirmation that interest in the call option is high and market sentiment may still be bullish. The price movement, or volatility, of a stock has a dramatic effect on an option’s price relative to its t-val. If you see highimplied volatility figures for an option contract, the trading price of the option will usually also be significantly inflated above the t-val. Stocks with high-historical volatility also tend to see more inflated options premiums because volatile stocks generally give aggressive traders more opportunities to make significant profits in a short period of time than less-volatile, more conservative stocks.

Technical Analysis and Options You have already become familiar with performing technical analysis and identifying buying or selling opportunities in your stock trading. One of the aspects of the stock market that makes

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Guide to Options Strategies

Notes options trading so attractive is the fact that the analysis skills you have already learned have direct application to options. A breakout above a support threshold on strong volume may be an indication to buy a stock; the same signal could be used to buy a call option on that stock since the call option requires the same movement to be profitable. A breakout below support is usually a sign to sell a stock if you haven’t done it already; the same indication could be used to buy a put option since put options are profitable trades when a stock is dropping. In addition, remember that options trading is by and large a very short-term strategy. If you are used to getting in and out of a stock within days or even weeks, this mindset will lend naturally to options trading. If you have previously held onto stock trades for a month to a year, you will probably find that your options trading will be much more active, which will require a mindset adjustment. Although there are many similarities, there are a few differences in options trading to be cognizant of. For example, there is specific additional information you should check for to confirm your signals with options. We will discuss this further in Chapters Three and Four.

Trading Rules and Trading Systems Many of the trading rules you have established for trading stocks will apply in equal manner and importance to options trading. One thing you should be absolutely certain to do if you haven’t already is to make sure your rules include requirements for planning your exit. Successful traders will plan their exit before getting into a trade regardless of whether they are dealing with a stock trade or options trade, but it is even more important to plan this process out prior to an options trade.

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The reason planning your exit is so critical to success in options trading is due to the time-sensitive nature of options contracts. When it comes to stocks, there is no expiration date to deal with, so it is entirely possible that when you reach a point in a stock trade that your rules dictate you should get out, you may decide that the current strength in the trend would justify staying in the trade longer. If your technical analysis supports such a decision, this would be perfectly reasonable. But in options trading, this kind of “adjustment on the fly” approach can have catastrophic results.

Chapter 2: Options Greeks

Notes Suppose you have purchased a call options contract due to expire on the third Friday of October. True to your analysis, the stock has moved up nicely and you have built a tidy profit into your options trade. By the end of September, the stock has reached a point where you would normally say, “Good enough, let’s move on.” But as you look at the strength of the upward trend, you think, “This is going to keep moving up—I don’t want to sell yet.” You would be better off to go ahead and take your profit and buy a longer option contract in the same stock if you think the upward trend is going to last than trying to stay in the trade until the very last day. Remember, if you haven’t taken action on your options contract before the expiration date, all of your money in the trade will disappear, regardless of profitability. Make sure before you enter an options trade that you have considered all of the current support and resistance levels and the strength of the current trend. You should identify specifically when you are going to get out of the trade on both sides of profitability. In other words, know what you will do to cut your loss short if the stock moves against your options trade, and make certain you know at what level you will get out of a profitable trade. Some options traders will identify a specific dollar or percentage amount they want to make before they get out of a trade. The reason they often do this is because options move so quickly. When your analysis is correct, you will very quickly reach a highly profitable level in your trade—far more so than in the stock alone. This is a dangerous trap to fall into because it establishes an expectation level the stock may not be able to meet. Suppose you say to yourself, “I will get out of the trade when I double my money!” The stock moves the way you want, and you are quickly looking at a profit of 50%. This is already a handsome trade, and you see that the stock is approaching resistance. But since you are looking to double your money, you stay in the trade. The stock hits resistance and drops quickly back to the levels it was at when you first bought your options contract. Now you are lucky to get out of the trade with as much money as you put into it or with a small loss. This example is illustrative of the kinds of issues traders run into. We all love the high profit trades when we get them, but expecting that level of performance trade after trade will often 47

Guide to Options Strategies

Notes turn a profitable trade into a losing one very quickly. Clearly, in our example you would have been better off seeing resistance for what it was and selling the options contract back to the market, happy with your 50% profit. This is the reason you don’t set profit expectations in your trade; instead, when you get into an options trade, make sure that there is enough room between where the stock currently sits and support or resistance to make the potential reward worth the risk and establish your exit points at those support or resistance levels. Another critical part of planning your exit strategy at the beginning of the trade is to use stop losses consistently. You should be familiar with the process of evaluating stop loss prices in a stock trade. In stock trades you will often use current support or resistance levels as your stop loss prices. You can generally use the same principle for options contracts, but remember that, as a percentage of your investment, your stop loss on an options contract will represent a wider gap than it would for a stock trade. The leveraged nature of options contracts makes their price swings more severe on a day-to-day or even intraday basis. To simplify the issue, a good rule of thumb in options trades is to use 50% as a baseline for your stop loss. If your analysis of support or resistance seems to indicate you could bring it in closer, fine, but you will find that most options contracts will fluctuate by 30 to 40% easily within a given day or period of time. You don’t want to put your stop loss so close to the current price of the contract that you will get stopped out because of normal fluctuations.

Trading Systems The consistent use of a disciplined trading system is one of the most critical keys to long-term success in the stock market. This is true both for straight stock trading as well as options trading. A trading system is a complex set of rules, conditions, and criteria that have to be met in order to place a trade; it also dictates what actions will be taken in the event of positive or negative moves in price. As much as possible, a successful trading system will also factor in the effect of surprise announcements that can sometimes take place.

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Chapter 2: Options Greeks

Notes Remember that a trading system doesn’t guarantee that you will win on every trade you make. There is no “silver bullet” for the stock market. This is why you have to consider your trading system in the context of long-term results. Your trading system should be built to increase your odds of success, help you minimize loss when you do have a losing trade, and to maximize profits when you are right. You have experience with building a trading system as it relates to stock trading. When you first started building that system, you likely spent a fair amount of time paper trading before you started trading with your real investment dollars. This was so you could begin to build experience and confidence in your trading abilities and the techniques you were learning. Although many of the same principles and techniques you already know will apply to options trading, there are dynamics and aspects of options trading that you will find to be very different from stock trades. For this reason, you should take the same approach to developing your options trading system. Paper trade first, and then begin going into real money options trades with small dollar amounts until you have built some confidence, experience, and history behind you.

Summary Understanding the various elements of an option and the way that Greeks try to measure these elements will help you identify both the potential opportunity and the risk of any option trade. Remember, when you trade options you are assuming the risk that is inherent to the underlying stock as well as the risk associated with the contract you choose to trade. Make sure that you take the time to analyze and properly evaluate both types of risk in every option trade you make. If you don’t, you may be surprised when the option’s price movement doesn’t track exactly as you thought it might, and you won’t be as prepared to deal with unusual circumstances when they arise.

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Guide to Options Strategies

3

Call Options

Simply put, a call option is a bet that the stock underlying the option will go up in value over a given period of time..” Many traders who are new to options try to oversimplify options trading by thinking, “If I think the stock is going to go up, I buy a call. If I think it will go down, I buy a put. Let’s go; I’m ready to get rich!” This is a common and often fatal mistake that beginning traders make. Just as it is necessary to establish a trading plan and trading rules before you ever place a trade in the stock market, you need to begin establishing a trading plan that is specific to options trading. In order to be successful, you must first understand all of the various factors that can affect your options trading. Understanding how options are issued, when they expire, what price each contract is associated with, and how to measure the leverage, time decay, and potential reward or risk are critical elements you must understand before you begin trading options. For example, time decay in options

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Guide to Options Strategies

Notes will often make a trader, who is correct about the direction a stock is going to move, actually lose money because he or she didn’t predict correctly when it would happen. If you don’t account for this risk up front, you are far more likely to make a mistake and not purchase enough time. More than just a few options traders have depleted their trading accounts because they failed to account for time decay. This is the reason Chapters One and Two are presented before any information about specific strategies has been outlined in this manual. In this chapter, we will discuss using call options to take advantage of short-term, upward moves in the stock market. We will discuss the fundamental, technical, and logistical aspects of trading calls, as well as the tools, such as Seeker,™ you can use to find good options opportunities.

Review—What Is a Call? Simply put, a call option is a bet that the stock underlying the option will go up in value over a given period of time. To be more specific, when you purchase a call option, you pay for the right to buy the stock at a specific price but at a later date. For example, you buy an option that expires three months from now. Assume the current month is April. You are looking at IBM. The current price of IBM is $100 a share. You have reason to believe that IBM is going up in price to $110. You do not know when exactly, but you reasonably expect it to do so before the June option expires. You purchase an option to buy IBM at $100. You buy an option that expires in June. It is called the June 100 call option. Hypothetically, the June 100 call option costs $10.00 a contract share or $1,000. Now 10 days have gone by, and IBM is at $110. Congratulations! Your research on IBM was correct and it happened sooner, not later. Do not feel bad that you expected it to happen in three months instead of 10 days. You now have an interesting choice. You can exercise your option and take delivery of IBM at $100 a share and sell it at $110.00 a share. If you do, you will break even on the trade because it cost you $10 to exercise. OR, you can just sell your option. Remember delta? Assume delta was .70 on the June 100 call options. That means that the option went up in value to approximately $17.00 (bid price) a contract share. At this point, you can simply sell your call for a $7.00 profit. REMEMBER, if you exercise, it costs you the price of the option to buy the stock. If you just sell your option, you sell it for its bid price. 54

Chapter 3: Call Options

Notes If you exercise the option, you will first buy the underlying stock for the option’s strike price, and then you can sell it at the going market rate or hold it for as long as you wish. If you sell the option back to the market, you will get back the money you originally paid for the option, plus the amount the option has increased in value. The appreciation in the option will be dictated by a variety of factors besides the price increase in the stock, such as how much time value the contract still has and how sensitive it is to an increase or decrease in the stock’s volatility. These factors can be roughly measured by looking at the Greeks information of an option, such as delta and implied volatility.

Why Trade Calls? Buying shares of a stock can be an expensive proposition; if you want to buy 100 shares of a $50 stock, for example, you would have to spend $5,000 of your trading money. For many investors who are starting with small accounts, this is a daunting reality. They are often attracted to call options because call options on the same $50 stock will be available for a small percentage of the value of the stock. A call option with a $50 strike price and a twomonth expiration, for example, may only cost around $500. One of the main reasons traders like to use call options comes from the leverage that is associated with a call option. For example, if the stock moves from $50 to $55 and you own 100 shares, you will make exactly $500, a total return of 10%. This is pretty good! However, if you bought the two-month call referred to earlier, you might get a move of around $4 per share, depending on how much leverage the option has. This would equate to a $400 increase in the value of your option contract, a total return of 80% on your money. This gives you the chance to get a much bigger “bang for your buck.” Big-percentage trades such as the one just described aren’t uncommon in options trading; however, it is important to understand that trading on the expectation or assumption that your profits will be this big is dangerous. Look at Figure 3.1.

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Notes

Figure 3.1 Suppose that you made your first options trade in IBM at the beginning of the new uptrend beginning in July. You bought four, two-month, at-the-money call option contracts for a price of $2 per share, or a total cost of $800 excluding commissions. This first trade was pretty conservative at the beginning; since you have a trading account of $50,000, it’s less than 2% of the total value of your account. The stock began its move at around $75; suppose that when you placed your trade, it had gone up to $76. Since then, we can see that the stock has made a most impressive run, with only three down days. The stock is now hovering just below $84, an increase of $8 per share from when you got into your call option trade. Your contracts are now one month from expiration, but since they are now nearly $9 in-the-money, suppose that they are worth $10.50 per share. This gives your position a total value of $4,200. Selling your contracts now will give you a total return in this single trade of 525%. Wow! Isn’t that exciting? You have probably called your friends, neighbors, and even your mother to tell them about the amazing results you got on your first options trade. You immediately sell your position and take the profit. Your profit in this first trade is so large, you feel like you are on top of the world! You begin to think that it was so easy, you should be able to do the same thing on every trade. You do a quick calculation: A 500% return on the next five straight trades will make you a multimillionaire and you can quit your job. You immediately start scanning your watch list for the next big trade, anxious to get back in the market as soon as possible. By now, you may even be thinking about taking an even larger position next time; you figure that if you increase your position size to 25% of your account, you will make even bigger profits and will be able to retire even sooner.

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Notes Suppose now that in your next trade, the stock you trade makes only a modest move initially, giving you a total profit about a month before expiration of 25%, and then stalls. If you are paying attention to your technical analysis, you may be getting signals that the stock is done for the time being and you should take your profit. The problem now is that since you have only made 25% on the trade, you will probably be looking for reasons to hold onto the trade. You will be so focused on getting a big profit again that you will be able to find ways to misinterpret selling signals for bullish indications. By now, though, you are one month from expiration. If the stock begins to drop, you will find the value of your trade falling quickly also. You will go from having a modest profit to none, or even a loss, in a very short period of time. Many options traders make exactly this mistake. By the time they realize that the stock isn’t going to come back, they are so desperate to see the stock make a miraculous recovery they will hold onto their option all the way to expiration. Even if that next trade was a loser from the beginning, the fact that you saw a ridiculously high profit on that first trade can still skew your perception of reality such that you will hang onto the option through expiration. Remember that when an option expires, its value disappears altogether, and all of the money you put into the trade will disappear as well. This kind of emotion will have a ripple effect across every aspect of your trading system. Now let’s suppose that you followed through on your thoughts of increasing your position size and put 25% of your total capital into the next trade. Waiting for the stock to make the big move you wanted forced you to hold the contract past the point where your mind told you the stock wasn’t working; you were so intent on being right that you couldn’t accept the fact that you were wrong. As a result, you held onto the contract through its expiration date, losing all the money you put in the trade and immediately reducing the value of your $54,000 account to $40,500. Now you are so upset by the large loss you have taken that you become determined to make back the money you lost. You realize that you might now get a 500% profit on the next trade, so you decide that you would be willing to settle for a 50% move. Since you now have an emotional need to make back the $13,500 you have lost, you put $26,000 into your next trade.

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Notes Do you see the slippery slope that options traders often find themselves on? What if you’re wrong again? You may lose all $26,000 you put into that trade, leaving only $14,000 of your original $50,000 account. You may be so desperate now that you take one final roll of the dice with everything that’s left; surely you can’t have three bad trades in a row. Sure enough, though, this trade doesn’t work either. You have now burned all $50,000 you started with, and are so despondent that you swear never to trade again. This example underscores the problems that come from looking for big profits on every options trade. When you get it, you will be so excited that you won’t be able to frame your next trade in its proper context as part of your trading system. You will feel so confident in your ability and mastery of the market that you may decide the rules you initially set up don’t apply anymore. The emotion associated with your astounding success will skew your perception of success so much that you won’t be able to accept modest profits, cut losing trades short, or think objectively about how much risk you are taking. Trading on the anticipation of huge profits creates an emotional vacuum that is extremely difficult for anybody to force himself or herself out of. Many traders have burned through their entire investment capital doing exactly what has been described here. IBM, as illustrated in Figure 3.1, is proof that stocks can and do make big moves that can yield incredibly impressive profits in options trades; however, forecasting which way a stock will move, how far it will move, and when it will happen are very tricky and are the main reasons options trading is so risky. The kind of big moves, such as that made by IBM, are extraordinary exceptions to the rule, not the norm. Your trading system should plan to take quick profits in options with short-term expirations. If you develop the discipline and mindset to do this, you will be a more effective trader. It doesn’t mean you won’t have trades that produce huge profits, only that you won’t trade on the expectation of getting them every time. This way, when they do happen, you will be able to react objectively to them and place your next trade in its proper perspective. You may be thinking, “This isn’t going to happen to me. If I get a big move like this, I won’t let my emotions carry me the way they’re saying. I can be objective.” This is the right mindset to have, but you will only be able to pull it off if you make sure that your trading system is geared around taking reasonable profits rather than 58

Chapter 3: Call Options

Notes huge ones. In options trades, a good guideline is to be ready to take profits once your profit reaches a total return of 25 to 50%. This way, the occasional big move will be a terrific bonus to your trading, but not the emotional crutch you use to define yourself as a successful trader. Be careful to remember also that most traders are wrong about the move a stock makes more often than they are right. If you keep this in mind, you will be able to deal with losing trades and streaks effectively and close them out before they become large losses. Now that we have examined the pitfalls of options trading and the mindset you must apply, let’s look at how you can identify stocks that could work well in your favor in options trading. It isn’t hard to understand that before you can determine if a stock would work well for an option trade, your technical analysis of the stock must indicate that the stock is due for a significant move. We will discuss the specific information your technical analysis should give you for a good options trade later, but first we should consider an area of analysis that many options traders ignore: fundamental analysis.

Fundamental Analysis and Call Options Due to the short-term nature of most options trades, many traders overlook fundamental analysis altogether as part of their options trading system. There is real value in including fundamental analysis in your system; even if you choose to trade options on stocks with poor fundamentals. Fundamental analysis will help you gain a broader, more complete picture of variables that are critical to success in options trading, such as: • Volatility • Trading ranges • Motivation that drives a stock in one direction or another • Ability and probability of a stock to sustain a significant trend As you analyze a stock’s volatility and trading ranges, completing a thorough look at the fundamentals of a stock will give you a good sense for why the stock moves as it does. Fundamentally strong companies generally tend to be less volatile, with more predictable swing and cycles. Lower volatility doesn’t mean that

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Guide to Options Strategies

Notes the stock doesn’t make large, profitable moves; in fact, when they begin a move to the upside, it often becomes a long, sustained upward trend. This is because the emotion and attitude of the broad market is driven by information that indicates the company in question is managing their business effectively and is good at maximizing their profits. If you plan your trade correctly, you can take advantage of these sustained trends with options just as you would with the stock. Lower volatility also makes it easier to identify your entry and exit prices since fundamentally strong stocks typically don’t experience wild day-to-day swings in price. They also tend to be less volatile on the downside, which makes your risk management easier to deal with. Identifying support thresholds for stop losses, for example, is easier and more straightforward. Fundamentally strong stocks tend to work best for call trades; their lower downside volatility generally makes them tougher to trade profitably on the downside. Fundamentally weaker stocks, of course, tend to be more volatile, with wider swings in price on a day-to-day basis as well as larger ranges between support and resistance. Many options traders prefer these kinds of stocks for their trades because the greater volatility equates to a higher profit opportunity when they are right. The value of performing a fundamental analysis in this case is that it can give you a very clear picture of exactly why the stock has so much volatility; the stock is fundamentally weak, so the principal drivers of the stock are speculation and emotion. Although these stocks can and often will make major moves to the upside, the fundamental weakness they have is part of the reason these stocks often experience steep, sustained moves to the downside. For this reason, most options traders who trade call options on these stocks look to take quick profits once the stock makes a move of around two or three dollars. If you are comfortable identifying entry, exit, and stop loss prices on volatile stocks and you are willing to take quick profits, these stocks can work in your favor as an options trader. If you are comfortable with a higher level of risk and more complicated management of the trade, mixing fundamentally weak stocks with strong ones can give you the opportunity to take larger profits from time to time.

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Notes

Technical Analysis and Call Options To a great extent, technical analysis for call options trades is no different than what you do when you are looking for a good stock trade. Breakouts above or below support and resistance, trend reversals, and bounces along a trend line are all opportunities for good short-term stock trades. Likewise, these types of moves generally have easy application to options trading. The analysis you use for stocks applies to options because, for any options trade to be successful you have to analyze the likelihood of the stock making a move you can take advantage of.

Duration of the Trade The biggest thing to remember about the technical analysis you use to place an options trade is that you must be sensitive to the amount of time it will take the stock to make the move you want. When you trade a stock, there is no limit on the amount of time it may take for the stock to move for you. As long as the stock doesn’t violate your stop loss, you can stay in the trade and wait for it to move. This isn’t true in options. If you buy an option that will expire in two months, you generally only have about one month to wait for the stock to move the way you want. If it doesn’t make the move in that time, it isn’t likely to at all. Even if it does actually start to move for you at that point, the time decay of the option will have eroded the value of the option to such a point that the stock will be unlikely to move enough to make up the difference in the time you have. More options trades go bad because of traders not buying enough time than perhaps any other element of options trading. As you perform your analysis of support, resistance, and trend, make sure to consider how long it usually takes the stock to move by a certain amount. For example, suppose that you have identified a trading signal on a stock that has broken above resistance on strong volume. A check of support and resistance levels gives you a likely $5 range between the current price of the stock and the next probable resistance point. When you make this conclusion, make sure to check the stock’s volatility over the past year. How long does it typically take the stock to make a $5 move? Taking a few minutes for this check will give you an idea of how much time you should purchase in the call option. A good rule of

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Notes thumb most traders use in options trading is to consider buying more time than you think you need. If the stock appears to need about a month to make such a move, buy at least two months. The more time you buy, the more conservative the trade is because you minimize the effect of time decay and widen your window of opportunity. Many new traders in the options arena assume that trading options means using short-term trading strategies exclusively. This isn’t true! Options contracts have a wide range of expiration dates. This makes it possible for you to take advantage of nearly any range of time that is available to you. This means that you really don’t have to change the technical analysis you are already used to; only that you must account for the amount of time your trading strategies generally require to make the moves you need. Since call options are designed to take advantage of upward moves in the price of a stock, you can profit nicely from short, intermediate, and primaryterm trends as long as you account for the time you need to let the stock make the move you expect.

Finding Stocks to Trade with Call Options If you have been using the software for any length of time, you have probably identified scans that give you the kinds of potential stock trades that fit your trading system. These same scans have the same translation to options trades, so you don’t necessarily have to try to find new ways to find potential plays in order to find successful options trades. But there are Seeker scans that are particularly well suited to short-term call options trades based on common short-term trading techniques. A few of these scans are listed below; you can find others by experimenting with Seeker and analyzing the results of the scans you try.

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• 5/50 SMA Approaching Cross Up—This scan uses a five- and 50-day moving average upward crossover as its trigger. Stocks that will come up in this scan will often be in current downtrends; the crossover will often come as the stock reverses direction and begins a new uptrend. Since the five-day moving average covers a very short-time period, the point where its line crosses the 50-day moving average gives a breakout signal at a very early stage of the trend. This can get you into a good call trade if the trend is confirmed and continues to move. It is important to remember; however, that this early signal will fail to get

Chapter 3: Call Options

Notes confirmation. Make sure that if you use this search that you have very specific filtering rules set up to confirm the existence of a breakout before you take a trade. This scan can work well for short-term options trades as well as longer ones. • Daily Swing Buy—This scan looks for stocks that have been in sustained uptrends or begun new uptrends, then retraced back down towards their trend lines. Short-term traders look for opportunities to trade stocks that bounce off their trend lines since these often prove to provide very attractive return potential. This scan epitomizes the concept, “the trend is your friend.” Not all of the stocks that come up in this search will provide the bounce you are looking for, but from any given search you run from this scan, you stand a good chance of finding at least one or two stocks that will. • Daily Breakout Buy Watch List—This search looks for stocks that have broken above previous resistance levels. These could be stocks in current uptrends that have retraced to their trend line, then broken above the resistance defined by the retracement; stocks that have broken 52-week high price levels, or stocks that have broken the resistance formed by a strong downtrend. A “breakout” in this scan is defined simply as a price move above resistance; there are no additional criteria such as volume used to confirm the move. Your filtering rules will be critical in whether the stocks you choose to follow actually give you the trade you are looking for.

Call Options Trading Rules The first, and perhaps the most critical component of any successful trading system is a carefully thought-out and planned set of trading rules. This is as true of options trading as it is of any other trading market. One of the advantages of trading in any market is that once you develop a successful trading system, you can apply the most important aspects of that system to just about any other trading market. That doesn’t mean that once you learn how to trade one market, you know them all. It simply means that there are common elements that can be applied to any market. For example, if you have learned how to effectively analyze the trend as well as support and resistance of a stock over any given time 63

Guide to Options Strategies

Notes period to identify entry, exit, and stop prices, you have a skill that will apply equally well to commodities, bond, futures, or currencies market trading. As you work to develop a system for your options trading, think about your previous trading experience and write down the skills that have made you successful in those areas that will translate to options. These could include areas such as the following: • Trend analysis • Support/resistance • Weekly/daily/intraday chart analysis • Fundamental analysis • Relative strength analysis • Money management In any financial market, there are dynamics and intricacies that cannot be learned in any other market. When it comes to your options trading system, you must account for the variables that make options different from any other financial market. Your trading rules must reflect how you plan to deal with these dynamics to minimize risk and maximize opportunity. These dynamics can be encapsulated as a whole in the following: • Choosing a strike price • Identifying your time objective • Your reward-to-risk ratio • Planning your exit

Choosing a Strike Price Once you have identified a stock that is poised for a strong upside move, you must decide what strike price you intend to use. For any given stock that offers options trading, you can purchase call options with strike prices that range from deep in-the-money 64

Chapter 3: Call Options

Notes to highly out-of-the-money. The strike price you pick will go a long way to identifying whether your options trade is very aggressive or more conservative. Because the strike price can have a large impact on the profitability level of your trade, you should develop trading rules that dictate your approach. Purchasing in-the-money call options is a conservative approach to options trading because of the intrinsic value of these contracts. Intrinsic value, or the difference between the current price of the stock and the strike price of your call option, can act as a buffer to minimize some of the loss you will deal with if the stock moves against you. Of course, in order to take advantage of this feature, you have to pay more money. In-the-money options are more expensive than out-of-the-money options. This higher cost also means that if the stock moves the way you want, your profit will be smaller as a percentage of your initial investment. In-the-money call options are considered more conservative, then, because they aren’t as volatile; the leverage they provide in a given trade is less than what you can get from out-of-the-money options. Out-of-the-money options provide a higher degree of leverage than in-the-money contracts primarily because of the fact that they are cheaper. An out-of-the-money call option has no intrinsic value because the strike price is higher than the current price of the stock; in order to have intrinsic value, the stock must rise in price past the option’s strike price. The further away from the current stock price the strike price is, the smaller the chance that the stock will rise past it, which is why out-of-the-money call options are so cheap. Your trading rules must reflect your attitude about risk and the efforts you intend to make to minimize that risk. As they relate to an option’s strike price, you need to find a balance between cost, risk, and opportunity. There isn’t a single best way to determine where that balance lies. Some traders will always purchase the first inthe-money call option on any trade they make, while others might prefer the at-the-money call, regardless of whether it is actually in or out-of-the-money. Still others will stick to purchasing the first out-of-the-money contract in an effort to maximize their opportunity. Defining your approach will probably take some experimentation. You will have to make a few options trades each with in, at, and out-of-the-money contracts before you develop a sense for the approach you prefer and that works best for you. Make sure you 65

Guide to Options Strategies

Notes try a few trades with each type of strike price so that your attitude isn’t unduly influenced by the success or failure of a single trade. Taking a losing trade with an out-of-the-money contract, for example, probably won’t be enough to determine if that approach is wrong for you. You will have a better idea of what works best if you have winning and losing trades in each approach so you can make a proper comparison among them. Using the delta value of an options chain is one way that you can get a good sense for how much leverage an option has, as well as the concurrent risk. This can be a good guide to follow for identifying the type of strike price you prefer. Look at Figure 3.2.

Figure 3.2 Suppose you had a signal to buy AAPL today, which is why you’re considering buying a call option on the stock. The stock last traded at $147.53, which means that every contract with a strike price below that level would be considered in-the-money. The $140 strike price, for example, is the closest in-the-money call to the current price of the stock. Every strike price above $147.53 and higher is out-of-the-money.

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Many conservative options traders like to look for options that carry a delta value as close to 1.00 as possible. In this event, the $100 call offers a delta value of .99, meaning that for every dollar AAPL moves, the $100 call will also go up in value by nearly a dollar. Does this mean that this is the option you should use? Maybe, but first a little more evaluation is in order before you decide. Look at

Chapter 3: Call Options

Notes the Last column in the table. This is the last trading price for the option you are considering and will give you a good idea of how much the option will cost you. The $100 strike price will cost you approximately $48.15 per share, or $4,815 in total capital. A $1 increase in this option will give you a return of just over 2%. By the same token, the $120 call option offers a delta value of .90, which is about .9 short of the delta offered by the $100 call, yet it last traded at $29.10. A $1 move in the stock would move the option $.90, this option would yield a return of close to 3% on your $2,910 investment. In this case, the differences are not that dramatic. However, this sometimes is a very valuable drill especially when dealing with options one and two strike prices in-the-money. Evaluating the out-of-the-money call options works the same way. The $150 call option, which is the first out-of-the-money call option available, carries a delta of .48 against a current price of around $8.70, giving you a potential return of 5.5% if the stock moves higher by $1. The $155 call is even cheaper, going for only $6.60, while its delta of .4061 provides a return of 6.1% if the stock moves up by $1. Of course, this option is much further out-of-the money than the others. Many traders new to options make the mistake of picking out-ofthe-money contracts because of the enticing combination of lower cost with higher potential returns. Why is this a mistake? As a society, we are used to trying to get the best possible deal we can on any purchase we make. We want more features and benefits for every dollar we spend, and when we can get them for a cheap price, we pat ourselves on the back for finding a good deal. The problem with this mentality in options trading is that cheaper options mean higher risk. The contracts in Figure 3.2 expire in just over one month. With the stock currently just below $148, what is the likelihood the stock will rise above $150 in just over one month? In the case of Apple, it could happen tomorrow but you also run the risk that Apple will choose to rest the next two months and the considerable money you’ve spent buying out-of-the-money options will make a large flushing sound as it goes in the toilet. You will find that it is usually worth the extra money required to buy options that are closer to the current price of the stock. The decision of whether you should go in-the-money or out-of-themoney lies solely with you. Using the delta can help you try to find 67

Guide to Options Strategies

Notes the best mix of risk and reward for your temperament, needs, and trading style, but you will still need to prove your decision out over time by applying it to your trades and evaluating the results.

Determining Your Time Objective Once you have developed rules around the strike price you will use, you will need to determine how much time to buy. If you have some experience trading options, you have probably already developed a sense of the importance of buying enough time to let the stock work for you because you have had trades that lost money, not because you guessed wrong about the direction of the stock, but rather because you didn’t buy enough time to let the move develop. Following the suggestions made in this section can help you avoid making those same mistakes again. If you are new to options trading, this section gives you the chance to learn from the mistakes of others and avoid many of the most common problems options traders face in making money. Incorporating these suggestions into your trading rules, whether you are experienced or not, can help you accelerate your learning curve and develop a solid options trading system. As noted before, one of the easiest mistakes to make in options trading is to not buy enough time to let a stock make the move you want. Your technical analysis should give you a good sense for what the future direction of a stock is likely to be; identifying short, intermediate, and primary-term trends is the most effective way to forecast future price movement. However, the point that many traders fail to learn without first making several bad options trades is forecasting how long that move may take. Look at Figure 3.3.

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Figure 3.3

Chapter 3: Call Options

Notes In this chart, FSLR was in a trading range from roughly 175 at support and 225 resistance. It has just broken resistance and could be poised for a strong upside move. The next closest major resistance is 275, meaning that it has shown the capacity to move +/- 50 points in a 30-day period. The next step to complete and to determine how much time you should plan to buy for this trade, is to look at the stock’s movement over the past year. How long does it typically take for the stock to move $50? In the last quarter of last year, FSLR moved about 75 points each 30-day period. This is a significant move to the upside. After a very strong upward trend, it began a longer downtrend with concurrent $10 or greater moves in a short period. However, over the last couple of months, as demonstrated in the chart in Figure 3.3, the stock’s volatility has dropped off; the stock now seems to make a $45 to $50 move in a month’s period of time. This means that if you wanted to take advantage of the entire $50 range between $225 and $275 if the stock breaks its current resistance, you should plan for an options trade of at least two months. The stock has a 30-day swing, it’s true, but the swing is not dependent upon beginning of the month to end of the month dates. More time for more insurance. Your analysis of FSLR has demonstrated that it is a money maker… but because it’s a huge money maker, it can also be a huge money loser. If it suddenly swings down, history illustrates it will do so for approximately 30 days. Buy enough time to prevent yourself from getting whipped out of the trade if FSLR decides to roll back a little. If volatility increases and it makes the move in a shorter time period, then your profit will be even better, but you should plan for at least as long as the stock’s current volatility indicates it should take. Purchasing even more time, maybe four-to-six months, would make the trade even more conservative and increase the likelihood that you will be there for the move if it happens. However, buying more time does not mean that good stop-loss curbs should not be in place to prevent catastrophic losses. The decision about whether you should buy more or less time depends on you, your attitude about the stock you are considering, and to what extent you are willing to let time decay affect your trade. Many options traders fall into the trap of purchasing less time than they need because options with closer expiration dates 69

Guide to Options Strategies

Notes are cheaper. If the stock quickly moves the way you want it to, you will make a large profit; however, if the stock doesn’t move within a couple of weeks, the time decay in the contract will degrade the value of your option to the point that realizing a profit just before expiration becomes highly unlikely. Your options trading rules should reflect whether you intend to take an aggressive approach by buying less time or conservative by buying more. Most successful options traders adopt a philosophy of buying more time than they think they need. For example, if the stock they are considering appears to take a month to move within a specific range, they will usually buy two to three months of time as a minimum.

Applying Reward-to Risk Ratios to Call Options Many traders look for trades that provide at least twice as much potential reward as the amount of risk they took. This 2:1 rewardto-risk ratio evaluation is an effective way to both look for attractive profits as well as minimize your downside risk. This evaluation applies to options trading as well as to stock trading. When you are using call options as a way to leverage long opportunities in a stock, your reward-to-risk analysis will be simplified if you use the stock rather than the option. Looking for the 2:1 reward-to-risk ratio works equally well in options trading. It can provide you with opportunities to take significant profits while still limiting your loss to a relatively low amount, even on an option trade. Perhaps the best aspect of using reward-to-risk ratios in any kind of trading is that it provides a thorough view of all of the possibilities for what the stock could do. Identifying your potential reward usually means evaluating the range between the most current support and the closest resistance levels. If the stock goes up to the top of this range, you will have an opportunity to take your profits. On the other hand, if the trade simply doesn’t work, it will probably drop below the current support; if it does, your reward-to-risk analysis will have identified the stop-loss point at which you will get out. The one aspect of options trading that affects reward-to-risk ratios differently than in stock trading is time decay. Since a stock won’t expire, you don’t have to worry about whether the stock moves the way you want quickly; you simply stay in the play until it goes the way you want or you get stopped out. This isn’t always true in 70

Chapter 3: Call Options

Notes options trading. If you have purchased a relatively short period of time, you will be facing a significant loss if the stock doesn’t move in your favor very quickly. Even if you buy what would ordinarily be a sufficient amount of time, the stock may not move in your favor in the time you have. Time decay alone can add up to a net loss in an options trade if the stock moves against you or simply doesn’t move at all. For this reason, you should carefully consider the effect of time decay in each of your option trades. Measuring time decay can be a difficult proposition if we try to do it ourselves. The following is a binomial table showing the damage theta can cause if a stock does not go in the direction of the trade. For this example, we’ll use a call play. As you can see from Figure 3.4, holding a call option position when the stock is staying flat is not a safe harbor.

Figure 3.4 If the stock stays at $30 a share and the option has 60 days prior to expiration, the decay factor, theta, breaks down like this: 71

Guide to Options Strategies

Notes • 1st day of purchase-no decay • In the first 15 days, the option value falls from $1.53 to $1.30 for a decay of 15% • In the next 15 days, the option value falls to $1.028 for cumulative decay of 33% • In the next 15 days, the option value falls to $.67 for a cumulative decay of 56% • In the final 15 days, the option value falls to $.0 for a cumulative decay of 100% As you can see, theta accelerates as time passes. With respect to theta, if the stock is staying relatively flat for a protracted period of time, get out. Staying in only makes matters worse. The deeper in-the-money or out-of-the money an option is, the smaller the effect time decay has on the contract. How much higher or lower the theta will be tomorrow is something that we can’t evaluate with the information at hand since forecasting future price movement is, ultimately, little more than a “best guess” venture. The main point you need to take from looking at theta is to get a ballpark sense for how time decay is likely to affect your option. Don’t use it as a precise measurement of exactly what time decay is going to do. Think of theta as an added cost you will have to incur no matter what contract you choose, and that the move made by the stock underlying your option must offset. This added cost should be considered as part of the risk portion of your reward-to-risk ratio in any given option trade. When you analyze reward-to-risk ratios, you should make sure that the target price your exit analysis gives you is enough to offset your time decay risk as well as the downside risk identified by your stop analysis. You should also combine your evaluation of theta with your analysis of how long you think it will take the stock to move the way you want. If you forecast a three-tofour month time period for your stock to move and plan to purchase a five-month option, for example, make sure to evaluate the theta value for that five-month option.

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Notes

Planning Your Exit One of the essential components of any trading system is making sure to plan your exit strategy. Most traders tend to think about trading primarily in terms of when they get in to a trade. This rationale is logical since the idea of any trading system is to buy low and sell high. The only problem with putting so much emphasis on the entry portion of a trade is that traders often try to split hairs on the price they buy at—“The option is priced right now at $2.35, but I only want to pay $2.30.” This mindset, then, can lead to traders to “trip over dollars to make pennies.” In the example just mentioned, if the stock moves the way you want and the option increases from $2.35 to $5, does it really make a difference whether you bought at $2.30 or $2.35? This is not to say that you don’t have to wait for a stock to begin the move you want; all of the trading rules you have developed for identifying when the opportunity is ripe still apply. Just remember that if you are confident the stock is going to move in your favor, it is more important to get into the trade than it is to try to get the best price possible. The more effective traders, in any market, understand the importance of identifying exit prices. Make sure you perform a complete analysis of the trend as well as support and resistance thresholds before you enter into any call option trade. You need to identify an entry threshold as well as an exit threshold; neither one should be ignored. Just as with analyzing reward-to-risk ratios, it is more effective to do this using the stock itself rather than the option. Use resistance levels to identify points at which you will either close out your call trade or, if you have purchased enough time, stay in the trade and maximize the trend. If you want to forecast where the option’s price could be if the stock moves to the level you have identified, you can use the delta to calculate the option’s potential increase.

Examples - Call Strategies & Setups Now that we have covered the specific information that you should make sure to account for when you are looking at a call option trade, let’s look at some examples of how to apply some of the stock trading strategies you use to options. We will outline each step of the trade and walk through an evaluation of the options information we need to plan the trade before we place it. Remember, these are only examples of one way to apply the 73

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Notes concepts discussed in this chapter. You can and should use these examples to get your own thoughts started in how your trading rules and system will use options, but make sure that your trading system reflects your personality, trading style, and risk tolerance. Strategy I — Swing Buy (also called a Bull Pullback) The software has a number of excellent searches which find setups with a high potential of being a winning trade. Remember, there is no such thing as a perfect search. One individual trader can make money on a search while another one finds it to be a losing proposition. The swing buy or bull pullback pattern is a favorite among a large number of traders which is indicative of the successful predictability of the pattern. In Figure 3.5, you can see how to set this search up.

Figure 3.5

Technical Analysis The search finds AAPL. Note from Figure 3.6 that AAPL has been on an impressive upward trend over the last month. In the last few days it has been pulling back to the intermediate trend line (red line). Today, on positive earnings projections and new product announcement, the stock has made a classic bull pull back pattern.

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Figure 3.6 Short-term pullbacks in upward trending stocks provide good opportunities for options traders to make relatively low-risk trades with very attractive profit potential. Based on previous peaks and valleys, we can identify support for the stock at around $138 and rock hard support at $120. The support provided by the intermediate trend is around $148. The high peak for the intermediate uptrend is around $160 with a secondary higher resistance at $180. We’ll use our first resistance level of $160. Also, the 52-week high is about $200. Of critical note is the fact that AAPL is declaring earnings on April 23. AAPL is currently trading at $153. On this bull pullback, some traders will buy the May 150c and exit the trade before earnings declaration on April 23rd. The current date is April 16th. The stock is poised to give a good trading opportunity. In addition, the market has been open for three hours and there have been almost 16-million shares traded so far today. This is not remarkable volume for Apple, but it’s also not wimpy. Available Call Options Exploring the opportunity further, we pull up an option table on AAPL to price the May 150 calls.

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Figure 3.7 Swing trades typically last no more than one-to-two weeks at most, so many options traders will look to take advantage of the higher leverage and lower costs associated with very short-term options. The current available month, April, offers the highest leverage, but also a very short window of time. Also, April options expire prior to the earnings announcement coming out on April 23rd. We don’t need more time than May. The May 150 strike price is 11.15 x 11.20 with a delta of 59.23. The May 155 strike price is 8.55 x 8.60 with a delta of 50.75. Let’s concentrate on these two options and determine which option provides the most leverage for the money. 1st Calculation: Buy the May 150c. Pay $11.20 at the Ask Stock goes up $1 (delta = 59.23) Option goes up $.5923 Percent return: .5923/11.20 = 5.2% return on the cost of the May 150c 2nd Calculation: Buy the May 155c Pay $8.60 at the Ask Stock goes up $1 (delta = 50.75) Option goes up $.5075 Percent return: .5075/8.60 = 6.7% return on the cost of the May 155c

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Earlier we stated that you should always buy one strike price inthe-money. However, when the delta is above .50 for any option, it pays to do the math to determine what the highest rate of return is, based on your cost. Options with a value of less than .50 have

Chapter 3: Call Options

Notes a difficult time making money given a short investment period. This is definitely a short investment period. Since the May 155’s have a delta above .50, they’re worth considering.

Reward-to-Risk Ratio Is there enough upside potential in AAPL to justify taking the risk of putting money into the trade? At the end of the day AAPL was trading at 153. The following morning, it opened at $153.65. The low of the prior day was $150. Setting a stop loss at just below yesterday’s low of $150 (down approximately $3) and a profit target of $160 (up approximately $7) gives us greater than a 2:1 reward risk ratio in the stock, which is quite encouraging. Strategy II — Trend Breakout and Reversal

Figure 3.9

Technical Analysis In the chart in Figure 3.9, AEE has been on a steady downtrend over the past few months, and then reversed its direction over the last and made a move to the upside. Four days ago it pulled back and today, corrected. If it continues tomorrow it could provide a good opportunity for a call option trade if the short-term trend continues its upward move.

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Notes We can use the short-term trend line that has formed since the beginning of this upward move as a likely immediate short-term support level at around $45.99, since if the stock breaks down below this level, we could call this move a fakeout move rather than a breakout. We see additional support at around $45. The stock has recently broken above short-term resistance of about $47 and the next likely resistance level is near $53. If this is a legitimate trend reversal, and the stock runs past $47.50 the stock is likely to continue its upward trend to $53.

Available Options See Figure 3.10.

Figure 3.10 With AEE currently just above $45 per share, the first in-the-money strike price for all the contracts listed in Figure 3.10 is $45. If we wanted to be aggressive and increase our leverage, we could purchase one strike price out-of-the-money at $50. For this play, let’s stay conservative and buy the $45 calls just in-the-money. We are forecasting a move from its current price around $45 to $53 in a stock that typically only moves about $2.50 over the course of a normal month. Buying the June contract would give us roughly five to six weeks of time for the stock to make its $4 move—probably not enough time. The next options available are the September calls.

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The September 45 calls are priced at $2.75 per contract share. The delta value is 70.93. That means if the stock goes up $1, the option should increase to about $3.10. Dividing .70 (the delta value) by the value of the contract gives a return of 25%. This

Chapter 3: Call Options

Notes does not take into account the spread between the bid and the ask. Please remember that delta, theta, volatility, interest rate, and a number of other factors play into the calculation of the option’s price. Delta is just a guideline for a small period of time. It changes very quickly. Also delta and theta are not the only factors used in the calculation of the option’s value. Spending an inordinate amount of time estimating the effect of delta on the price of an option can sometimes be an exercise in futility. Many traders believe that it is more important to make a trade with a high probability of reaching a projected profit than structuring a trade favoring the highest leverage value.

Summary Call options provide excellent opportunities to combine the same kinds of short-term stock moves you have already learned to use with the leverage and profit potential of options trading. It is important to make sure that your rules for trading call options reflect the elements of time, leverage, and time decay that exist in all options contracts. Following the process of evaluating the viability of a potential call option trade should begin in the same way as any stock trade: by analyzing the strength of the current trend. Basing your entry, exit, and stop prices on the stock’s movement is also a straightforward, logical way to approach money management in your options trades. In addition to the stock’s trend and support and resistance thresholds, use the delta and theta values of a given option contract to realistically gauge the profit or loss potential of that option trade. This will become an important part of your options trading system as you learn to manage the risk of any given options trade and minimize loss. Maximizing the profit of a call option trade must be contrasted against the amount of time remaining in the contract you have purchased. If you are dealing with a short-term option that expires in two months or less, you will have less opportunity to maximize profit and should look to take quick profits. Buying contracts that extend across a time period of several months can give you better opportunities to maximize profits by staying in a trade while an upward trend is strong.

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4

Put Options

Put options provide an excellent profit opportunity for long trading strategies in stocks making downward moves and trends. In Chapter Three, you learned one of the simplest, yet most powerful ways to trade options: using calls. One of the things about trading calls that makes them so attractive is the fact that you can use many of the same long trading strategies you have already become familiar with as a stock trader. Put options provide a similar opportunity on the opposite side of the market, with excellent profit potential in stocks making downward moves and trends. Playing the downside (usually referred to as the short side) of any market or stock can be part of any established, long-term trading system. Most traders who are new to the market begin by making long trades—buying and then selling—in stocks first. After establishing some confidence and experience in the long side of the market, they next begin to learn about shorting the market using the margin in their brokerage accounts. The same principle

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Notes applies to learning about trading options. For most traders, learning to manage the dynamics of options trades works best by practicing bullish options strategies first. This is the reason the call options chapter precedes this chapter. Put option strategies, however, are just as powerful and can provide, in many ways, even better profit potential. For this reason, any smart options trader will take the time to learn how to incorporate put strategies into his or her trading system.

Review - What is a Put? Chapter One introduced you to some of the basic concepts behind a put option. If you have never tried to profit from the bearish side of a market, the simplest way for most new traders to think about put options is to contrast them against bullish trades. If you think a stock or market is going to go down in the immediate future, put options give you the best opportunity to make a profit. Put options give you the ability to reserve a selling price for the underlying stock ahead of time. If the stock drops below the price you have reserved for yourself, you can buy the stock at the current price and then sell it back to the market at the price you reserved. The concept of shorting actually applies in more areas than just the financial markets. Grocery stores are just one common example. A grocery manager may know that he needs to stock up on hot dogs, hamburgers, and other barbecue fixings in advance of the Fourth of July. He knows he will be able to mark these items at a higher price than he normally might because demand for them is going to be particularly high going into the holiday. Because he might not have the cash flow to pay for the entire order up front, suppose the grocery manager uses a line of credit to buy the items he needs and stocks up his shelves. After the holiday has passed, he can use the money he’s made by marking the items higher to pay off the line of credit and pocket the difference. A very similar process happens when you short a stock. The advantage of a put is that, unlike shorting, you don’t have to use margin in your brokerage account to reserve the right to profit when the stock goes down. You only need to pay the cost of the put option, which will be a fraction of the cost of 100 shares of the stock. The strike price of the option is the price you have reserved the right to sell the stock at. If the stock drops, you can exercise 84

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Notes the put by buying the stock at the current price, and then sell the stock back to the market at your strike price. You can also choose not to exercise the option and simply sell it back to the market. Since the stock is below the strike price of your put option, you will be able to get a higher price for the option than what you paid for it. Simply closing out a profitable put trade is the course of action most options traders take.

Why Trade Puts? A common adage states, “What goes up must come down.” It’s physics, right? You can’t jump up into the air without coming down. The same is true of the stock market. Everybody loves to see stocks going up, but smart traders understand that bull markets only last so long. Every upward run comes to an end at some point, and when it does, it usually leads to a downward turn. Downward trends in stocks are sometimes very short-lived, but they can also turn into long, extended pullbacks. Both situations offer opportunities for astute options traders to make money with puts. Look at Figure 4.1.

Figure 4.1 In March, Intuitive Surgical (ISRG) ran from $250 to $350. However, we can see that the stock began to hit resistance at its

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Notes high price of $350 per share. Finally, after the third sloppy bounce off of $350, the stock fell through the support offered by the upward trend, as indicated by the green line in Figure 4.1. This precipitated the consolidation the stock now finds itself in. This appears to be a good opportunity for a put play. The short-term trend to the downside established the first of May might continue. It appears that the cycles for this stock last approximately 15 days. Since ISRG is in the middle of a cycle, there are about 7-10 days left in the current cycle. The stock price is about $287.57. Support is at $275. That is a potential dollar move of $12. If ISRG breaks through resistance at $275.00, its next resting place (support) is around $250. One of the most powerful tools in the software is its dynamic risk graph module. Let’s use it now to illustrate the projected profit of buying a put on ISRG. Figure 4.2

Figure 4.2 shows that we can buy a July 290 put for $24.65. That’s 100 x $24.65 for a total of $246.60 + commissions to make the trade. Since there are so many different commission structures, we will leave those out of the equation. Just know that they exist. We also set up the risk graph to show the profit curve with a 30-day time frame. That means all calculations are done at the end of 30 days. If the stock goes down, it considers it to have happened at the 30-day mark. Remember that we projected that the stock would fall from $287.57 to $275. History shows that it could happen in 15 days. We’ve given it an additional 15 days to hit that mark. 86

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Notes If the stock performs as expected and is at $275 on day 30, we will have made about $915 on our investment of $246.60. Of course if the stock goes nowhere, the option expires worthless. We don’t want that to happen of course ,so we set a stop loss of roughly 30% below the purchase price of the put. Also, ISRG might fall but not to the level we expected. If it suddenly shows strength and starts back the other way, exit your trade and take your profits. One of the things about downtrending stocks that makes them so attractive to options traders is the rate at which stocks decline in value. Think of a rollercoaster at an amusement park. Most start with a long, gradual ascent to the highest point of the ride. This can be favorably compared to the long, extended uptrends stocks often experience. What happens after all of the cars have crested the top? The entire coaster careens at insane (or exhilarating, depending on your perspective) speeds to the bottom. The same thing often happens to stocks at the end of an upward trend—after everybody has realized the upward run is over, they all try to get out at the same time, sending the stock crashing, often to amazing lows. Smart traders learn to identify, through technical analysis, when these drops are likely to occur and take corresponding short positions. Then, just like the enthusiastic rollercoaster riders hanging at the edge of that first steep descent, all they have to do is hang on and wait for the drop. Once it happens, they take their profit and look for another trade. Of course, this isn’t a foolproof strategy; sometimes a stock simply pauses in an upward trend for a period of time, and then continues its run. This is why the same approach to stop losses and money management is necessary when you trade puts as you would use in any other type of trade. The purpose for this chapter is to help you learn to identify when a stock is about to begin or continue a downward trend and how to construct a put options trade that you can use to take advantage of it. We will also discuss methods to minimize and manage risk in put options trades. Because stocks in downward trends often drop very quickly, trading put options is a strategy that generally doesn’t lend itself well to extended periods of time. A common mistake option traders make with puts is to try to squeeze every last bit of profit in a downward trend. Most downward trends don’t last as long as a stock’s upward trend, although they may be just as severe as

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Notes or even more dramatic in price decline than the increase in price experienced in an upward trend. This means that you should typically plan to take quick profits when you have them. We will examine this fact in more detail later. Many traders who first begin learning and trading options tend to gravitate towards the options trades that most closely approximate the approach they use to stock trading. In other words, if you have become familiar with buying a stock and selling later at a higher price, you will naturally lean towards trading calls. If you are already familiar and comfortable with shorting stocks, then trading puts will be an easy fit for your style. This is a good thing; the more you can replicate what you have already done successfully in the stock market, the better your chances of making money in the options market are. Even if you aren’t already familiar or comfortable with shorting stocks, however, you should still take the time to learn how to use put options to take advantage of downward trends. Successful traders make sure they know how to trade in as many markets and environments as possible. Were you in the market in April of 2000? If so, like most people, you probably didn’t think the bull run would ever end. But the people who made money that year, and the next, were the ones who knew how to adjust when the market adjusted. Learning how to trade puts is just one way to make sure you can do exactly that. If the market in general is dropping, which does happen more frequently than many people think, the worst thing you can do with your money is to place bullish trades. Many traders in this situation simply put all of the money in cash and wait for the market to begin to go up again. Couldn’t you do better than earn 1 to 2% interest in a money market or cash account while you’re waiting for the market to go back up? Trading put options will allow you to respond to the market and keep your money in the types of trades that market conditions dictate will be the most likely to make money. This section only discusses trading puts as a growth strategy to take advantage of downward movements and trends. There are other approaches to put trading, such as selling puts, which emphasize income. These strategies are outside the scope of this material, but are available to explore.

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Fundamental Analysis and Put Options Fundamental analysis provides an effective way to make sure that the stocks you are considering have strong business reasons for moving up; thus, looking for fundamentally strong stocks generally applies to bullish strategies. Fundamental analysis does have a place on the short side of the market; just as in bullish trades, this is an area that many traders neglect to pay attention to. If fundamental strength provides a reason to look for bullish trades in a stock, it stands to reason that fundamental weakness gives you a reason to look for bearish moves; however, be careful about making this assumption too much. Fundamentally weak companies often go up and experience dramatic bullish moves just as fundamentally strong ones do, so fundamental weakness doesn’t always equate to the expectation a stock will go down. To put fundamental analysis in its proper context in put options trading, think about some of the characteristics that fundamentally poor stocks often have: • They tend to be more volatile, providing larger swings and trading ranges between support and resistance levels. Bounces off resistance provide opportunities for put trades with good reward-to-risk ratios. The higher volatility associated with weak stocks means that when they begin a downtrend, they would be more likely to break existing support levels than stronger stocks, which often show resilience around support. • The factors that drive these stocks up tend to be based primarily around the news. Speculation, favorable rumors, and “hot buzz” often lead to the dramatic price increases you will see in fundamentally weak stocks. By the same token, any kind of negative news or speculation will send the stock spiraling downward very quickly. These kinds of events often lead to extended downtrends in fundamentally weak stocks. These downtrends may provide multiple opportunities for profitable put trades. • Fundamentally weak stocks generally have a more difficult time sustaining upward trends than strong stocks. If you see a fundamentally weak stock in an upward trend, check 89

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Notes the news to see if you can determine what is driving the upward move. If you find that improving fundamental information such as increasing sales and earnings are the driver, the stock may continue its upward trend for a while. On the other hand, if the news driving the stock is speculative in nature, then you may want to watch for the stock to become overvalued and drop below its trend lines. These might give you early opportunities to make a good put trade.

Technical Analysis and Put Options You should already be familiar with identifying and drawing downward trend lines. The Threshold Trading Method is equally well equipped for dealing with bearish trades as it is with bullish ones. Remember the basic rules of threshold trading: 1) Trade in the direction of the next longer trend. 2) Identify three levels of support. 3) Identify three levels of resistance. Most bearish trades are very short-term in nature; therefore, your highest-probability put trades will generally come in stocks in intermediate downtrends. Identifying three levels of support will help you identify likely exit thresholds, while identifying three levels of resistance will give you an indication of where your entry thresholds are likely to be. The range between current support and resistance levels in relation to the current price of the stock will also give you a way to determine if the time is right for the trade or whether you should wait for a specific event first.

Deciding How Much Time to Buy The question of how much time you should buy is an important part of a successful options trading system. The way you answer the question will be dictated, as with most questions related to risk, in large part by your personal aggressiveness and tolerance for risk. There are a few different ways to apply a put options trade, which are outlined later in this section. Each of these strategies and setups has a slightly different perspective associated with time decay risk.

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Notes Go through each strategy thoroughly and practice them on paper so you can be well associated with the impact time decay will have. To simplify their system, many traders will simply apply the same logic about time decay in put options as in call options; they look to buy more time than they think they need. This can be a good guideline to follow in put trading, but you should remember that put options with longer expiration dates tend to be even more expensive than equivalent call options. Don’t fall into the trap of buying several months away from expiration in put options. This can make a call trade more conservative and increase the chances of a successful trade, but in the case of put options, the extended time in the contract tends to detract even more sharply from the effectiveness of the trade than in call options. The reason buying more time in a call contract is a good strategy to apply lies in the fact that stocks tend to go up more than they go down over time. This is also the reason that buying more time when you trade puts is more dangerous. If your short-term forecast leads you to believe a stock is going to drop significantly enough to warrant a put trade, you should generally look to buy no more than one month longer than you believe the drop will take. If the stock is going to drop, it will generally happen sooner rather than later. The longer you hold onto a put trade in a stock that is showing resilience at a support level, the less likely the stock is to actually drop for you. In the meantime, the put option will continue to decay throughout the period you hold it. If you do eventually happen to get the drop you had previously anticipated, the stock will have to drop more than your original analysis predicted in order to yield a respectable profit. At this stage, time decay will likely have eroded the value of your option to such a point that you won’t be profitable. You will usually be better served by keeping a short-term perspective on put trades and getting out of them quickly if the stock doesn’t drop the way you thought in a short period of time—even if the stock hasn’t violated your stop loss price.

Finding Stocks to Trade with Put Options There are a number of methods you can use to find stocks that provide good trading opportunities with put options. Some of the tools available to you include:

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Notes • Your broker’s website • Your watch list • Seeker™ scans

Your Broker’s Website Most online brokers provide several tools to help their account holders find trading opportunities. Many of these tools, if used properly, can give you timely information about stocks that are ready to make downside moves. Familiarize yourself with any searching tools your broker offers, and contact them with any questions you have.

Your Watch List A broad, sufficiently large watch list will help you keep track of stocks you are already familiar with and identify opportune times to place trades—on both the long-and-short side of the market. By now, you should have already created a watch list with numerous stocks in it. A broad watch list is one that includes stocks from a wide range of sectors and industries. Many traders tend to focus on one sector or industry—technology or pharmaceuticals, for example—but in doing so they actually limit the opportunities they get to take advantage of. The broader the list is, the more opportunities you will have to place trades in any kind of market. This is because when one sector is down, you can almost always find another that is moving up. At any given moment in time, in any particular market or economic setting, there are always sectors that move up or down in contrast to each other, while still others move sideways, without any particular direction. Each of these situations can be taken advantage of by smart traders, and your watch list is the tool that will allow you to make sure you can respond to whatever condition a given sector or industry is in. Central to the operation and execution of an effective watch list is the amount of time it takes you to analyze stock movements on a day-to-day basis. Although any watch list can be effective, don’t forget that you have access to powerful, easy-to-use charting 92

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Notes and analysis tools that will greatly simplify this aspect of your trading system. With these tools, you can quickly analyze the current market action on any stock and identify optimal trading opportunities as they arise.

Seeker™ Scans Seeker has a variety of scans that can help you identify stocks at several different stages of a downward trend. Seeker scans are based on specific types of stock movements over varying time periods. These time periods can be as long as one week at a time or as short as five minutes. In this section, the scans we describe are specific to one-day periods and are just a few examples of some of the bearish scans that you might find helpful. Experiment with the scans yourself to identify the ones that you specifically find applicable to your trading style. • Daily Swing Sell Watch list — This scan identifies stocks in current downtrends. Just as in an uptrend, a stock won’t always track close to its trend line. It will often extend away from it, then retrace back towards it. A stock may do this several times in a given trend. This is as true of stocks in a downtrend as in an uptrend. This scan looks for stocks that have dropped well below their downward trend lines, but are now retracing back up to it. Stocks in this environment are likely to bounce off the resistance found at the trend and move lower again; this scan attempts to identify stocks with good chances of bouncing lower before it actually happens. • Daily Breakdown Short Watch list — The stocks that this scan identifies are typically at the extended top of an upward trend, with a repeated failure to create new highs, or are in already established downtrends. In both cases, the stock will have entered a “consolidation” phase during the most recent few days, meaning that the stock has begun to trade sideways. In addition, their daily trading range during this consolidation phase will usually be significantly lower than in the time periods previous to the consolidation. This lower volatility combined with a failure to create new highs is usually seen as a bearish indication, which makes many of the stocks this scan highlights worth watching for a bearish move to confirm the downward forecast. 93

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Notes • Bear Area Stocks — This scan identifies stocks in similar situations to those that come from the daily swing sell watch list, but provides more specific information. The “bull area” or “bear area” on a stock chart can be seen by applying multiple moving averages to a stock chart. The bear area is identified as the space between downtrending 20-day and 50-day moving averages. When a downtrending stock rises above its 20-day moving average, the likelihood that the stock will bounce off the 50-day moving average and continue its downtrend is significantly increased. Since this scan identifies stocks that have entered this bear area within the most recent few days, you will be looking at stocks that are likely to drop but haven’t done so as of yet. You should make sure to wait until you get confirmation the drop has occurred before taking a trade.

Put Options Trading Rules Just as with trading calls or stocks, you will be more effective as a trader with put options by following specific rules you have outlined for yourself about the types of information you will look for. The types of technical signals you should look for in put trades vary according to where a stock is in its trend and trading range. These signals are outlined more specifically late in this chapter in the Put Strategies and Setups section. The use of trading rules doesn’t apply only to the technical signals you have decided you will wait for. In options trading, it also applies to the information about the contract itself: the strike price you want to buy at, how much time you want your contract to carry, the risk you are taking contrasted against the opportunity you have, and what you will do in the event of either a profitable result or a loss.

Choosing a Strike Price Choosing the strike price you will use in your put trade is a critical question you must answer. Just as with call options, buying in-themoney puts is more conservative the deeper in-the-money you go, while buying out-of-the-money contracts is more aggressive the further out-of-the money you are. Whether you decide to go in-themoney or out-of-the money, a good general guideline to apply to put trading is to not go further out of the money than the nearest 94

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Notes out-of-the-money strike price to the underlying stock’s current price. Going deep in-the-money simply makes a trade more conservative, but remember that by doing so you will have to place a significantly greater amount of your money into the trade. Making an options trade more conservative by going deep in-the-money doesn’t increase the odds that you will place a winning trade; it only improves the likelihood that if the stock moves against you and you need to get out, you will be able to do it without incurring a large loss. Being able to minimize loss is critical to the success of your options trading system, and this can be effective. Just remember that you will be using larger amounts of your capital to do so. The more money you put into a trade, the smaller your profit will be if you are right, because your leverage is lower than with a strike price that is closer to the current stock price. Many traders prefer to defer the decision of whether to buy inthe-money or out-of-the-money contracts until they are ready to place a trade. This means that before they place the trade, they must complete another step in their analysis. In the last chapter, we discussed using delta as a way to identify which contracts are likely to provide the best value for the given opportunity you are looking at. This analysis can be applied with equal effectiveness to put options once you have considered how much time you want to buy. Let’s apply this analysis to an example. To find a viable put, let’s give ourselves as much advantage as is possible. Let’s look for stock that is losing price on increased volume. Seeker has an excellent search engine under its basic scan “Top Losers on Increased Volume.”

Figure 4.2

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Notes The results are in alphabetic order. We will select VLO because it has a negative five-star rating and its price is above $20. At the risk of sounding predatory, it has room to fall. Figure 4.3 is a side-by-side chart comparison of VLO using a 60-minute chart and a daily chart. In both time frames, the stock is headed toward the basement. Notice in the daily chart, VLO has just broken through a triplebottom resistance at about $45. Further, the 14, 5, 3 stochastic shows no sign of reversal.

Figure 4.3 VLO is currently trading at $44.56. We need to check news and find why VLO is in this downward trend.

Figure 4.4 96

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Notes Earnings is the culprit. Usually when a stock falls as a result of bad earnings there is an initial opportunity created to take advantage of the “market shock and awe.” Perhaps a five-point play. It is, in any case, a short-term play. An initial trade with June Options may be prudent. VLO is an energy stock. Going into summer is usually not a wise time to bet against energy for a long period of time. Checking for put options we obtain the option chart seen in Figure 4.5.

Figure 4.5 The June 45.00p are going for $2.82 at the ask. There is a substantial volume on these puts and the delta is -48.46. The June 42.50p (one strike price out-of-the money) are going for $1.62 at the ask. There is respectable volume and the delta is -33.60. If we compare the two respective positions to determine maximum leverage we get the following results: June 42.50p June 45.00p

.3360/1.62 = .20 .4846/2.82 = .17

Said differently, for every dollar we invest in the June 42.50p we will receive $.20. For every dollar we invest in the June 45.00p we will receive $.17. That assumes, of course, that the stock goes the direction we have anticipated.

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Notes From this perspective, it appears the June 42.50p options are the better play. They are not, however, the safer play. The laws of probability always favor the plays that are just in-the-money as opposed to those which are just out-of-the money. Which option to buy is left to the discretion of the individual investor. If there were a “best” solution, there would be no other options sold at a different strike price.

Determining Your Time Objective When using call options, a common principle many options traders follow carefully is to buy more time than they think they need. This approach minimizes the effect of time decay and allows a trader the choice of staying in a trade longer if a stock shows strength in its trend so as to maximize its profit. It may sound logical to take the same approach with put options trading, but be careful. Put options with longer expiration dates tend to be more expensive than the call options with the same expiration. This means that even though you can minimize time decay in your put trade by buying more time, you will usually do so at a much higher cost; the cost may be such that if the stock moves in the direction you forecast, you won’t get enough profit in the trade to justify the amount you risked. This is simply because of the fact that stocks tend to drop more quickly than they rise in price. Corrections and downward trend reversals are harder to maintain in most stocks than are rallies and upward trends. You can generally assume that if the stock is going to drop, it will do so in a short period of time; if you don’t get the drop you anticipated within a week to two weeks, it is unlikely the stock will give it to you, and you would be best served to close out the trade and look for something else. For this reason, a good guideline for choosing your expiration dates on put options trades is to buy no more than a month of time more than you expect it will take the stock to make the drop you forecast. Identifying how quickly a stock will likely drop to a support level or to your target price is not an exact science and will vary depending on the type of put trade you are placing.

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It is important to note that there is an inherent danger of projecting an option price based on the delta and theta. Because there are actually six elements in an option formula, using just two of them to

Chapter 4: Put Options

Notes determine the advantage of a one option position or that of another by just using two of the six elements is overly simplistic. The elements in the formula are: n s = the price of the underlying stock n x = the strike price n r = the continuously compounded risk free interest rate n t = the time in years until the expiration of the option n

= the implied volatility for the underlying stock

n Ф = the standard normal cumulative distribution function Taking the time to gather all the data required by the Black-Sholes formula to make an accurate projection is an exhaustive process. An Excel spread sheet calculating all the elements in the BlackSholes formula and making two additional assumptions necessary for a valid projection is illustrated in Figure 4.6. The two additional assumptions are the predicted future price of the stock and the date on which that price will occur. In this example, the future date is arbitrarily set at June 10 and the price of the stock is projected to drop an additional $5 on that date. Now, taking into consideration all the dynamic formula elements, you can see from the spread sheet that the 1st strike price in-the-money has a greater rate of return. That option would be the June 45 puts.

Figure 4.6 In doing projected calculations without the benefit of a sophisticated spread sheet, do not fall into the trap of using a static delta value 99

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Notes for movements greater than $1. As the price of the stock changes so does the delta value. Assuming it will stay the same over a $5 movement of the stock is not a safe assumption. When trying to figure out which expiration month you should use, remember that if all other information is equal, buying adequate time to let the stock move while minimizing the effect of time decay is generally the best strategy. Again, remember that buying as much time as possible may not be the most effective approach— January may or may not be more profitable or effective at managing loss than November, for example—so you have to find a reasonable balance. Experiment in your first several put options trades with different expiration months to develop a feel for how much time works best in the application of your trading system.

Planning Your Exit You are probably used to identifying a specific target price on any stock trade you make. This target price is a level at which you need to re-evaluate the stock’s move and its current strength, and determine whether it is time to get out of the trade or stay in it and let the trend continue to work for you. Planning your exit helps you to rationally and objectively manage the decision you have to make once the stock has reached your target price; you have already thought about what you will do when the stock gets there, so you don’t have to deal with indecision or “what if” questions. This is an important element of a successful stock trading system, and it is no less important to successful options trading.

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Notes

Figure 4.7 In Figure 4.7, we see that VLO stock has just broken through a double bottom at approximately $45. Prior to that it broke through a triple bottom at about $47.50. In the last seven trading days, it has fallen six points. We are going to assume, given the trend, the news and the time frame of the previous seven days, that the stock will fall another $5 on or before June 10. There is nothing magic about June 10. But if it has not moved to that point by that date, it’s time to take your money off the table and look for another opportunity. If the stock falls $5 three days from now, take a serious look at exiting the trade. Once again, the only thing predictable about the market is its lack thereof. The stop loss should be set at about 30% less than the purchase price of the option. There are no hard and fast rules about stop losses. All traders wishing to maintain a friendship with one another agree to disagree on where to establish a stop loss. Set it at your own comfort zone. If you’re getting stopped out of your trades too quickly, then make it more generous. If you’re losing too much before you get out of the trade, make it tighter. Remember that when you are trading a put option, trying to maximize a trend is usually more dangerous than advantageous. Unless you see clear indications of continued weakness in the stock—high-selling volume along with an increasing number of short positions, for example—the best general guideline to use is to sell your put and close the trade once you reach your target price. If the stock does continue its downtrend, you will likely get another trading signal before too much longer.

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Notes The next section will demonstrate specific applications of planning your exit following the principles discussed here.

Put Strategies and Setups In general, there are three specific strategies you can apply to put options: 1) Stocks beginning new downward trends 2) Stocks in current downtrends 3) Trendless stocks trading at the upper end of a trading range

Stocks Beginning New Downward Trends Stocks that have just begun or are about to begin new downward trends provide the earliest opportunities to place a put options trade. Just as we like to buy calls for a stock at the earliest confirmed indication of an upward trend breakout that we can find, buying puts on a stock at the earliest confirmed indication of a downward trend breakout that we can find provides the greatest overall opportunity to reap a significant profit. Look at Figure 4.8.

Figure 4.8 102

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Notes The stock in Figure 4.8 has begun to make a significant move to the downside and just started a downward trend. It moved below its 50 sma three days ago. The 50-day moving average is often a critical support point for a stock in an upward trend; professional investors and institutions will often watch for a break below this level as an indication of a genuine trend reversal. Let’s apply our threshold analysis to this stock.

Threshold Analysis Look at Figure 4.9

Figure 4.9 The stock’s primary and intermediate trend lines are clearly moving up; however, the stock has found significant resistance at the $67.50 level. An attempted breakout at the middle of April and again near the end of the month failed very quickly, which lends even more strength to the resistance at this level. In addition, at today’s close, the stock closed below the support provided by the primary trend line. Even though today’s price action was positive, it failed to rise above the intermediate trend line, suggesting that the stock may now be finding resistance in that price area. The volume three days ago as the stock broke below the 50 sma was quite a bit stronger than the volume of the last week, while the volume for today’s attempted rally was measurably lower than yesterday. All of 103

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Notes these readings point to an overall bearish current view of this stock. The factors just described can all be taken as early indications of a bearish trend reversal, at least for a short-term trend time frame. The stock is presently around $65.71; its most immediate level of support is now around $65. Let’s assume that if the stock closes tomorrow or the day after below the current support at $65, we would want to initiate a put options trade. This would apply a simple price filter to our threshold analysis; we could also stipulate that selling volume continue to be at least as large as the volume shown in today’s upward move to add an extra filter and make the trade even more conservative. We will place our entry price at around $64.75; if the stock reaches this area, we will buy a put option. Additional support can be seen around $63 and $60, as demonstrated by the upward trending primary trend line. Since our entry point is quite close to the secondary support, justification for the trade can only be made if there is strong evidence that the stock will fall to at least $60. Looking at a risk-reward graph on AFL in Figure 4.10 and projecting 15 days into the future with a predicted stock price falling to $60.00, we buy 10 contracts of the June 65p at $1.85. According to the risk graph (which considers all the Black-Scholes elements) our puts will be worth $3.37 per share or $3,373. Our purchase price was $1,850. That is a net profit of $1,523.

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Figure 4.10

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Notes Trying to jump into a put trade on a stock that appears to be on the verge of starting a new downtrend can be tricky and somewhat hazardous. Naturally, you have to be wary that the downside breakout you are looking at isn’t actually a fakeout; this is why you need to be careful to apply filtering rules to the signals your threshold analysis gives you just as you normally do on bullish trades. The other aspect of downward trending stocks that often makes this a difficult trade to actually place lies in the increased volatility stocks often experience as they initiate a new downtrend. Look at Figure 4.11.

Figure 4.11 Early in May CCOI began a strong uptrend. However, in the face of disappointing earnings, it gapped down almost five points. This type of action is fairly common in stocks as they begin a new downward trend. Extreme sell-offs that trigger downward trends often force the stock to exceed its normal daily trading range by a large amount, which produces the gap we see in Figure 4.11. If the gap is large enough, the stock can often find support very quickly at the bottom of the gap space, meaning that if you didn’t get into the put trade before the gap occurred, there isn’t likely to be much downside left in the stock. One of the mistakes traders will make when they see a move such as this is to “chase the stock”—they will be afraid that if they don’t 105

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Notes get in as soon as possible, they will miss whatever opportunity might be left. Don’t let an extreme move to the downside ruin your objectivity; a simple way around the problem is to ignore the stock for the rest of the day and see what its movement is like the next day. Be careful to identify the current support and resistance thresholds that apply to the stock now; if it continues to move lower, for example, closing just below today’s low price on higher than average volume, there may still be enough downside room left to afford you an opportunity to trade. In these situations, you should also remember that although a stock may be poised to experience a significant drop, any positive catalyst—a favorable guidance report, a bullish analyst upgrade, etc.—could also cause the stock to move to the upside and begin a new uptrend. This is why you should make sure to wait until the stock actually does break below support and begin the downtrend. If it breaks, it could gap lower, which means that you should expect to miss many of these moves. The gaps often mean that your reward-to-risk ratios in the trade no longer work in your favor. Since your objective is to identify trades with the highest possible odds of success, understand that many of these moves will happen so fast that you won’t be able to take advantage of them, and that is all right. There is always another opportunity. In fact, when you miss moves in stocks that gap lower, your next approach should be to watch for the next setup: stocks that have already begun a downward trend.

Duration of the Trade Trying to take advantage of the drops a stock makes as it begins a new downtrend can provide opportunities to take greater advantage of the price range of a downtrend than many of the other strategies that can be applied to put options trading. However, remember that downtrends typically aren’t as easy to sustain for extended periods of time as strong uptrends. Because of this, few downtrends actually last longer than a couple of months. In general, one of the most effective strategies to use when planning a put options trade in a stock that is about to begin a new downtrend is to purchase sufficient time to allow the stock to begin the downtrend and make a large enough move to give you a good profit. But planning to stay in a put trade throughout a downtrend is a risky and expensive trade. Once you have identified the most immediate support thresholds for the stock you 106

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Notes are about to trade, you should be prepared to exit your trade and lock in your profits at these levels. Look back at Figure 4.11.

Figure 4.11 CCOI dropped from $32.50 to $30.97 and broke its 50 dma. If you entered the trade here and purchased 10 put contracts, you would be in a favorable position two days later as the stock fell to $28.42 as seen in Figure 4.12.

Figure 4.12 107

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Notes The eternal question do you take your profit or let the play run? Assume the put option cost $1 per share. The stock fell in price about $2.50. The option probably increased in value $1.25. You’ve made over 100% on your investment. You may seriously wish to consider taking the money and running. Frankly there’s not time to perform additional analysis. The stock can stabilize or run the other direction just as quickly as it fell. Reconsider the trade and if the indicators signal re-entry you can get back in, but protect your profit first. It is common for a stock initiating a new downtrend to breakdown and then find support. However, when it does finally find support, the stock typically will attempt to fill the space between support and those previous highs. Fighting against a new downtrend, the stock will require a greater amount of time to fill a portion of the space before any further action occurs that could continue the downtrend. This rally attempt, and the time it takes, will erode your profits at rates that you may not be able to recover from if the stock does continue its downtrend. The moral of the story is simple: If you are fortunate enough to get into a put trade at the beginning of a new downtrend, be prepared to take your profits as soon as the stock finds support. Thus, you should plan to purchase only enough time to allow the downtrend to continue. Purchasing more than two to three months’ time in this type of put trade is usually more costly than it is effective.

Stocks in Current Downtrends Look at Figure 4.13.

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Figure 4.13

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Notes HMC began a new downtrend near the first of May and continued by breaking below its 20 sma shown in Figure 4.13. It dropped from $33 to $31 in five days. While this is not a substantial amount it promises a $3 stock play or perhaps a $2 option play in the next five to eight days if it holds pattern. Assuming the $30 puts initially cost around $2, that approaches 100% return in a very short period of time. Stocks in these situations can provide good trading opportunities if you can apply a little patience and wait for the proper signals. These are generally considered to be the types of put options trades that carry the least risk since the stock has already begun a downtrend. Just as a stock in an upward trend will experience occasional retracements to its trend lines before bouncing and continuing upward, a stock in a downward trend will experience occasional short rallies to its downward trend lines, then bounce and move lower. These bounces are the put options trading opportunities you should look for in these situations. Let’s discuss how to identify the signals that you can use to take advantage of these opportunities.

Threshold Analysis Look at Figure 4.14. Figure 4.14

Figure 4.14

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Notes SGR has been trending downward since the last part of February. Over the past 10 days, the stock has consolidated. It appears to be finding substantial support at the $50. It hit this bottom three times since April (strong triple bottom signal). That can be a basis for a return to the $55 level. However, if it breaks through the $50 support, it may be an excellent put play. Stochastic and MACD, while not conclusive, do not show positive direction.

Confirmation Indicators In this type of put trade scenario, paying attention to the direction of the MACD histogram and stochastic lines can be helpful. The MACD histogram in particular can aid in the timing of your put trade. Look at Figure 4.15.

Figure 4.15 As a stock in a downward trend attempts to rally above its downward trend lines, watch the MACD histogram carefully. The end of the rally can often be found when the histogram makes a peak, then drops off of the peak. It isn’t necessary for the histogram to cross the zero line; if you wait for this to happen, the drop you are looking for will have already occurred and you will miss your opportunity. Although stochastic doesn’t necessarily provide a trading signal in this kind of trade, it can be used to provide additional confirmation of the analysis that has led you to consider this type of trade. In Figure 4.15, we can see that stochastic has moved strongly to the downside. This is an indication of the lack of bullish momentum in the stock, and lends credence to the trade we are considering.

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Notes

Warning! Be careful about trying to maximize the downward trend in this type of trade. Remember that downward trends are generally harder to maintain than upward trends. This means that the bounce you identify may be the only bounce the stock will see in a downward trend. This is usually truer if the underlying stock has strong fundamentals behind it. Some traders will purchase more time for their put option trade to attempt to stay in the downward trend for as long as possible. This is risky since longer-term put options tend to become quite expensive and staying in a downward trend hoping for an additional bounce lower increases your exposure to time decay in the put option. Generally, the best approach is to buy enough time to allow the stock to make the short-term drop you forecast, and be ready to take profits once it reaches your target price. If the stock does continue its downward trend or stage another rally to its trend lines, you may have an opportunity to place another low-risk put trade by applying the same method again, but since you would be waiting for the bounce lower to begin, you don’t expose yourself to the same risk you would if you were already in the play and the stock broke resistance to begin a new upward trend.

Duration of the Trade One of the advantages of using put options on stocks that are bouncing lower off of trend-driven resistance is that this bounce will usually lead to a continuation of the downtrend. Stocks that bounce off their downward trend lines will often bounce more than once, providing multiple opportunities to use this strategy. However, you should plan to use a separate put trade for each bounce rather than purchasing a single put option with enough time for any bounces lower the stock could make. A bounce off resistance in a downward trend will usually only last a few days to a couple of weeks at the most; planning to be in a put trade for a longer period will place you at risk of eroding your profits when the stock moves in your favor. Thus, this type of move usually works well with put options that have an expiration of no longer than one to two months. Using these shorter expiration periods will also reinforce the need to take quick profits when you have them rather than trying to stay in the trade hoping the stock doesn’t find resistance. Look at Figure 4.16. 111

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Notes

Figure 4.16 Notice that WB has been in a downtrend since mid-October. After reaching $30 in mid January, it rebounded to around a consolidation point of $37. The news about the financial sector has been unkind, even in its positive moments. Assume you believe WB is going to continue to fall. Because of your belief, you bought a March $40 put for $2. On March 14, the stock closed at $26.54. You have a $10.50 move on the stock and probably a $7 increase in the value of your put now showing a value of $9.

Trendless Stocks at the Hig End of a Trading Range Let’s look back at Figure 4.13.

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Figure 4.13 From late 2004 until May, SYMC began a strong downtrend that provided several good put trading opportunities. Since then, through the time represented in the chart, the stock has been trading largely within a fairly specific trading range. These trading ranges, or “channels” as they are often referred to, can provide reasonably good put option trading opportunities as long as your analysis of the stock, from a fundamental and technical perspective, doesn’t lead to a bullish attitude for the near future. Assuming that factors such as news, earnings announcements and supply and demand continue to confirm the current trendless environment, this is considered to be a relatively low-risk, shortterm put trade.

Summary Put options provide abundant opportunities to take advantage of the downward price swings all stocks make. Smart traders make sure that they understand how to use both the bullish and bearish sides of the market to their benefit, because it gives them the ability to potentially profit no matter what direction the market is actually moving. Doing technical analysis on a stock for put option opportunities is no different than the analysis you would do for any stock; applying the Threshold Trading Method to your analysis will help you identify clear put option opportunities and what the stock must do to give you a high-probability put trade. 113

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Notes Although stocks do occasionally experience long, extended downtrends, trying to maximize profit by buying more time in put options generally increases your risk in the trade. An effective guideline for understanding how much time to buy in a put trade is to buy no more than one to two months longer than you think it will take the stock to drop to your target price. Once the stock has dropped to your target price, get out and take your profit.

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5

Covered Calls

One of the most conservative options strategies for any investor is selling covered calls.

Many investors shy away from trading options because of the perception that options trading involves an extremely high level of risk. While there most certainly are options trades that represent that extreme high side of the risk equation, there are also very conservative strategies that options can be used for. One of the most conservative options strategies for any investor is selling covered calls. Many investors use covered calls as an incomegenerating strategy. It can also be used to enhance an overall growth strategy. This section will discuss both approaches and ways to identify stocks that address each type of strategy.

What Is a Covered Call? Why Should I Sell Them? A covered call is simply a call option that you sell on a stock you own. Remember, a call option gives the option buyer the right to

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Notes buy the stock at a specific price—a lower price than where the stock will be if it goes up and the buyer chooses to exercise the option. This is a right, not an obligation. They can exercise the option and buy the stock, sell it to somebody else, or do nothing. As the seller, you take on the obligation to sell the stock to the buyer at the option’s strike price if they do exercise the option. Most investors buy a stock because they like the company, right? So why would you want to sell a call option on a stock you own when you run the risk of having to sell the stock at a cheaper price? The first answer to this question is to remember that successful investors don’t buy stocks just because they like the company; they do it because they think it is going to go up or because there is some other benefit owning the stock gives them at the time. Successful investors will buy and sell stocks as quickly as their analysis tells them it is necessary; selling covered calls gives them a way to take in extra income on a stock while they own it that they wouldn’t have seen if they relied only on price appreciation. The second answer is to remember that the covered call strategy is generally a bullish strategy; you should only buy stocks you would be willing to own, and selling covered calls means you have to own the stock. The statement, “The trend is your friend” applies to covered calls just as to trading stocks. You shouldn’t sell covered calls on a downward trending stock, because you shouldn’t be in the stock in the first place. If you plan your covered call trade correctly, a worst case scenario where you have to sell the stock at a lower price than you bought it at should be a rare occurrence and should translate to only a small loss. The third answer to “Why would you want to sell covered calls?” is that selling a covered call on a stock you own (also called writing a covered call) accomplishes two things: It provides a measure of downside protection and can add income to your investment portfolio.

Downside Protection When you sell an option on a stock you own, you receive a premium for that option. You recall that when you buy an option, you pay the ask price, and when you sell it back to the market, you receive the bid price. This is also true when you sell a call using the covered call 118

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Notes strategy. You will receive the bid price for that option. This premium is immediately credited to your brokerage account and can act as a buffer against loss if the stock begins to drop. Suppose you own 100 shares of a $30 stock. You sell a call option and receive $2 from the premium, or $200. After you sell the call, the stock begins to drop. The advantage you have over other investors is that your covered call has given you a $2 buffer. Unless the stock drops below $28, you haven’t lost anything. The downside protection afforded by covered calls is a reason many long-term investors make regular use of this strategy. It is important to remember that you don’t have complete downside protection with covered calls. In our example, if the stock suddenly dropped to $25 per share, you would quickly be in a net negative situation and would have to take some kind of action to protect yourself. Nevertheless, for stocks that you might take a longer-term view of, covered calls can be a way to even out the volatility of the stock and weather minor drops in price.

Income Most investors who use covered calls do so primarily for the income they provide. If you are in a situation where you need to live on your investments, covered calls can be a perfect fit. It is not unrealistic to potentially earn 2 to 5% per month on a monthly basis when using covered calls. That works out to a much better return on your money than you would see from a bank, CD, or Treasury note! Each time you sell a call option, the premium you receive is deposited immediately in your trading account. You can then use the money as you wish—pay living expenses, reinvest the proceeds, and so on. Many investors who are seeking long-term growth of their portfolio will read the last paragraph and say, “That isn’t me. I don’t think covered calls would help me out at all.” Not true! Although covered calls are considered an income source, they can also be a valuable component of an aggressive growth strategy. Suppose you have purchased 100 shares of a stock at $30 and it has increased to $40, and your technical analysis indicates the stock is approaching resistance. Congratulations—you have a 30% or more profit in your

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Notes trade. So it’s time to get out, right? Maybe, but before you make that decision, you might want to look at the current prices for the call options on that stock. Many stocks at the top of an upward trend don’t start downtrends right away. Instead, they will often hover at or around their high price for a period of time before they begin to go down. This period of time can last anywhere from days to months, but it isn’t uncommon to see this kind of pattern last at least a few weeks. Suppose you could add an additional $2 per share to your account by selling a call that will expire in one month. Would you? Why not, if your analysis leads you to think the stock might be topping out but isn’t likely to drop quickly? Instead of a $10 profit, you give yourself a handsome $12 potential profit—and $2 of that comes to you immediately! If the stock continues to go up, you will get called out and lock in your profit and move on to another trade; if you don’t get called out and the stock hasn’t dropped, you can decide whether to move on or try it again. Now suppose you repeated this process at the end of each profitable stock trade you made. An extra $2 per share on a single trade may not sound like much, but what if you were to repeat this process again and again over a period of time? Your trading account would grow exponentially over time. This is one of the secrets of the market that not everybody knows—covered calls can be a major component of a successful, long-term wealth building strategy.

Stocks to Use with Covered Calls An important consideration in implementing a strategy for using covered calls is to identify what kind of stocks you intend to use. Specifically, you need to determine what level of volatility you want to deal with in the stocks you will sell covered calls on. Volatility has a dramatic effect not only on the potential downside risk of a stock, but also in the valuation of its options. In Chapter Two we stated that the options for highly volatile stocks are typically overvalued. This is because the greater relative volatility in those stocks makes them more attractive to speculative options traders. The reverse of this mindset is that for the options seller, overvalued options offer more attractive yields. It isn’t uncommon to find call stocks that offer options premiums in excess of 10% under these conditions. The fact that the stock is volatile, 120

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Notes however, means that you have to make sure the stock is one that you would want to own in the first place. This consideration follows hand in hand with whether you are using covered calls to generate income or as part of a growth strategy. If you are trying to generate income, highly volatile stocks may not be appropriate to your needs, despite the higher premiums you would collect. If you are trying to live off your investments, you likely don’t want to put your capital at great risk. Highly volatile stocks make capital preservation more difficult, so the higher potential reward may not be worth the risk. In these cases, looking for covered call premiums of 1 to 2% per month is usually a better idea. You will find less volatile, more conservative stocks this way, and you could still be earning around 12% per year! If you are an aggressive investor seeking long-term growth, you will probably be trading more volatile stocks anyway, so you will be in a good position to take advantage of the overvalued nature of the options associated with these stocks. Remember to conduct a thorough analysis of the stock first so you can completely evaluate the risk associated with the stock. Fundamental analysis is a key part of determining what stocks you should use for covered calls. It’s a simple concept: You have to own the stock in order to write a covered call, and you have to conduct fundamental analysis before you buy a stock anyway, so it makes sense to conduct a complete fundamental check before selling covered calls on any stock. Make sure that the fundamentals of the stock are such that you would be willing to accept the level of risk associated with it.

Covered Call Trading Rules Any investment strategy, no matter how conservative or speculative, must follow specific trading rules. You have learned about setting and establishing trading rules already. This section discusses how to expand the trading rules you have already established for buying stocks to include an effective covered calls strategy. There are several decisions you will have to make before you can sell a covered call on any stock. These decisions are the additions to your trading rules you will make.

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Notes The assumption is made here that you have already determined the stock fits your fundamental requirements and risk profile. Your covered calls rules apply specifically to the direction of the stock’s short-term trend, which call to write, how much time to sell, analyzing the potential downside, and how you will exit your covered call play.

Direction of the Trend As stated earlier in this section, it is important to make sure that the covered call trade you are about to make is consistent with the direction of the trend of the stock. Make sure that you use the shortterm trend as your barometer; the primary reason for not using a longer trend is that most covered call trades only last one month. Using a longer trend than the trade would cover will likely result in incurring unnecessary losses since longer trends such as the primary or intermediate trends generally take longer to change direction. Remember that to write a covered call, you have to own the stock. In order to own a stock, it has to satisfy the original trading rules you established. If a stock you may be considering for covered calls wouldn’t pass those trading rules, it doesn’t matter how attractive the premium might be; you should avoid the stock. The direction the short-term trend should be going depends on whether you are using covered calls to generate income or enhance growth. Let’s look at the graph in Figure 5.1.

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Notes

Figure 5.1 Although BRY pulled back in late April, it now continues a very impressive trend to the upside. This is a fairly volatile stock. An appropriate play might be to buy a long call. Now look at the graph in Figure 5.2.

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Figure 5.2 Over the last six weeks, this stock has become “range-bound,” meaning that it has found consistent support at around the $23 mark while resistance appears to be at $27 per share. Rangebound stocks are also considered to have a flat short-term trend. Stocks in flat trends are generally the types of stocks that offer the most reliable and attractive income-producing opportunities through covered calls. The trading rule that applies to using the short-term trend to identify covered call opportunities is very simple: The short-term trend of the stock should be moving upward or flat.

Selling Time 124

What expiration month should you use? This is an important consideration you should account for as soon as you have determined that the trend of the stock works for a covered call trade.

Chapter 5: Covered Calls

Notes In Chapter Two, you learned that the more time an options contract has built into it, the more it is worth. As an options seller, you can garner larger premiums by selling more time. However, as a general rule, you should focus on selling short-term call contracts. This is because selling short-term, monthly contracts on a consistent basis can give you a greater percentage return over time than selling a single long-term contract. Selling long-term contracts also increases the amount of time you are exposing yourself to being exercised by the individual that bought your call contract. Let’s use some examples to illustrate the benefit of selling shortterm call contracts. Look at the options chain in Figure 5.3.

Figure 5.3 These contracts on CCU are about 37 days from expiration. The current price for CCU is $30, meaning that the June 30c is at-themoney. If you own the stock, you can sell this contract for $3.30 at the bid. That’s an immediate return of 11%. For every $3,000 invested, you receive $330; 11% for 37 days is equivalent to approximately 130% annualized. If the stock doesn’t move higher than $30, the contract will expire worthless, and you’ll still have the stock and be able to sell another contract for another month. 11% on a covered call contract is uncommonly high; 2 to 3% is more typical. Suppose you get 2.25% every month for 12 months—that’s 33.8% return on your money, not counting commissions, just from writing covered calls! 125

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Notes One wrinkle you should be careful not to forget is the effect of commission costs on your returns. Remember that when you sell a covered call, you will be charged a commission on that trade. Your covered call premium needs to be high enough to give you an attractive return after commissions. If your commission costs are eating at a significant portion of your premiums—$20 to $30 or more per trade—then you should probably try to find a broker with lower commissions. Now let’s compare our 11% return from short-term June call to a longer period of time. Look at Figure 5.4.

Figure 5.4 This option chain is for the October 30c contracts, four additional months of time. They are going $4.20 at the bid. That’s 14% rate of return but it ties up our stock clear through the month of October. As a general rule, we buy a stock and sell the next or current month’s option contracts one strike price out-of-the money. Since the 30 strike price is at-the-money, it is usually where we receive the highest rate of return on our premiums. Also selling one short month after another is almost always more profitable than selling a long-term option with four to six months of time. Also, selling a call with an expiration date four months into the future implies that you are convinced you want to own that stock for that much time. That may or may not be the case.

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Notes The stock could experience a significant, extended downtrend. This is the greatest danger associated with selling long-term contracts. When you sell a covered call, you are required by your broker to hold on to the stock for as long as you are liable for the call contract. If the stock takes a sudden downturn, you cannot sell the stock until you eliminate the obligation for the call contract. You can remove this obligation by buying a call at the same strike price (this is called buying the call back), but in the meantime, you are sitting in a declining stock. This risk is greater because, over time, any stock will experience declines. Concentrating on short-term contracts lessens this risk since you are committing yourself to a smaller amount of time. Remember that the closer to expiration an options contract is, the more time decay erodes the value of the option. This is another reason selling short-term contracts is valuable—time decay erodes the value of the option faster. As the seller, time works for you rather than against you, as we are used to with the normal buying mentality. If the stock stagnates or hovers relatively close to the price it was when you sold the call, you won’t lose any value in your principal, but the likelihood of the call expiring worthless increases, which lessens the value of the option. Suppose you sold the June 30 calls and one week before expiration, the stock price was still at $30. You could buy the call back for a very small amount, say $.25, keep the difference of $3.25 and remove your obligation to sell should the stock suddenly move past $30 before the expiration date. This is a money management technique that you won’t always have occasion nor need to use, but you will find situations where it will be in your best interest to do so.

Choosing a Strike Price Next, you must decide at what strike price you want to sell. Just as when you buy an option, you have to decide whether you want to sell an in-the-money or out-of-the-money call. Many investors look at this question primarily from the viewpoint of how much money they will get in their premium. This is a limited perspective; however, it only addresses the immediate benefit of the trade and not the potential risk or downside of the covered call itself. Remember that in-the-money options are more expensive than outof-the-money contracts. This means that selling an in-the-money covered call would translate to a higher immediate payment to 127

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Notes your account. It also means that the person who buys your option could immediately exercise the option and buy the stock for a lower price than it is at right now; this is the rare exception because most traders won’t exercise an options contract until or close to the expiration date. However, if you sell in-the-money options, remember that if the stock is still in-the-money as you approach the expiration date, you probably will be exercised. Most buy-and-hold, long-term investors avoid selling in-the-money options, while traders who are simply trying to supplement and enhance growth use them actively. If you do decide that selling an in-the-money option might work for you, make sure that the strike price you sell the option at isn’t so low that it completely offsets the premium you receive if you are exercised. You want your covered call trades to produce a net profit, not result in a zero-sum transaction. Out-of-the-money options don’t produce higher premiums like inthe-money contracts, but in order to be exercised, the stock will have to increase in value above the strike price you have sold at. This is the approach used by most traders who use covered calls for income purposes because if they do get exercised, they will be selling the stock at a higher price than where it was previously, and they keep the premium they were paid at the beginning of the trade. Although the premiums aren’t as high as for in-the-money options, out–of-the-money premiums can still be very attractive and produce a win-win scenario for the astute covered calls trader. We don’t favor selling one type of covered call over another. The simple fact is that each approach has its advantages and drawbacks. Sophisticated covered calls traders don’t limit themselves to only selling one type of contract; they evaluate each potential covered call on a case-by-case basis to determine which approach would work better. Later in this section, we will examine scenarios in which selling in-the-money options provides the greatest overall benefit in using covered calls as well as those in which staying out-of-the money works best. After you have identified a stock you would like to sell a covered call on, based on the movement of its short-term trend, and determined how much time to sell, identify the at-the-money strike price. If it is in-the-money, identify the first out-of-the-money contract. If it is out-of-the money, identify the first in-the-money 128

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Notes contract. Write down the strike price and the bid price for each contract so you can begin to analyze each one.

Developing Your Exit Strategy Before you sell a covered call, you should always make sure to develop a specific exit strategy for that specific trade. This isn’t a new concept. Planning how you will end a trade is something that you do for any trade, be it buying stock or options. It is just as important to do the same thing when you are selling options; in fact, covered calls have an added layer of complexity to deal with, which make planning your exit absolutely critical. This may sound counterintuitive in relation to the concepts of selling time that were covered earlier. After all, when you sell a covered call, you want the option to expire worthless, right? So all you have to do is be patient and wait until the third Friday of the month. This is only one way a covered call trade could end. There are actually three possible scenarios, each of which requires a different course of action, as listed in the following table: Scenario Stock stays below the call’s strike price. Stock moves above the call’s strike price; buyer exercises option to buy the stock. Stock drops below its price when the call was sold.

Action Required None, the option expires worthless. None. The stock is purchased at contract’s strike price. Buy the call back and sell the stock.

The first scenario is straightforward and easy to deal with; the option expires worthless, you do nothing but keep the premium that was credited to your account when you sold the call. Realistically speaking, this is the most common scenario for covered call sellers. It is also the least expensive, since you only pay a commission to your broker when you sell the call contract.

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Notes The second scenario can be straightforward if you don’t mind being exercised and selling out of your stock. You need to remember, though, that you will have two commissions to pay: one when you sell the contract and another when you sell the stock. What can complicate this situation is if the stock has made a significant upward run well above the strike price of the option you sold. Being exercised would mean selling the stock at a dramatically reduced price compared to where it has risen; many traders in this situation will buy the call back before expiration to remove their obligation and allow them to ride the stock’s upward run. It is important in this situation; however, to compare the increase in the stock’s price to the cost of buying the call back. If the stock has increased in value, the call option you sold will also have gone up; often, the net result is the same as if you sold the stock at the option’s strike price. The counterbalance to this problem is your analysis of the stock’s upward momentum. If you think the stock has reached the peak of its run, it may not be worthwhile to buy the call back; on the other hand, if your analysis leads you to conclude the stock may still have room to continue increasing in price, you will find it easier to justify buying the call back. The third scenario is the most urgent of all, particularly if the stock has begun a downward trend. Remember that as long as your covered call position is open, your broker will not let you sell your stock. The downward trend mandates action before your loss becomes more severe, so you will need to buy the call back and then sell the stock. In some cases, it is possible to sell the stock before buying the call back, but since this would place you in a naked position, meaning that you don’t own the stock on a call you have sold, you should pay particular attention to the sequence of your orders. In this scenario, you will lose money and incur your highest commission costs because you have three transactions—sell the call, buy it back, and sell the stock. However, there is a silver lining: buying the call option back will cost you less than you took in when you sold it, and the difference will give you some cushion against your loss. This situation is one of the principle reasons the direction of the trend is so important—if you focus on stocks in upward or flat trends, this extreme scenario will be the rare exception to your covered call experience. 130

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Notes When it comes to planning your exit, make sure that you account for all three of these possibilities. If your analysis of the stock leads you to believe that it won’t rise above the strike price of the option, be content to sit through the play and enjoy your premium when the option expires. If there is a good chance you could be exercised, be prepared to evaluate whether to buy the call back or allow the exercise to happen. Analyze the downside of the stock as well so you can identify specific price points at which you need to take action. This analysis is simpler than most traders think. If you paid $36 per share for the stock, for example, and sold a call option for $1.50, your actual cost for the stock is only $34.50. Technically, you could allow the stock to drop to that price and you would still break even, not including commissions. The point at which you would need to determine whether to get out of the stock, to avoid a downtrend in this case, would be when the stock dips below $34.50.

About Stop Losses One thing about using covered calls you should always remember is that when you write a covered call contract, your broker will generally not allow you to place a stop loss on the stock. This is because if you were to get stopped out of a stock you have written a covered call on, you would still be liable for the contract even after selling out of the stock. You would be in a naked call position, which you might not have permission for. Most brokers prefer to avoid this added complexity and simply don’t allow it. This means that when you write a covered call, any stop losses you might use are mental stop losses only; identify a price level where you would simply have to move on, but be very careful about watching the stock every day to see if that circumstance comes to pass. Daily vigilance is very important to a successful covered call strategy.

Income Strategies and Setups The purpose for this section is to take the information we have covered to this point and apply it to specific trades that would be effective in generating covered call income. Let’s start by assuming you purchased SOL stock around the middle of May at $15. The current price is now around $19.47 after trading around the $17.50 mark for the last 15 days. You check the MACD and stochastic indicators to assist in the decision-making 131

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Notes process of identifying the trend. You see they are in the upper part of their buy-sell signals and indicate that the stock is on course to maintain its upward trend. Checking the profile on SOL you see that it is engaged in the manufacture and sale of solar wafers in the Republic of China. Its last consensus earnings estimate was $.27. SOL made $.34. This is a very positive sign. Finally their guidance is positive for the next quarter. It would appear that the stock will not decline in value in the foreseeable future. Another factor that could make this stock attractive for generating income with covered calls is the fact that over the past four months, the stock has maintained a steady upward growth but has not had serious gaps up or down. This is the type of steady-growth stock that investors seeking income like to look for with covered calls. The table in Figure 5.5 gives us the call option chain for SOL. Since there is very little time left in May, we will look at June.

Figure 5.5 Although we only paid $15 for the stock, we look at the next strike price out-of-the-money. The stock is currently at $19.47. That means we look at the June 20c. They are going for $2.50 x $2.70. Because we sell at the bid and buy at the ask (remember we are the retail side of the market), we can sell this option for $2.50. The returns are impressive.

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Notes Date

Day of Expiration

Days to Expire

Stock Symbol

Stock Price

Option

Bid Premium

Static % Rate of Return

Annualized % Return

11-May-08

20-June-08

40

SOL

$ 19.49

June 20c

2.5

13%

117%

Figure 5.6 Although the original purchase price was $15, it is prudent to use the next strike price out-of-the-money from the current stock price of $19.49. We do not want to sell the stock for a strike price of $17.50 because it is a growth stock. There is a high probability that the stock will be above $20 on the day the option expires. The math is simple. If we sold the $17.50 strike price we would receive $3.60. If the stock closes anywhere above that price on the day of expiration we would receive an additional $2.50 (the difference between our purchase price and the $17.50 stock price). Net received: $2.50 + $3.60 = $6.10. If we sell the June $20c and the stock closes above $20 when the option expires, we receive $5.00 + $2.50 = $7.50. Note: Stocks change personalities. A growth stock can reach an unexpected maturation price and stay in a trading range for five years (Microsoft). Other stocks can break out of their flat-trading range and double their price unexpectedly (CBI). If you play every stock as though it were not going to break out of its trading range in the foreseeable future, and it does, you’ll have the pleasant surprise of making more money. You make more when the stock is called away than you do just selling the premium. If you make a covered call play on a stock with a strong uptrend, you are probably using the wrong strategy. To capitalize on a stock in a strong uptrend, you may wish to consider a pure call play. Usually the best approach to a covered call play is to stick with stocks that are basing sideways or trending slightly upward. If you wish to build a long-term investment portfolio, then play blue chip stocks with moderate covered call returns and good dividends. You can receive a sustained revenue stream from the calls. Usually mature stocks have very small monthly covered call returns. Longterm investors sell three to four months of time in their covered call positions. They also benefit from dividend payments.

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Notes

Growth Strategies & Setups Although most covered call sellers do so for the purpose of generating income, even aggressive traders seeking growth to build wealth over time can and should look for opportunities to use covered calls. Aggressive traders actively look for opportunities to exit profitable trades. Proper application of covered calls gives you a way to set up your exit strategy beforehand at a specific price, while adding to your total return in the trade with the covered call income. Using covered calls to supplement growth as suggested in this section is counterintuitive to many traders. Those traders who buy and sell stocks on an active basis tend to focus on the simple appreciation of the stock—the difference between the price they bought the stock at and where it is now. In order for an active trader to want to stay in a stock, it must demonstrate strength in its current trend. Writing a covered call on a stock in a strong upward trend increases the likelihood that you will have to sell the stock at the strike price—which would be a lower price than the stock will be at when you are called out. Why count yourself out of potential profit? The appropriate strategy lies in your attitude and approach to trading. Think of it this way: You can take a known amount of return early in a stock trade or you can try to take an unknown amount of return later on. If a stock is in a strong upward trend, its call options are likely to be priced at a higher premium than they would under normal circumstances. These premiums represent that known amount of return. Although you take the chance of getting called out if the stock continues its upward run, if you plan the trade correctly, you can combine the covered call premium with price appreciation to realize an attractive overall profit. The strength of the upward trend makes the downside risk of writing a covered call less than it might normally be due to the support the stock will usually see at the price level of the current trend line. This is a conservative approach to selling stocks because you bring in extra return at an earlier stage of the trend than you might by selling at the end of an upward trend. The known return dynamic means that the returns you realize this way generally won’t be as high as they could be if you extend your trade throughout an upward trend. The alternative, of course, for a stock in a strong upward trend is to stay in it, adjust your stop loss upward or scale more money into the stock, and ride the upward trend for as long as possible. If you 134

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Notes are an aggressive investor and aren’t willing to sacrifice the potentially greater appreciation prospects of a stock for covered call income, don’t use this strategy. Determining whether this strategy works for you lies in whether you would prefer to take what known profit you can get for a relatively small amount of risk, or take the chance of greater profit further down the road. One approach is not better than another; it depends completely on you and your attitude about taking profits. However, many smart, aggressive investors do look for opportunities to supplement growth through covered calls when the time is right, so it is worth your time to become familiar with how it works. Earlier, we discussed strategies for using covered calls to generate income on stocks you own. This is a regularly recurring strategy that in many cases is repeated on a monthly basis. Supplementing growth with covered calls is a strategy that is used less frequently; you might write a covered call only once every two or three months, depending on how often you trade and what your time frame is for cycling in to and out of a stock. This is an important distinction; as a growth investor, you are still going to be looking for appreciation first. The covered call income you can generate doesn’t come until you have already gotten into the stock and realized a positive return in it. Let’s look at a stock that may be a good candidate for this strategy. Look at Figure 5.7.

Figure 5.8

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Notes In the in Figure 5.7 chart, AA is cycling with several days of strong rallies. It has increased in value from $35 to $39. Assume you purchased the stock at $27.50 last January. At this point you’ve recognized an $11.50 profit on a stock that is a DOW component. Since March it has bounced off $39 three to four times. You’d like to take profit, but wouldn’t mind holding onto the stock if it falls back to the $35 level as well. Stochastic and MACD are also indicating a retracement might be in the near future. Look at the option price for the June40c.

Figure 5.8 As you can see, the premiums are $2.41 x $2.51. You can sell the June 40c for $2.41. If on the day of expiration the stock is trading above $40, it will be purchased from you. Said differently, your position will be “assigned.” You will recognize the difference between your purchase price of $27.50 and $40. That is a $12.50 profit as well as the $2.41 you received on the June premiums. Essentially, you sold your stock for $42.41. and made $13.91 on the trade. If, however, the stock pulls back and is at a number lower than $40 on the day the options expire, you still have a $2.41 profit, you still own a strong stock and you can wait until the stock reaches resistance again and sell another call. Buying and holding can be a very profitable strategy, when combined with a covered call at the apex of the stock’s trend.

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Notes Successful traders will always make sure to evaluate support and resistance thresholds before they get into a stock trade. They use resistance to identify price levels at which they should be ready to sell the stock. These resistance levels will often have call option strike prices that match or closely approximate them, so anytime you get into a stock trade it could be a good idea to evaluate the value of selling an out-of-the money covered call. This is why wise growth investors make sure to consider including a covered call in any stock trade they make. The numbers won’t always bear themselves out to give returns as attractive as those shown here, but when they do, be ready to take advantage of them!

Summary The covered call approach is a conservative strategy that can be used both to generate income as well as enhance long-term growth. Properly used, this can provide income or be a major component of a long-term, wealth-building plan. Selling options places you on the opposite end of the time/risk equation; time works for you rather than against you. Make sure that when you are thinking about covered calls to consider both in-the-money and out-of-the-money contracts, and that you carefully analyze the current trend of the stock. Be vigilant when you are in a covered call trade to make sure you can react properly to extreme changes in the stock. Think beforehand about how you will get out of the covered call trade—decide ahead of time if you will allow yourself to be exercised if the stock moves above your strike price, and how far you will let the stock drop before you buy the call back and sell out of the stock. One final word of caution: Making annual projections based on a monthly return is a very disappointing game to play. You might get 15% in one month on a specific stock and see returns of only 3% the next month. A stock generating respectable option returns will not continue to do so throughout the year. As stated earlier, stocks change their personalities. It is incumbent on the wise investor to learn to recognize when a stock moves into a trading range that is no longer dynamic in terms of generating high-option returns. Also be careful not to play stocks that have high rates of returns, but are in a flat-trading range. It is usually a sign that the stock is going to

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Notes drop in value. Picking stocks is an art as well as a science. Learn to judge the personality of a stock as well as its current returns. The market suffers fools poorly. Those believing they have an unfailing knowledge of its undercurrents are destined for hard and abrupt reality checks.

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Options Strategies with Leaps

You can use options on longer trades intended to take advantage of intermediate and primary-term trends.

Up to this point you have learned about using options to take advantage of shortterm moves, both on the upside and downside, using call and put options. You have also learned about using covered calls to generate income and enhance overall returns in your stock trades. All of these strategies are intended as relatively short-term strategies; however, option trading isn’t limited only to short-term trading. You can also use options on longer trades intended to take advantage of intermediate and primary-term trends. This closing chapter will discuss how to use LEAPS to do this.

LEAPS Defined Put simply, LEAPS (long-term equity anticipation securities) are options contracts with a duration of six months or longer. LEAPS contracts all carry a uniform January expiration date; the only difference from one

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Notes contract to another is the year of expiration. LEAPS contracts in many cases will be available for a given stock for a period of anywhere between one and three years. Just as not all stocks offer options, not all stocks that offer options include LEAPS. Options contracts are offered and listed by the Chicago Board of Options Exchange, not the company underlying a stock. In order to offer options on a company, the CBOE usually waits to see the stock establish a fairly consistent level of interest so as to ensure the liquidity of that particular options market. The list of stocks that offer LEAPS in addition to shorter-term options contracts is considerably smaller than that of stocks that offer options; however, the list is growing regularly as LEAPS become more and more popular. LEAPS offerings include calls and puts just as any short-term options offering.

Strategies for Using LEAPS Options There are several ways that LEAPS options can be used; these strategies make LEAPS options attractive for virtually any trading system. This section will outline each strategy and the generally accepted best way they can be used. You may not necessarily use all of these strategies or find them applicable to your goals and trading style. That’s okay! Go through each one carefully and think about how it may apply to your trading system. Odds are that at least one of the following strategies will be a good fit for your trading style and goals. You may even find that they are all attractive for your needs. Note: The strategies listed here are not comprehensive. There are other, very advanced strategies for using LEAPS options that are beyond the scope of this material. Strategy I — Using LEAPS as an Alternative to Owning Stock

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For many traders, one of the challenges of stock trading lies in the considerable capital required to purchase shares of a company. If a stock that trades at $50 gives a good buying signal, for example, it would cost you $5,000 to purchase 100 shares. If you are starting your stock trading with a small amount of capital, this could represent a large chunk of your trading account. Although you can purchase stock shares in any quantity you desire, the sizable amount of money required to take advantage of significant moves in stock price represent a significant stumbling block for many traders.

Chapter 6: Options Stragegies With Leaps

Notes One of the things that makes options trading attractive is the smaller capital outlay required to purchase a single contract. A call option on the $50 stock in our example may only cost $5 per share, requiring only $500. If the stock moves up, the leverage associated with your option will cause the price of the option to increase in value faster than a proportionate stock position. The downside risk of short-term options, of course, is that if the stock doesn’t move the way you need before the contract expires, you can lose a significant chunk of that $500, or even all of it. LEAPS options provide a wonderful alternative to owning shares of a stock, with two added benefits: They also take advantage of leverage when the stock moves in your favor and they are affected to a much smaller degree by time decay than shorter-term options. Since LEAPS contracts last for a period of six months to three years, buying a LEAPS contract gives you the opportunity to take advantage of the longer-term intermediate and primary trends without having to invest the larger sums of money it would take to buy the stock outright. Look at the stock chart in Figure 6.1.

Figure 6.1 In this example, let’s assume it’s May 2008 and this is the chart we have before us. AAPL has experienced a significant upward trend since March. The 30 sma and 50 sma are well below the price indicating continual strength of the trend. We make the assumption that AAPL will reach its 52-week high of $202 and then Steve Jobs

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Notes will do a three for one split sometime in December. You could buy a two to three call option or, in anticipation of AAPL’s continued dynamic behavior, purchase a LEAP that expires in January of 2009. Let’s look at the two alternatives. The rules for short-term options are fairly explicit in that, unless you are a seasoned options player, you should stay conservative and buy one strike price inthe-money.

Figure 6.2 From Figure 6.2 you can see that the July 180 calls have a bid of $14.55 x $14.75. Those are expensive options…but not when compared to the price of AAPL at $183.16. That is probably a good trade and given the current trend should return a profit on the position. Unfortunately, it does not last through the opening of school season, when many computers are purchased and it expires prior to our anticipated split in December…again a month where a lot of computers are purchased. A LEAP may be a better alternative.

Figure 6.3

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In addition to costing less than a stock, LEAPS have two other attractive attributes. The delta on a LEAP is more generous than a regular option and theta is less severe. That means all other things being equal, a LEAP goes up in value faster than a two to three month option and decays more slowly.

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Notes Further, if we follow the rule, except in special circumstances, to only buy options that have a delta greater than .50, the Jan 10 230 LEAP calls have a delta of 50.42. They are actually five strikes outof-the-money. Still, every time AAPL goes up in price $1, the LEAPS go up $.50. If we buy one strike price in-the-money on the LEAP, the delta is 68.13. Using delta alone to calculate leverage presents a distorted future price calculation. It does not take into account the amount of time contained in the option contract. Knowing the stock, and being aware of business cycles throughout the year can be extremely helpful in determining if a LEAP is more advantageous than a regular call. Just as with short-term options, LEAPS provide leverage that increases your profit opportunity as a percentage of the capital invested when the underlying stock moves in the direction you forecast. This leverage isn’t quite as high as it would be on a short-term contract because the time remaining on the contract improves your odds of getting the move you want. This translates directly to the premium you pay for the LEAPS contract; it is also reflected in the delta value of the contract. Clearly an option has greater leverage than a LEAP or the stock itself. The great unknown is “what will the stock do between now and December?” If the stock continues to trend upward as it has for the last two months, then pure calls are the better selection. If the stock maintains its annoying habit of pulling back radically as it did in August of 2007 and again in November of 2007 (see Figure 6.4), then a LEAP is clearly the safer and better choice.

Figure 6.4

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Notes The number of variables in the stock market, the economy, related costs of goods sold and other factors is almost unlimited. Making a decision based on leverage or rate of return between two options with largely different time frames is probably extremely short sighted. The best basis for making a decision on any investment is to consider your overall objectives and tailor your strategies accordingly. Remember also that LEAPS have two disadvantages when compared to owning a stock. LEAPS decay with time and should a company declare a dividend, the holder of a LEAP does not participate. One approach to maximizing profit in a good trade that professional traders use frequently is scaling in to a trade. This refers to placing a smaller amount of the total capital you would be willing to risk in the trade at the beginning, when the risk of failure is the highest. If the stock begins to move the way you want, you can add to your position until the entire amount you were originally willing to risk is in the trade. This is a way to reduce risk and still take advantage of a long trend. LEAPS options offer the same opportunity to scale into a trade as if you had purchased the stock itself. Consider the AAPL example. If an investor is willing to spend $183 for 100 shares of AAPL and the LEAPS at the $230 strike price were $29.50, that’s roughly 16% of the cost of the stock. Suppose the stock reached its initial profit target and your technical indicators signaled that the upward trend was likely to continue. You could easily add another contract and achieve the same scaling in effect keeping the LEAP leverage in place. Strategy II — Using LEAPS Options in Place of Short-Term Options

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Most traders who use LEAPS think of them primarily as vehicles for longer-term investments. In this case, traders use LEAPS to take advantage of option leverage, while approximating the nearly infinite period of time a stock can be held, while still positioning themselves for attractive short-term profits. However, conservative traders can also use LEAPS as an alternative for short-term options contracts. This approach applies a logic that is the reverse of using LEAPS in long-term plays; it sacrifices some of the leverage associated with the option in favor of the ability to minimize the time decay associated with short-term options. Look at Figure 6.5.

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Notes

Figure 6.5 AAPL made a strong move over the past two months moving up some $60 per share. In the past three days it has pulled back. If the stock reverses and continues its upward trend it may reach the $200 mark achieved in late December A simple options trade here would be to buy a call contract with a duration of one to two months so as to maximize the potential reward if the stock makes the $18 move between the current resistance to its next resistance. The downside risk on such a trade, of course, is that if the stock doesn’t move up quickly, time decay will erode the value of your contract to the point that you would have to absorb a large loss. Many traders understand and accept this risk, but don’t think about ways to manage the trade beyond using a stop loss or to make sure the trade is only a small portion of their capital. Using a LEAPS option in place of the short-term option is a good way to add yet another layer of risk management to your trade; it minimizes the effect of time decay while still putting yourself in position to reap a handsome profit if the stock moves the way you want. Let’s compare using a LEAPS option versus a traditional call option using an example. Look at Figure 6.6.

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Figure 6.6 If you were to purchase the July 180 call, you would pay $14.75 per share. The January 230 LEAPS (delta > .50) are more than double the call price at $29.50 because of the additional time. If we are looking for the stock to go up by December, you could hold onto the LEAPS without experiencing hardly any negative effect from time decay.

Measuring Time Decay Since the contract we are referring to in our example doesn’t expire until January 2010, you could hold on to this option for nearly that entire period without experiencing the kind of severe price degradation due to time decay that is so common to short-term options. That doesn’t mean that time decay doesn’t exist in LEAPS options; only that it doesn’t begin to have a significant impact on your trade until the contract is within three to four months of its expiration. The effect of time decay on an option is reflected in its theta value. Theta is a dollar value that indicates how much time value an option will lose in a single day. As an option gets closer to expiration, the theta value will increase in the negative, reflecting the increase in time decay. This means that every day the stock doesn’t make a significant change in price from its current level, your loss will increase on an accelerated basis. You can minimize the effect of time decay by either buying more time or by using an option that is deeper in-the-money. 148

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Notes Since stocks, in general, tend to go up over time, the LEAPS option gives you a greater window of opportunity to let the stock move in the direction you need. With a longer time frame to work with, you can usually afford to loosen your stop loss prices to give the stock room to extend itself along the intermediate and primary trends more than you can do with short-term contracts. This way, if the stock moves the way you want in a short period of time, you have given yourself the choice of either taking your profit, which will still be attractive, or staying in the trade to maximize your opportunity in the upward trend. These are both good choices to have, and the more you can put yourself in this type of position, the more you will be able to realize attractive profits in your options trading.

Leverage At this point, you may be thinking, “Minimizing time decay is good, but if I’m aggressive about the stock anyway and think it’s going to move, why do I want to pay that much?” Remember that successful traders do everything they can to put the odds of a successful trade in their favor. This is true whether they trade stock or options. Putting the odds of success in your favor means finding as many ways to minimize downside risk—whether it comes in the form of price volatility or time decay—as you can possibly take advantage of. Using LEAPS options is a conservative approach to taking advantage of short-term stock swings. AAPL’s price currently stands at $183.45, meaning that to purchase 100 shares of the stock outright for a short-term swing trade would require $18,345. If the stock makes the $18 you would make just under 10% on the trade. While that is a respectable profit, you are risking $18,345 on 100 shares. Buying the LEAP risks $2,950 on effectively the same position. If we assume an average delta value of .70, all other things being equal, the value of the call would increase $1,260 (.70 x 18 x 100). $1,260 / $2,950 = 42.7% return. Quite a bit better return than the 9.8% received by buying the stock. A LEAP also allows time for the trade to develop if it stalls out in the first month or two. This is the downfall of many options traders: They correctly forecast the direction of a move, but guess incorrectly about how soon it will happen. If you don’t buy enough time to allow a stock to move the way you want, you stand a much greater chance of losing money on the trade. 149

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Notes Another aspect of this kind of short-term options trade that is often ignored is how quickly a stock is capable of making the kind of move you forecast. Buying too little time puts you in danger of losing money even if the stock does move the way you want. Time decay begins to erode very quickly in the month leading to expiration; if the stock isn’t volatile enough to make up for that decay, you have no chance of success. The chart clearly indicates that AAPL can, and often does, move by $18 or more in a month. It is also capable of falling that amount or more. While it is making up its mind, it also does something that causes pain to all short-term option players. It can base for upwards of two months. Suppose the stock reaches $200 shortly after you purchase the January 2010 $230 LEAPS call. You are now looking at a very handsome profit, but the longer expiration of the contract means that you can take the time to re-evaluate the stock and its trend. There may be an opportunity to take advantage of a new extended upward trend. Purchasing a short-term option automatically precludes you from maximizing the trend on this trade unless you repurchase another short-term contract, which generates higher commission costs; by comparison, a LEAPS option gives you the choice of bringing up your stop loss and staying in the trade with commissions attached only to the buy and sell side of that option. Strategy III — LEAPS Puts on Stocks You Own Smart investors who hold long-term positions in stocks look for ways to minimize their downside risk whenever possible. Another strategy in addition to using trailing stop losses and position sizing techniques is to buy LEAPS on the stock you own. This technique is commonly known as hedging. A stock position is considered completely hedged when the number of put contracts is directly proportional to the number of shares. For example, if you own 500 shares of XYZ Company, you would need to purchase five LEAPS put contracts on XYZ to be fully hedged. This strategy may sound counterintuitive at first blush. Why would you want to buy a put on a stock you already own? A put is, in essence, a bet that the stock will go down. Who would want to bet against a stock they already own? If you think it could go down, shouldn’t you simply sell the stock? The answer to that question 150

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Notes depends on the situation under which you bought the stock and your overall investment objectives. If you are a short-term trader looking to take advantage of quick reversals and short-term trends, this strategy won’t help you. On the other hand, if you are a longterm investor who prefers to buy fundamentally strong companies and ride their long-term trends, buying a LEAPS put can be a useful, if somewhat expensive, way to minimize risk. Besides simply wanting to take advantage of long-term strength, one of the most common reasons investors might want to hold onto a stock for a long-term basis is to receive dividends. If you own a dividendpaying stock and sell the stock when it begins a downtrend and the stock pays a dividend during the downtrend, you will miss out on receiving that dividend. Many long-term, buy-and-hold investors rely on dividend income to help pay their living expenses. In this case, buying LEAPS puts is a practical way to guard against dramatic loss while still receiving your dividend income as a shareholder of record. Another reason investors often hold onto stocks is because of the tax implications associated with selling a stock that has increased in value over a long period of time. Suppose, for example, that you have inherited stock from a recently deceased grandparent. Your grandparent purchased the stock 30 years ago when the stock was at a much lower price before stock splits, dividends, and so on. Seeing the stock begin a downtrend is usually a compelling reason to sell the stock, but in this case it could result in a massive tax liability due to long-term capital gains. It may not even be a stock you inherited—maybe you purchased a stock 10 years ago that has since split several times and increased dramatically in price. Anytime you are in a situation such as this and you don’t want to incur the immediate tax consequence associated with selling out of the stock, buying a LEAPS put could be an attractive approach to take. Let’s consider an example of a situation where a LEAPS put might be a good strategy. Look at Figure 6.8.

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Figure 6.8 In the above example RIMM has experienced an extremely attractive upward trend over the last 4½ months. With very strong fundamentals, this is a stock that many long-term investors would consider as a good position to hold onto. Suppose that you had purchased 500 shares of this stock in early February of this year and had been enjoying this run, but you are beginning to be concerned about the overbought state of the stock. You don’t want to sell it because of its strength and you believe that the stock will continue to show overall strength for the long-term. Buying a LEAPS puts is a strategy that could help you minimize any downside risk you may encounter in the short-term and stay in the stock to take advantage of its long-term strength. Look at Figure 6.9.

Figure 6.9 This table shows the LEAPS puts that are available for RIMM. The stock is currently just below $143 per share. You could purchase the January 2009 145 put for $24.85 per share, or a total of 152

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Notes $2,485.00 x 5 = $12,425 expense for five contracts to completely cover your 500 shares of RIMM valued at 71,225.00. If the stock experiences a short-or-intermediate downtrend, which is likely at some point in the next year and a half, and drops below $47.50 per share, the value of your LEAPS puts will increase in value; it should offset a portion of the decline in value of your 500 shares during that time. If the stock begins a new uptrend after this decline, you can sell the puts back to the market, pocket your gains, and purchase more shares of the stock to take further advantage of the uptrend.

Determining Which LEAPS Put to Buy There are a couple of points to keep in mind if you intend to use this strategy. First, deep in-the-money LEAPS puts are the most effective at offsetting any decline in the value of the stock. The reason for this is that the deeper in-the-money an option is, the higher its delta value is. Finding an option with a delta at or close to 1.0, which means you get a dollar-for-dollar move in your option usually requires going deep in-the-money, which is particularly true for LEAPS options. Finding a LEAPS put with a delta around 1.0 also means that you will pay a higher premium for the option, as we can see from our example. This is the reason that this strategy can be expensive. An effective way to think of this strategy is to equate it to purchasing insurance. Whether it is for your life, car, home, health, or some other purpose, the point in buying insurance is to protect yourself against unforeseen expenses due to mishap, accident, or disaster. You purchase insurance not because you think something bad is going to happen, but because you need to guard against the high sudden costs that are usually associated with that event. You accept that the cost of your premiums is the price you have to pay for the peace of mind of knowing that if something happens to you or your family—sudden death, traffic accident, fire, or serious illness—the costs that will come from it will be covered. Buying LEAPS puts against stocks you already own is very much like buying insurance for your stock. It doesn’t mean that you expect the stock to suddenly experience a serious downturn in price, only that you want to protect yourself against loss in the event it does happen. Although the $12,425 premium paid in our example seems high, it is the cost associated with giving yourself the peace of mind of knowing that if the stock does suddenly 153

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Notes drop in price, you won’t have to absorb a massive loss. This is a very conservative strategy that fits well into a long-term trading system. If perchance the stock doesn’t experience a significant downtrend, then your LEAPS put option will simply decline in value and expire worthless and you will still have your increase in the value of the stock. Think of the premium you pay for the LEAPS put not only in context of the total initial cost; think about it also in terms of the value of that stock position as well as the total gain you have already seen in the stock. In our example, you own 500 shares of RIMM; rounding up to $143 per share, your position is worth a total of $71,500. The $4,050 required to purchase five LEAPS puts contracts is only about 17% of that total value. If you have experienced a long-term gain of more than 17% in the stock, you should consider the LEAPS put as a bargain in terms of its ability to help you minimize loss and protect your profit.

Important Conditions to Success There are some important points to remember when you are thinking about using this strategy. It can take up a significant amount of your investment capital, so you should consider these conditions carefully as you plan this trade. 1. Attitude—This strategy is only practical so long as you use it on stocks you have a long-term bullish outlook on. If the fundamentals of a stock begin to degrade or you find information that changes your outlook, it probably won’t help you. The purpose for using this strategy is to stay in a stock because you think it will continue to be strong in the long-term future. If you don’t believe this to be the case, you will likely be better off selling the stock and dealing with any tax consequence that may come.

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2. Strike Price—The deeper in-the-money you go, the more conservative the trade will be, and the better your LEAPS put will offset any loss your stock experiences. Check the Greeks for each LEAPS put available to make sure you get a delta value as close to 1.0 as possible. Going deeper in-themoney also gives you better protection over time. Buying the at-the-money LEAPS put at the time you place the trade can be dangerous because if the stock increases significantly in value before beginning a downtrend, it may not drop

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Notes enough in value to give you any appreciation in the option. From our RIMM example, if you bought the $47.5 LEAPS put and the stock quickly increases to $55 before it begins a downtrend, it will have to drop below $47.50 per share before your LEAPS put does you any good. 3. Potential Future Reward—If you want to use this strategy on stocks you have recently purchased but intend to hold long-term, you should make sure that the potential longterm gain in the stock is greater than the cost of the LEAPS put. Otherwise, you increase the chances of playing a zerosum game in the stock, which accomplishes nothing in the long-term. Consider the effect of dividends, if they are paid, as well your forecasted price appreciation. 4. Repetition—This strategy is not likely to work if you buy a LEAPS put and intend to hold the same contract through its expiration. If your stock is in a significant uptrend, you will probably need to repeat this strategy multiple times. Think about the situation described in the second condition. If the stock is in a dramatic uptrend, your LEAPS put will likely only be worth a fraction of its original cost, which it may be unlikely to recover if the stock does begin to decline. In terms of providing protection against a future downtrend, you would be better selling the contract back to the market for whatever price you can get and purchasing another deep in-the-money contract with a higher strike price. Strategy IV — Calendar Spreads You learned about using covered calls to generate income off of the stocks you own in Chapter Five. Selling calls in this situation can be an extremely attractive way to take advantage of sideways trends in stocks you have held for a long period of time. Successful traders, whether they are trading to generate income or to simply build wealth, make sure to incorporate options selling strategies such as covered calls in their trading systems. LEAPS options provide another way to achieve the same result as covered calls, but with a lower capital outlay required on your part using a strategy referred to as a calendar spread. 155

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Notes A calendar spread is applied by first buying one or more LEAPS contracts, then selling an identical number of short-term contracts. The principal advantage of using calendar spreads is that rather than having to allocate thousands of dollars of your capital to purchase a stock in 100-share lots, you can use smaller amounts to control the same number of shares with your LEAPS contracts. If the stock rises above the strike price of the call option you sold and you are called out, your LEAPS option will be exercised to cover the trade. If you plan the trade properly, this should yield a net profitable result. There are a couple of caveats associated with calendar spread trading you need to be aware of: • Trading Authority—A calendar spread is considered to be a covered position. You are long an option and then selling a call against it. It is not considered to be a risky trade since the amount of risk you take is protected by the LEAP you own. Most brokers consider this a level-two trade. Since most LEAPs are not marginable, you do not have to maintain a margin in your account to make this trade. • Capital—Literally speaking, the only capital required for a calendar spread is the cost of the LEAPS option. You can use this strategy to generate income on sideways-trending stocks, or you can incorporate it as part of an overall growth strategy. The rules for applying this strategy in these scenarios are the same as they would be for covered calls. Let’s look at some examples of each application and compare the benefit of writing a covered call versus applying a calendar spread.

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Notes

Using Calendar Spreads for Income The first, most common use of calendar spread trading is to generate income. In Chapter Five, we discussed the general characteristics a stock should have to make a covered call an attractive option. These criteria are the same if you intend to apply a calendar spread: • Flat trend (usually produced by a channeling stock trading between narrow support and resistance levels) • Low volatility • Good fundamentals Technical indicators such as stochastics can also be useful in determining the timing of a covered call trade in an incomegenerating situation. If the stock you are considering is trading in a narrow range between support and resistance, stochastics will help you identify if the stock is likely to bounce off resistance and move lower by turning down in the upper band. The signal is even more important if it crosses below the 80 line. Look at Figure 6.10.

Figure 6.10 Again, for the sake of our example, let’s assume it is May 2008 and we have pulled this information on MSFT. In the last three months, 157

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Notes and for that matter, with few exceptions, MSFT has been range bound between $25 and $29 for the previous three to four years. This epitomizes the definition of a flat trend. Rarely MSFT breaks out and runs bravely to the $30s but then dutifully returns to the high $20 range. There is not a great deal of volatility in the stock. Since it is the largest software company in the world and has cash reserves in excess of $55 billion, we will assume for our purposes that the fundamental strength of the stock is adequate. The fact that last January, MSFT rose to the mid-$30 range gives evidence that it might go that high in the next six months. Since a calendar spread includes purchasing a LEAPS call contract, an overall, primary-term uptrend works in our favor. With our basic criteria for the stock satisfied, let’s consider the premiums involved in this trade. Look at Figure 6.11.

Figure 6.11 With the stock at $29.99, you could purchase 100 shares of the stock for $2,999, then sell the June 30 call for $.95 per share (remember, you will always sell at the bid price). Assuming the stock stayed below $30 through expiration, you would keep the stock and realize a very nice 3.2% return on investment for a month’s worth of time. You would then be able to decide whether to sell another call, sell the stock, or hold onto it if it begins a new upward trend. This is a very attractive trade for a covered call, but even more interesting for a calendar spread. The LEAP January 25 strike price is currently priced at $6.10 share (see Figure 6.12), meaning that you would need to spend $610 to purchase it. You could then sell the June 30 call for $.95. If the stock stayed below $30 at 158

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Notes expiration, you would realize a total profit of 15.5% on the money you have invested—for doing nothing more than selling the call and sitting on the stock for a month.

Figure 6.12 Suppose the stock rises above $30 at expiration. Some traders fall into the trap of exercising their LEAP in order to take delivery on the stock to sell at $30. DO NOT DO THIS. Here’s why. If you exercise your LEAP, you sacrifice the price you paid for it. Said differently, it costs you the price of the LEAP to exercise the LEAP. So although you buy the stock for $25 and sell it for $30 with an anticipated profit of $5, you’re $1.10 in the hole. Remember, you paid $6.10 for the LEAP. Subtract the price you sold the June options for ($.95) and you’re still down $.15 + commissions. If, on the day of expiration, the stock price is above the strike price of the short call (the one you sold), buy it back. Then sell your LEAP. Because your LEAP has a very small theta compared to the call you sold and the LEAP is in-the-money while the call you sold was out-of-the-money, the LEAP will always go up faster in value than the call. Therefore any loss you sustain in buying back the call will be more than compensated for in the selling of the LEAP. Why sell the LEAP? Look at MSFT. If it goes above $30 you are profitable with your LEAP. If you hold onto your LEAP thinking it will go higher, you’re betting against the odds. Take your profits off the table and wait for MSFT to drop back down into the mid $20s.

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Notes Of course, the stock could drop below the $32.5 strike price of the LEAPS contract. Subtracting $1.10 from $32.5 gives a breakeven price of $31.40. If the stock drops below this level at expiration, you should re-evaluate the technical strength of the stock. If the primary upward trend is still intact, you can consider keeping the LEAPS contract and writing another call for the next available month. If it has been violated, then you should consider selling the LEAPS contract, taking a small loss, and moving on. In this event, the $110 premium received will minimize the total loss you absorb. Although writing a covered call provides an attractive return that cannot be dismissed, if you can use the calendar spread, it gives you a way to take advantage of the leverage associated with options, on both sides of the trade. Time decay works in your favor in the short call, and the delta of the LEAPS contract improves your total returns if you are assigned. This enhances your returns well above the level associated with covered calls.

Calendar Spreads to Enhance Growth Just as using calendar spreads for income looks for the same stock characteristics as using covered calls for income, calendar spreads to enhance growth returns use the same criteria as covered calls to enhance growth. The criteria are as follows: • You already own the LEAPS contract. This approach assumes that you are using one of the LEAPS strategies described earlier in this chapter, either as a replacement for owning the stock or as an alternative to owning a shortterm option. • The upward trend has begun to stall or even retrace back to its primary trend line. • The fundamental strength is driving the stock upward. • You can sell an out-of-the-money short-term call at the next closest strike price.

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In this scenario, the fundamental strength may not be as important as it would be when you are trying to generate income in a sideways trend. In fact, higher volatility in an upward trend should increase the premium you receive as well as the likelihood you will be assigned. If you set up the trade correctly, you should lock in

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Notes an attractive profit in the LEAPS contract, with the short call premium adding to that overall return. Look at Figure 6.13.

Figure 6.13 SOHU has experienced an attractive upward trend since late March. In the last month there was a pullback and then a continuation. This could be a signal of a trend-continuation. Suppose you purchased a Jan 2009 $70 LEAP for $19.80 as shown in Figure 6.14.

Figure 6.14 The stock seems to move about $9 a month and might provide an attractive return over a short period of time. It also may consolidate around the $80 level for 30 to 60 days before continuing its upward trend.

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Notes Assume you feel comfortable buying the LEAP and selling the June calls one strike price out-of-the-money. Currently the June $85 calls are going for $5.30 at the bid. See Figure 6.15 below.

Figure 6.15 Remember the LEAPS you bought cost $19.80. Selling the June $85 calls and receiving $5.30 is a staggering rate of return. It is 26%. It is also somewhat risky. Would you be happy selling the $90 calls for $3.60? It is still 18% return for 37 days? The chance of SOHU going above $85 and forcing you to buy back the call is fairly high. The chance of SOHU going to $90 and forcing you to buy back the call is much less. Also, the $90 call will not go up in value as fast as the $85 because of the differences in their delta. Notice that the delta on the LEAP is .69. The delta values on the 85 and 90 calls are .48 and .36 respectively. Remember that the theta value for the LEAP is much less than for either of the calls. These factors alone make the trade attractive. Even if you are forced to buy the calls back at a higher price on expiration because the stock price is higher than the strike price, the LEAP will have gone up considerably more. The net effect of this trade is that if the stock stays flat, you win. If the stock goes up, you win. If the stock goes down such that the LEAP decreases in value, as long as the LEAP does not fall more than $3.60, you still have a winning trade. There are not many strategies that provide this type of directional advantage. 162

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Notes

Summary LEAPS options provide a variety of ways to minimize time decay and downside risk while being in position to take maximum possible advantage of an upward trend. Although your trading system may not benefit from all of the strategies covered in this section, analyze the merits of each one. You will likely find at least one or two of them to be applicable to the type of trading you are interested in. Successful traders make sure to add as many layers of risk management as they can to each trade they make. LEAPS options provide an additional layer of risk management beyond stop losses, position sizing, and analyzing reward-to-risk ratios. Buying LEAPS calls gives you the ability to take advantage of a long, upward-trending stock while adding the benefit of leverage to your potential profits. It also minimizes the risk associated with purchasing shorter-term options since time decay in LEAPS options is much less. Buying LEAPS puts gives you a way to protect yourself from dramatic losses in stocks you have held for long periods of time. Calendar spreads provide all of the same advantages of covered calls, while adding the benefit of leverage and time decay working for you. You can significantly improve your returns over covered calls by buying a LEAPS call, then selling a call at-the-money or just out-of-the-money. This gives you a way to benefit from calendar spreads irrespective of whether you seek to generate income or to simply enhance growth.

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Glossary

Glossary

A AGI (Adjusted Gross Income) – A key number used by many different sections of the tax code to determine the eligibility of the taxpayer for deductions and credits. As a general rule, you want above the line expenses, such as business expenses, which are used to reduce your AGI. Active Account – Refers to a brokerage account in which many transactions occur. Brokerage firms may charge a fee for an account that does not generate an adequate level of activity. Analyst – An employee of a brokerage, fund management house, or other financial institution who studies companies and makes buy-and-sell recommendations on stocks of these companies. Most analysts specialize in a specific industry. Announcement Date – The date on which news concerning a given company is announced to the public. It is used in event studies to evaluate the economic impact of events of interest. Ask Price – This is the lowest price a market maker will accept to sell a stock. The quoted offer at which an investor can buy shares of stock; also called the offer price. Asset – Any possession that has value in an exchange. Authorized Shares – Number of shares authorized for issuance by a firm’s corporate charter.

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B

Basis – In simple terms, your cost of the asset. If you paid $10/share for stock and $1/share commission, your basis would be $11/share. Bear – An investor who believes a stock or the overall market will decline. Bearish – Refers to the attitude of an investor as being pessimistic; a pessimistic outlook. Bear Market – Any market in which prices exhibit a declining trend for a prolonged period, usually falling by 20% or more. Benchmark High – The most recent zone of resistance above the current price of the stock on an upward trend. Benchmark Low – The most recent zone of support below the current price of the stock on a downward trend. Beta – A measurement of the volatility associated with a stock relative to the S&P 500. A beta of 1.0 means the stock’s volatility is equal to that of the S&P 500. Bid Price – The highest price a market maker is willing to pay to buy a security. The price an investor will pay to sell shares of stock. Bid-Ask Spread – The difference between the prices buyers are willing to pay and what sellers are asking for. Big Money – A term used to refer to institutional money as it flows in and out of the stock market. Black Monday – Refers to October 19, 1987, when the Dow Jones Industrial Average fell 508 points after sharp drops the previous week. Blue-Chip Company – A large and creditworthy company which is renowned for the quality and wide acceptance of its products and services, and for its ability to make money and pay dividends. Bond – Debt issued for a period of more than one year. When investors buy bounds, they are lending money. The seller of the bond agrees to repay the principal amount of the loan at a specified time.

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Notes Breakout – A rise in the price of a security above a resistance zone (commonly its previous high price) or a drop below a zone of support (commonly the former lowest price). It can be used as a buy or sell indicator. Broker – An individual who is paid a commission for executing customer orders; an agent specializing in stocks, bonds, commodities, or options, and must be registered with the exchange where the securities are held. Bullish – Refers to the attitude of an investor as being optimistic; an optimistic outlook. Bull – An investor who thinks the market will rise. Bull Market – Any market in which prices are in an upward trend. Buy – To purchase an asset, usually taking a long position. Buy-and-Hold – A passive investment strategy with no active buying and selling of stocks. Buy Limit Order – A conditional trading order that indicates a security may be purchased only at the designated price or lower. Buy on Margin – Borrowing to buy additional shares of stock, and using those same shares as collateral. Buy Order – An order to a broker to purchase a specific quantity of a security. Buy Stop Order – An order to buy that is not to be executed until the market price rises to the stop price. Once the security breaks through that price, the order is then treated as a market order. Buyer’s Market – A market in which the supply exceeds the demand, creating lower prices.

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Notes

C

Capital – Money available to invest. Capital Gain – When a stock is sold for a profit, the difference between the net sales price of the securities and their net cost results in your total profit, which you then report to the IRS as a capital gain and pay capital gains taxes on. Capital Gains Tax – The tax levied on profits from the sale of capital assets. Capital Loss – When a stock is sold below cost (sold at a loss), the difference between the net cost of a security and the net sales price. Cash Flow – Represents earnings before depreciation, amortization, and non-cash charges; sometimes called cash earnings. This indicates the ability to pay dividends. Ceiling – The highest price, interest rate, or other numerical factor allowable in a financial transaction. Chart Patterns – The pattern made by a stock on its stock graph as it fluctuates over a given period of time. These patterns provide traders with information about support and resistance, breakouts, and so on. Close – The period at the end of the trading session; sometimes used to refer to the closing price of a stock. Closing Price – The price of the last transaction of a particular stock completed during a day’s trading session on an exchange. Closing Quote – The last bid and offer prices of a particular stock at the close of a day’s trading session on an exchange. Collateral – An asset that can be repossessed if a borrower defaults. Commission – The fee paid to a broker to execute a trade, based on number of shares, bonds, options, contracts, or their dollar value. Commodity – A fixed physical substance that investors buy or sell, usually through futures contracts. Commodities are basic goods and products, such as food, steel, metal, and so on. 170

Glossary

Notes Common Stock – Traditionally, units of ownership that do not give guaranteed payments or dividends to their owners, and are usually limited in their voting power. In return for accepting these restrictions, owners of common stock normally receive all growth over the amount paid to preferred shareholders. Confirmation – The comparison of technical signals and indicators to ensure that the majority of them are pointing in the same direction; information that validates your opinion of a buying or selling opportunity. Coupon Rate – Interest rate on a bond the issuer promises to pay to the holder until maturity, expressed as an annual percentage of face value. The term derives from the small detachable segment of a bond certificate which, when presented to the bond’s issuer, entitles the holder to the interest due on that date. CPI (Consumer Price Index) – Measure of change in consumer prices, as determined by a monthly survey of the U.S. Bureau of Labor Statistics. Traders use this as a way to track inflation. Also known as the cost of living index. CRB Index (Commodities Research Bureau) – An index of 21 of the most influential commodity categories, such as oil, gas, steel, etc.

D

Daily Price Limit – The level at which many commodity, futures, and options markets are allowed to rise or fall in a day. Exchanges usually impose a daily price limit on each contract. Day Order – A request to buy or sell stock that is good only for the day the order is placed. If the buy or sell request is not filled before the close of the market, the order is cancelled. Most stock buy and sell orders are day orders unless otherwise specified by the investor. Day Trading – Establishing and liquidating the same position or positions within one day’s trading. Debt Market – The market in which bonds are issued and bought and sold between investors.

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Notes Debt-to-Equity Ratio – Total liabilities divided by shareholder’s equity. This shows to what extent owner’s equity can cushion creditor’s claims in the event of liquidation. Delayed Quote – A stock or bond quote that shows bid and ask prices 15 to 20 minutes after a trade takes place. Depressed Market – Market in which supply overwhelms demand, leading to weak and lower prices. Discount Broker – A brokerage house featuring relatively low commission rates in comparison to a full-service broker. Diversification – Dividing investment capital among a variety of securities with different risks, rewards, and correlations in order to minimize risk. Dividend – A portion of a company’s profit paid to common and preferred shareholders. Domestic Market – A nation’s internal market for issuing and trading securities or entities domiciled within that nation. Dow Jones Industrial Average (Dow) – The best known U.S. stock index. A price-weighted average consisting of 30 actively traded blue-chip stocks, primarily industrial, including stocks traded on the New York Stock Exchange and NASDAQ. It is also a barometer of how shares of the largest U.S. companies are performing. Downtick – A move down in a particular stock. Downtrend – The stage in which a stock begins making lower highs and lower lows. Downturn – The transition point between a rising, expanding economy to a falling, contracting one. Drawdown – The total amount of money your trading system will lose during a losing trade or losing streak. Average drawdown can be calculated by adding all of your losing trades over a given period of time and dividing the total by the number of losing trades. This is a way to establish the amount of risk you have taken historically for the reward you have received.

172

Glossary

E

Notes

Earnings – Net income for a company during a specified period of time. Earnings Surprise – Positive or negative differences from the consensus forecast of earnings by institutions. Effective Date – In an interest rate swap, the date the swap begins accruing interest. Entrance/Entry Threshold – An entry price to buy stock at a zone of support. EPS (Earnings Per Share) – Net income for a company during a specified period of time expressed as a per share value. Net income divided by shares outstanding. Equities Market – The various exchanges that make up the stock market. Exchange – A location where buyers and sellers can exchange securities. This can be a trading floor, such as the New York Stock Exchange, or an electronic, computerized exchange, such as the NASDAQ. Exit Threshold – An exit price to sell stock at a zone of resistance. Expected Gains – In a money management system, your reward multiplied by your chances of winning over time. Export – Goods and products produced in the U.S. and sold in foreign countries. Exponential Moving Average – A moving average, calculated over any period of time, where the most recent price information is weighed more heavily than later information.

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Notes

F

Fakeout – The event that occurs when a stock appears poised to break through a zone of support or resistance but fails to do so. A false trading signal that can be minimized through the use of filtering techniques. Fed Funds Rate – The rate banks charge to each other to cover Federal Reserve requirements. These are usually very short-term loans, often overnight. Fed Funds Discount Rate – The rate at which banks can borrow money from the Federal Reserve Bank. Usually a relatively slowchanging rate, it is adjusted up or down in increments as the Fed deems necessary to boost the economy or guard against inflation. The stock market reacts dramatically to changes in this rate. Filtering (see Price Filter, Time Filter, Volume Filter) – A method used to determine whether a market is breaking or holding support or resistance zones. Financial Analysis – An analysis of a company’s financial statement, usually done by financial analysts. Financial Analysts – Professionals who analyze financial statements, interview corporate executives, and attend trade shows of companies in order to write reports that recommend purchasing, selling, or holding various stocks. Also called securities analysts and investment analysts. Fiscal Quarter – The three-month period of time the company uses to track their quarterly performance. All quarterly statements and financial reports are tied to this time period. Although this quarter often follows standard calendar quarters, it just as often does not. The quarter period a company follows is dictated by its fiscal year. Fiscal Year – The twelve-month period of time the company uses to track their yearly performance. All year-end statements and financial reports are tied to this time period. Although many company’s fiscal years follow the standard calendar year (January—December) it is just as common that they do not. A fiscal year can begin and end in any twelve-month period on the calendar. 174

Glossary

Notes Fixed Percentage – A money management technique to dictate how much of the investment capital an investor has will be used in a single trade. Encourages more conservative position sizing which helps to minimize risk. Flight to Quality – Moving capital to the safest possible investment to protect oneself from loss during an unsettling period in the market. This movement can manifest itself in any of the various financial markets; for example, unexpected volatility and risk in the stock market often results in investors selling stocks and buying more government bonds. Float – Shares outstanding minus insider holdings. The float consists of all shares that are available for trade in the stock market at any given time. This number can help identify how liquid a stock is as well as how much control of the stock insiders maintain. Fluctuation – A price or interest rate change. Forecasting – Making projections about future performance on the basis of historical and current conditions data. Full-Service Broker – A broker who provides clients an allinclusive selection of services such as advice on security selection and financial planning. Fully Invested – Used to describe an investor whose assets are totally committed to investments, typically stock. Fundamental Analysis – Security analysis that seeks to detect mis-valued securities through an analysis of a firm’s business prospects and historical performance, focusing on earnings, dividend prospects, expectations for future interest rates, and risk evaluation of the firm. Futures – A term used to designate all contracts covering the sale of financial instruments or physical commodities for future delivery on a commodity exchange. Futures Contract – An agreement to buy or sell a set number of shares of a specific stock in a designated future month at a price agreed upon today by the buyer and seller. The contract is often traded on the futures market. A futures contract differs from option as an option is the right to buy or sell, while a futures contract is the promise to actually make the transaction.

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Notes

G

Gain – A profit on a securities transaction recognized by selling a security for more than the security originally cost. The gain is the difference between the cost and the sale. Gross Profit – Sales minus the cost of goods sold. Gross Profit Margin – The gross profit divided by sales, which is equal to each sales dollar left over after paying for the cost of goods sold. Growth Opportunity – Opportunity to invest in profitable projects.

H

Hedge – A transaction that reduces the risk of an investment. Hedging – A strategy designed to reduce investment risk using call options, put options, short-selling, or futures contracts. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss; it helps lock in profits. Held Order – An order that must be executed without hesitation or if the stock can be bought or sold at that price in sufficient quantity. High-Tech Stock – Stocks of companies operating in hightechnology fields. Intel, Microsoft, IBM, Yahoo! and Amazon.com are example of high-tech stocks. Hold – To maintain ownership of a stock over a long period of time; also a recommendation of an analyst who is not positive enough on a stock to recommend a buy, but not negative enough on the stock to recommend a sell.

176

Glossary

I

Notes

IRA (Individual Retirement Account) – Tax deferred accounts one can contribute to as long as there is earned income. Independent Financial Market – A financial market that trades a specific type of financial instrument. The stock market, bond market, currency market, and commodity market are all examples of independent financial markets, because although each can impact the other, they don’t necessarily depend on each other to operate on their own. Index – Statistical composite that measures changes in the economy or in financial markets, often expressed in percentage changes from a base year or from the previous month. Indices measure the ups and downs of stocks, bonds, and some commodities markets, in terms of market prices and weighting of companies in the index. Indicator – Technical or fundamental measurement securities analysts use to forecast the market’s direction, such as investment advisory sentiment, stock trading volume, interest rates direction, and corporate insider’s buying or selling. Individual Investor – Average, typical investors who trade their own money, rather than doing it for institutions. Even wealthy, very successful investors who trade their own accounts are considered individual investors. Industry – A subcategory of market organization below the sector level. Industry Groups – A subcategory of market organization below the Industry level. Inflation – Rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market - too much money chasing too few goods. Moderate inflation is a common result of economic growth, while prices rising at more than 100% per year are considered hyperinflation and reflective of a lack of confidence in the dollar. Interest Rates – Cost of borrowing money, expressed as a rate per period of time, usually one year, in which case it is called an annual rate of interest. 177

Guide to Options Strategies

Notes Intermarket Analysis – The process of analyzing each of the independent financial markets to determine their impact on the stock market. Intermediate Trend – A trend period of six to nine months. Changes in the Intermediate Trend are generally taken as market corrections. Insider Information – Material information about a company that has not yet been made public. Insiders – Directors and senior officers of a corporation; those who have access to inside information about a company; someone who owns more than 10% of the voting shares of a company. Institutional Investors – Money invested in the market by mutual funds, investment banks, insurance companies, brokerage houses, and major corporations. Large dollar volume transactions that can dramatically impact the price of a stock in a short period of time. Investment Income – The revenue from a portfolio of invested assets. Investment Manager – The individual who manages a portfolio of investments; also called a portfolio manager or money manager. Investments – The study of financial securities, such as stocks and bonds, from the investor’s viewpoint. Investment Strategy – A strategy an investor uses when deciding how to allocate capital among several options, including stocks, bonds, cash equivalents, commodities, and real estate. Investor – The owner of a financial asset; one who is looking to earn money in the stock market through a “buy and hold” strategy. Most earnings are either long-term capital gains, dividends, or interest. Import – Goods and services brought into a country from sources outside its borders.

178

Glossary

K

Notes

Keogh Plan – A type of pension plan in which taxes are deferred. Available to those who are self-employed.

L

Large-Cap Stock – A stock with a high level of market capitalization, usually at least $5 billion in market value. Leader – A stock or group of stocks first to move in a market upsurge or downturn. Limit Order – An order to buy stock at or below a specified price, or to sell stock at or above a specified price. A conditional trading order designed to avoid the danger of adverse unexpected price changes. Listed Stocks – Stocks traded on an exchange. Long-Term Capital Gains – Gains from the purchase or sale of capital assets that are held for longer than 12 months. Long-Term Investor – A person who makes investments for a period of at least five years in order to finance his or her long-term goals. Lower Band – The bottom range of a technical oscillator such as MACD or Stochastic.

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Notes MACD – A hybrid technical analysis tool which combines the characteristics of an oscillator with trend tracking to identify buying and selling signals. Majority Shareholder – A shareholder who is part of a group that controls more than half of the outstanding shares of a corporation. Margin – Allows investors to buy securities by borrowing money from a broker; the difference between the market value of a stock and the loan a broker makes. Margin Account – An account that can be leveraged, in which stocks can be purchased for a combination of cash and a loan. The load is collateralized by the stock; if the value of the stock drops sufficiently, the owner must either put in more cash, or sell a portion of the stock. Market Analysis – An analysis of technical, corporate, and market data used to predict movements in the market. Margin Call – A demand for additional funds because of adverse price movement in a stock bought on margin; maintenance margin requirements; security deposit maintenance. Market Capitalization – The total dollar value of a company’s equity. Calculated by multiplying the current price of the stock by the shares outstanding. Market Ceiling – The most immediate zone of resistance in a stock. Market Floor – The most immediate zone of support in a stock. Market Index – A measure of the market consisting of weighted values of the components that make up a certain list of companies. A tracking of the performance of certain stocks by weighting them according to their prices and the number of outstanding shares using a particular formula. Market Opening – The start of a formal trading day on an exchange. Market Order – An order to buy or sell a stated amount of a security at the most advantageous price obtainable after the order is presented in the trading crowd. Special restrictions cannot be specified (all or none or good till cancelled orders) on market orders. Market Prices – The amount of money a willing buyer pays to acquire stock from a willing seller. 180

Glossary

Notes Market Research – A technical analysis of factors such as volume, price trends, and market breadth that are used to predict price movement. Market Return – The return on the market portfolio. Market Risk – Risk that cannot be diversified away. Market Share – The percentage of total industry sales that a particular company controls. Market Value – The price at which a security is trading and could presumably be purchased or sold; what investors believe a stock is worth, calculated by multiplying the number of shares outstanding by the current market price of the stock. Mature – To cease to exist; to expire. Merger – An acquisition in which all assets and liabilities are absorbed by the buyer; any combination of two companies. Midcap – A stock with a capitalization of usually between $1 billion and $5 billion. Momentum – The amount of acceleration of an economic, price, or volume movement. Money Management – A complete, holistic set of trading rules and specifications that defines how you should make your stock trades. Establishes the balance you need to maintain between reward and risk to be successful in your trading over time. Moving Average – The mean price of a stock calculated at any time over a past period of fixed length to help define trend direction and support and resistance zones. Moving Average Crossover – The point when moving averages reflecting different time periods (such as a 20-day MA and a 50-day MA) intersect and cross. Depending on the direction of the trend, these crossovers can be seen as critical breakthrough points to the upside as well the downside. Many oscillators use these crossover points to identify specific buying or selling signals.

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Notes

N

NASDAQ – The National Association of Securities Dealers Automatic Quotation System. A nationwide computer network for buying and selling NASDAQ-listed stocks. Narrow Market – An inactive market, which displays large fluctuations in prices due to a low volume of trading. Narrowing the Spread – Reducing the difference between the bid and ask prices of a security. Net – The gain or loss on a security sale as measured by the selling price of a security less the adjusted cost of acquisition. New York Stock Exchange – The most well-known stock exchange in the world. Also called the Big Board or the Exchange. News – Daily events reported on news programs and the Internet which can often have a sudden and dramatic effect on the price of a stock. NYSE Amex (formerly the American Stock Exchange) – Located in downtown Manhattan, this stock exchange consists primarily of index options and shares of small and medium-sized companies. NYSE Composite Index – Composite index covering price movements of all common stocks listed on the New York Stock Exchange. It is based on the close of the market on December 31, 1965, at a level of 50.00 and is weighted according to the number of shares listed for each issue. The composite index is supplemented by separate indexes for four industry groups; industrial, transportation, utility and finance.

182

Glossary

O

Notes

Offer Price – Indicates a willingness to sell at a given price. Open – Having either buy or sell interest at the indicated price level and side. Open Position – A long-or-short position whose value will change with a change in prices. Opening – The beginning of the trading session officially designated by an exchange during which all transactions are considered made “at the opening.” Opening Price – The range of prices at which first bids and offers are made on an exchange. Order – Instruction to a broker/dealer to buy, sell, deliver, or receive securities or commodities that commits the issuer to the terms specified. Oscillator – A tool used to confirm trend direction and short-term buying and selling signals. Oscillators are generally designed to measure momentum and overbought/oversold conditions. Over the Counter (OTC) – A market in which securities transactions are conducted through a telephone and computer network connecting dealers in stocks and bonds, rather than on the floor of an exchange. The NASDAQ is an OTC market. Also, a stock that is not listed and traded on an organized exchange (bulletin board stocks, for example) is traded over the counter. Overbought – A condition in which a stock is considered to have risen as much as it is likely to in the short term, forecasting a shortterm pullback. Oversold – A condition in which a stock is considered to have dropped as low as it is likely to in the short term, forecasting a shortterm increase in price.

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P

Par Value – The face value of a bond. A bond selling at par is worth the same dollar amount it was issued for or at which it will be redeemed at maturity. Paper Gain/Loss – Unrealized capital gain/loss on securities held in a portfolio based on a comparison of the current market price to the original cost. Paper Trading – Placing stock trades in paper format rather than with actual dollars to gain experience in using research and timing techniques without putting investment at risk. P/E Ratio – The price to earnings ratio, which is calculated by dividing the current stock price by trailing annual earnings per share or expected annual earnings per share. Peak – The high point at the end of an economic expansion until the start of a contraction. PEG Ratio – A derivation of the P/E ratio and expected growth rates. It is calculated by dividing the current P/E ratio by the expected EPS. Portfolio Manager – A professional who assumes responsibility for the securities portfolio of an individual or institutional investor. In return for a fee, the manager manages the portfolio and chooses which types are most appropriate over time. Position – A market commitment. The number of shares bought or sold for which no offsetting transaction has been entered into. The buyer of a security is said to have a long position, and the seller of a security is said to have a short position. Position Sizing – The process of determining what portion of an investor’s capital should be placed in a single position. This is an important component of risk management in an effective trading system. Preferred Shares – Shares that give investors a fixed dividend from the company’s earnings and entitle them to be paid before common shareholders.

Glossary

Notes Price Divergence – A condition in which technical indicators such as Stochastic and MACD begin to move in the opposite direction of the price of the stock. Rather than confirming a buying signal, this is a warning sign in an uptrending stock. Price Filter – A method for identifying breakthroughs of support and resistance zones. Price filtering refers to waiting for a stock to break through a specific price that has been identified as support or resistance before initiating a buy order on the stock. Primary Market – Where a newly issued security is first offered. All subsequent trading of this security occurs in the secondary market. Primary Trend – The longest-term trend, lasting nine months to two years. This trend is most directly impacted by the fundamental strength of the broad economy. Prime Rate – The interest rate banks charge to their most creditworthy customers, and which acts as a baseline for loans to less creditworthy customers. Profit – Revenue earned minus the cost and the commission. Total amount made on the transaction. Profit Forecast – A prediction of future profits of a company that could affect investment decisions. Profit Margin – An indicator of profitability. The ratio of earnings available to stockholders to net sales. Determined by dividing net income by revenue for the same 12-month period. Also known as net profit margin. Profit Taking – Action taken by short-term securities traders to cash in on gains created by a sharp market rise, which pushes prices down temporarily but implies an upward market trend. Public Offering – A stock offering to the investment public, after compliance with registration requirements of the SEC, usually by an investment banker or a syndicate made up of several investment bankers, at a price agreed upon between the issuer and the investment bankers. Public Ownership – The portion of a company’s ís stock that is held by the public. Publicly Held – Describes a company whose stock is held by the public. 185

Guide to Options Strategies

Notes Publicly Traded Assets – Assets that can be traded in a public market such as the stock market. Purchase Order – A written order to buy specified goods at a stipulated price.

Q Quarterly – Occurring every three months. Quoted Price – The price at which the last trade of a particular security or commodity took place.

R

Rally (Recovery) – An upward movement in the price of a stock or the broad market. Range – The high and low prices recorded during a given period of time. Real Time – A stock or bond quote that is current with the current buy or sell price of the stock or bond. Realized Return – The return that is actually earned over a given time period. Recession – A temporary downturn in economic activity, usually indicated by two consecutive quarters of a falling gross domestic product.

186

Glossary

Notes Relative Strength – The rate at which a stock falls relative to other stock groups in a falling market or rises relative to other stocks in a rising market. Analysts reason that a stock that holds value on the downside will be a strong performer on the upside and vice versa. This logic can also be applied to industry group and sector comparisons. Resistance – A price level above which it is supposedly difficult for a security or market to rise. A price ceiling at which technical analysts and traders note persistent selling of the security or market. Return – The change in the value of a portfolio over a period of time, including any distributions made from the portfolio during that period. Return on Equity (ROE) – An indicator of profitability determined by dividing net income for the past 12 months by stockholder equity and shown as a percentage. ROE is used to measure how a company is using its money. Return on Investment (ROI) – Book income as a proportion of net book value. Revenue Total dollars brought into a company through sales, stated on a quarterly and annual basis. Reversal – A change in the direction or trend of a stock. Reward: Risk Ratio – The potential reward in a given trade or set of trades over time divided by the amount of risk taken. If a trade appears to have $2 of upside potential against $1 of downside potential, then the reward: risk ratio is 2:1. A critical component of risk and money management. Risk – The risk that the issuer cash flow will not be adequate to meet its financial obligations. Additional risk a company’s shareholder bears when the firm uses debt and equity. Risk Factor – A set of common factors that impact returns (e.g., market return, interest rates, inflation, etc.). Risk Management (see also Money Management) – The process of identifying and evaluating risks and selecting and managing techniques to minimize risk. Roth-IRAA – type of IRA account that allows contributors to invest up to $2,000 per year, and for assets to grow completely tax-free, and to withdraw the principal and earnings tax-free under certain conditions. This differs from a traditional IRA, however, in that yearly contributions are not tax deductible.

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Notes

S

Scaling In – A conservative approach to position sizing and money management that places smaller amounts of money in a position at the beginning of the trade, then increases the size of the position as the stock extends into an upward trend. SEC – Securities and Exchange Commission. A federal agency that regulates the U.S. financial markets, oversees the securities industry and promotes full disclosure in order to protect the investing public against malpractice in the securities market. Sales Forecast – A key input to a firm’s financial planning process based on historical experience, statistical analysis, and consideration of various macroeconomic factors. S&P 500 Composite Index – An index of 500 widely held common stocks that measures the general day-to-day performance of the market. Sector – Used to characterize a group of securities that are similar with respect to maturity, type, rating, industry, and coupon. Sector Rotation – The flow of institutional money into various sectors of the stock market. Securities – Stocks and their derivatives, bonds, and commodities. Any financial instrument that can be publicly traded. Sell Limit Order – Conditional trading order that indicates a security may be sold at the designated price or higher. Sell Off – The sale of securities under pressure. Sell Order – An order that may take many different forms by an investor to a broker to sell a stock, bond, option, future, mutual fund, or other holding. Seller’s Market – A market in which demand exceeds supply. As a result, the seller can often dictate the price and terms of the sale. Selling Short – Selling a stock not actually owned. If an investor thinks the price of a stock is going down, the investor could borrow the stock from a broker and sell it. Eventually, the investor must buy 188

Glossary

Notes the stock back on the open market to close the position and repay the obligation to the broker. Sentiment – The general attitude or feeling about a stock or market. Most accurately reflected by tracking buying and selling volume. Shareholder – A person or entity that owns shares or equity in a corporation. Shareholder Equity – Total assets minus total liabilities of a corporation. Shares – Certificates or book entries representing ownership in a corporation or similar entity. Shares Outstanding – Shares of a corporation, authorized in the corporate charter, which have been issued and are outstanding. Short – One who has sold a contract to establish a market position and has not yet closed out the position through an offsetting purchase. Short Position – Occurs when a person sells stocks he or she does not yet own. Shares must be borrowed from the broker before the sale to make “good delivery” to the buyer. Eventually, the shares must be bought back to close out the transaction. This is done when an investor believes the stock price will drop. Short-Term – Any investments with a maturity of one year or less. Short-Term Gain/Loss – A profit or loss realized from the sale of securities held for less than a year. This is taxed at normal income tax rates if the net total is positive. Short-Term Trend – A trend that lasts two to four weeks. Changes in the short-term trend generally come about from random news events such an analyst ratings and downgrades and profit forecasts. Sideways Trend (see Trendless) – A horizontal price movement within a narrow price range over an extended period of time, creating the appearance of a relatively straight line on a stock’s price graph. Simple Moving Average – A moving average that is calculated by adding the closing prices over a given period of time, then dividing the sum by the number of days in the period. Each day in the calculation is given the same weight. This contrasts with an exponential moving average which places a heavier weighting on the most recent days. Slump – A temporary fall in performance, often describing consistently falling security prices for several weeks or months.

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Notes Small-Cap – A stock with a small capitalization, meaning a total equity value of less than $500 million. Smart Money – Experienced, sophisticated investors who use advanced techniques to track sector rotation and institutional money flow as a guide for stock trades. Speculation – Purchasing risky investments that present the possibility of large profits, but also pose a higher-than-average possibility of loss. Split – When a company splits its outstanding shares into more shares. The investor’s equity in the company remains the same, and the share price is one-half the price of the stock on the day prior to the split. Stage I Trend – The highly speculative early period of an upward trend. The immediate trend at this time is flat or sideways. Stage II Trend – The period of an upward trend immediately after a breakout from support or resistance zones. The period of time where investors buy into a stock hoping the early price surge will continue. Stage III Trend – The final upward thrust of an upward trend when everybody who wants to be in the stock now is. This is usually the beginning of the end of the upward trend. Stage IV Trend – The final period of the upward trend where the stock begins to test support zones and fails to break resistance zones, resulting in a sideways movement of the stock. Stochastic – An oscillator that measures overbought and oversold conditions in a stock over time. Stock – Ownership of a corporation indicated by shares, which represent a piece of the corporation’s assets and earnings. Stockbroker – A person registered with the SEC who is employed by and solicits business for a commission house or futures commission merchant. Stock Buyback – A corporation’s purchase of its own outstanding stock, usually in order to raise the company’s earnings per share. Stock Certificate – A document representing the number of shares of a corporation owned by a shareholder.

190

Stock Dividend – The payment of a corporate dividend in the form of stock rather than cash; often used to conserve cash needed to operate the business. Stock dividends are not taxed until sold.

Glossary

Notes Stock Exchanges – Formal organizations approved and regulated by the SEC that are made up of members who use the facilities to exchange certain common stocks. Stock Index – An index such as the Dow Jones Industrial Average that tracks the performance of a basket of stocks. Stock Market – Also called the equities market. Stock Split – Occurs when a firm issues new shares of stock and in turn lowers the current market price of the stock to a level that is proportionate to pre-split prices. Stock Ticker – A letter designation assigned to securities and mutual funds traded on U.S. financial exchanges. Stop-Limit Order – A stop order designating a price limit. Unlike the stop order, which becomes a market order once the stop is reached, the stop-limit order becomes a limit order. Stop Loss Order – An order to sell a stock when the price falls to a specified level. Stop Order – An order to buy or sell at the market when a definite price is reached, either above (on a buy) or below (on a sell) the price that prevailed when the order was given. Stopped Out – A purchase or sale executed under a stop order at the stop price specified by the customer. Strengthening Trend – An upward or downward trend that becomes steeper as buying or selling activity increases in the stock. This usually serves to extend the current trend even higher in the short term. Success Rate – The rate at which winning trades make money. This is correlated with drawdown rates to identify reward: risk profiles and appropriate position sizes in specific trades. Support (see Price Floor) – Price zone at which a security tends to stop falling because demand begins to outweigh supply. Symbol – Letters used to identify companies on the exchanges.

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Notes

T

Target Price – The price an investor hopes a stock will reach in a certain time period. Technical Analysis – Security analysis that seeks to detect and interpret patterns in past security prices. Technical Analysts – Analysts who use mechanical rules to detect changes in the supply of and demand for a stock in order to capitalize on the expected change. Technical Indicators – Information that confirms or supports trading signals. Oscillators such as MACD and Stochastic are examples of effective technical indicators. Threshold Trading Method – A systematic approach to identifying entry and exit points in stock trades. Tick – Refers to the minimum change in price a security can have either up or down. Time Filter – A method for identifying breakthroughs of support and resistance zones. Once a stock has broken a support or resistance zone, waiting one to three days to see if the stock holds the new higher price can provide confirmation of the move. Time Order – An order that becomes a market or limited price order, or is cancelled at a specific time. Total Cost – The price paid for a security, plus the commission and any accrued interest owed to the seller (as with a bond). Total Dollar Return – The dollar return on a non-dollar investment, including the sum of any dividend/interest income, capital gains or losses, and currency gains or losses on the investment. Total Return – In performance measurement, the actual rate of return realized over an evaluation period. Total Revenue – Total sales and other revenue for the period shown.

192

Total Volume – The total number of shares or contracts traded on national and regional exchanges in a stock, bond, commodity, future, or option on a certain day.

Glossary

Notes Trade – An oral (or electronic) transaction involving one party buying a security from another party. Once a trade is consummated, it is considered final. Settlement occurs one to five business days later. Traders – Individuals who take positions in stock investments with the objective of making profits. Traders take proprietary positions in which they seek to profit from the directional movement of prices or spread positions that can be held for either the long-term or shortterm. Trading – The buying and selling of securities. Trading Costs – Costs of buying and selling securities, including commissions, slippage and the bid/ask spread. Trading Pattern – The long-range direction of a security’s price, charted by drawing a line connecting the highest prices the security has reached and another line connecting the lowest prices at which the security has traded over the same period. Trading Range – The difference between the high and low prices traded during a period of time. Trading Rules – A set of predetermined, customized rules that must be followed on each and every trade you place. Trading Signal – An indication of a buying or selling opportunity. Trading System – A holistic view of the trading process that encapsulates trading rules, fundamental, technical and intermarket analysis, and money management techniques to increase the odds of success over time. Trading Volume – The number of shares transacted every day. Because there is a seller for every buyer, trading volume is half of the number of shares traded. Trailing Stop – A stop loss order that trails the progress of an upward trending stock. It helps to preserve profit while also providing downside protection. Transaction – The delivery of a security by a seller, and its acceptance by the buyer. Treasury Securities – Short-and long-term bonds issued by the Treasury Department and backed by the full faith of the U.S. government. Treasury yields are commonly used to track fluctuations in interest rates. Trend – The general direction of the market.

193

Guide to Options Strategies

Notes Trendless (see Sideways Trend) – A horizontal price movement within a narrow price range over an extended period of time, creating the appearance of a relatively straight line on a stock’s price graph. Trendline – A technical chart line that depicts the past movement of a security, and that is used to help predict future price movements.

U

Under Perform – When a security appreciates at a slower pace than the overall performance of the market. Undervalued – A stock price perceived to be too low, as indicated by a particular valuation model. For instance, a company’s stock price may be considered cheap if the company’s P/E ratio is much lower than the industry average. Unissued Stock – Shares authorized in a corporation’s charter, but not issued. Unmargined Account – A cash account held at a brokerage firm. Up – Market indication that securities, or the market in general, is doing well in volume trading. Up Tick – A plus tick; a price movement in the upward direction. A trade occurring at a price higher than the previous trade. Upgrading – Raising the quality rating of a security because of new optimism about the prospects due to tangible/intangible factors. This can increase investor confidence and push the price of the security up. Upside Potential – The amount by which analysts or investors expect the price of a security may increase. Upswing – An upward turn in a security’s price after a period of falling prices. Uptrend – Upward direction in the price of a stock, bond, or commodity future contract or overall market. 194

Upper Band – The top range of a technical oscillator such as MACD or Stochastic.

Glossary

V

Notes

Validation – The comparison of technical signals and indicators to ensure that the majority of them are pointing in the same direction; information that confirms your opinion of a buying or selling opportunity. Valleys – The low point at the end of an economic contraction until the start of an expansion. Valuation – A determination of the value of a company’s stock based on earnings and the market value of assets. Variable – An element in a model; variables change through time and are not constant. Volatility – A measure of risk based on the standard deviation of the asset return. A variable that appears in option pricing formulas where it denotes the volatility of the underlying asset return from now to the expiration of the option. Volume – The daily number of shares of a security that change hands between a buyer and a seller. Volume Filter – A method for identifying breakouts through support and resistance zones. Volume Filtering refers to waiting for an increase in buying or selling volume to support the breakout you are observing.

W

Wall Street – Generic term for the security industry firms that buy, sell, and underwrite securities. Watch List – A list of securities selected for special attention as potential investments. 195

Guide to Options Strategies

Weak Market – A market with few buyers and many sellers, and a declining trend in prices. Well-Diversified Portfolio – A portfolio that includes a variety of securities in order to approximate the overall market risk. The unsystematic risk of each security is diversified throughout the portfolio. Whipsaw – A highly volatile environment in which a stock experiences severe fluctuations on both the upside and downside. Traders will sometimes get stopped out of these trades only to see the stock continue to rally higher after they have exited the trade.

Y

Year-End Dividend – A special dividend declared at the end of a fiscal year that usually represents higher-than-expected company profits. Year-to-Date (YTD) – The period beginning at the start of the calendar year up to the current date. Yield – The percentage rate of return paid on a stock in the form of dividends.

Z

Zone – A price level of support or resistance for a stock. Looking for breakouts through support and resistance zones provides opportunities to buy stocks at the early stage of new rallies.

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