Options Trading Strategy Guide

Options Trading Strategy Guide: Foreword In Global Financial Markets, for many years, options have been a means of conveying rights from one party to another at a specified price on or before a specific date. Options to buy and sell are commonly executed in real estate and equipment transactions, just as they have been for years in the securities markets. There are two types of option agreements: CALLS and PUTS. •

A CALL OPTION is a contract that conveys to the owner the right, but not the obligation, to purchase a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date.

•

A PUT OPTION is a contract that conveys to the owner the right, but not obligation, to sell a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date.

Consequently, if the market in a security were expected to advance, a trader would purchase a call and, conversely, if the market in a security were expected to decline, a trader would purchase a put. With the advent of listed options, the inconvenience and difficulties originally associated with transacting options have been greatly diminished. The purpose of this book is to provide an introduction to some of the basic equity option strategies available to option and/or stock investors. Exchange-traded options have many benefits including flexibility, leverage, limited risk for buyers employing these strategies, and contract performance guaranteed by Stock Exchanges. Options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright. Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing (selling) options, to earn premium income. Options give you options. You're not just limited to buying, selling or staying out of the market. With options, you can tailor your position to your own financial situation, stock market outlook and risk tolerance. Whether you are a conservative or growth-oriented investor, or even a short-term, aggressive trader, your broker can help you select an appropriate options strategy. The strategies presented in this book do not cover all, or even a significant number, of the possible strategies utilizing options. These are the most basic strategies, however, and will serve well as building blocks for more complex strategies. Despite their many benefits, options are not suitable for all investors. Individuals should not enter into option transactions until they have read and understood the risk disclosure section coming later in this document which outlines the purposes and risks thereof. Further, if you have only limited or no experience with options, or have only a limited understanding of the terms of option contracts and basic option pricing theory, you should examine closely another industry document.

An investor who desires to utilize options should have well-defined investment objectives suited to his particular financial situation and a plan for achieving these objectives. Options are currently traded on the following Indian exchanges: Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Like trading in stocks, options trading are regulated by the SEBI. These exchanges seek to provide competitive, liquid, and orderly markets for the Purchase and sale of standardized options. It must be noted that, despite the efforts of each exchange to provide liquid markets, under certain conditions it may be difficult or impossible to liquidate an option position. Please refer to the disclosure document for further discussion on this matter. All strategy examples described in this book assume the use of regular, listed, American-style equity options, and do not take into consideration margin requirements, transaction and commission costs, or taxes in their profit and loss calculations. You should be aware that in addition to SEBI margin requirements, each brokerage firm may have its own margin rules that can be more detailed, specific or restrictive. In addition, each brokerage firm may have its own guidelines with respect to commissions and transaction costs. It is up to you to become fully informed on the specific procedures, rules and/or fee and commission schedules of your specific brokerage firm(s). The successful use of options requires a willingness to learn what they are, how they work, and what risks are associated with particular options strategies. Individuals seeking expanded investment opportunities in today's markets will find options trading challenging, often fast moving, and potentially rewarding. BRIEF OPTIONS HISTORY Ancient Origins Although it isn't known exactly when the first option contract traded, it is known that the Romans and Phoenicians used similar contracts in shipping. There is also evidence that Thales, a mathematician and philosopher in ancient Greece used options to secure a low price for olive presses in advance of the harvest. Thales had reason to believe the olive harvest would be particularly strong. During the off-season when demand for olive presses was almost nonexistent, he acquired rights-at a very low cost-to use the presses the following spring. Later, when the olive harvest was in full-swing, Thales exercised his option and proceeded to rent the equipment to others at a much higher price. In Holland, trading in tulip options blossomed during the early 1600s. At first, tulip dealers used call options to make sure they could secure a reasonable price to meet the demand. At the same time, tulip growers used put options to ensure an adequate selling price. However, it wasn't long before speculators joined the mix and traded the options for profit. Unfortunately, when the market crashed, many speculators failed to honor their agreements. The consequences for the economy were devastating. Not surprisingly, the situation in this unregulated market seriously tainted the view most people had of options. After a similar episode in London one hundred years later, options were even declared illegal.

Early Options in the US In the US, options appeared on the scene around the same time as stocks. In the early 19thCentury, call and put contracts-known as "privileges"-were not traded on an exchange. Because the terms differed for each contract, there wasn't much in the way of a secondary market. Instead, it was up to the buyers and sellers to find each other. This was typically accomplished when firms offered specific calls and puts in newspaper ads. Not unlike what happened in Holland and England, options came under heavy scrutiny after the Great Depression. Although the Investment Act of 1934 legitimized options, it also put trading under the watchful eye of the newly formed Securities and Exchange Commission (SEC). For the next several decades, growth in option trading remained slow. By 1968, annual volume still didn't exceed 300,000 contracts. For the most part, early over-the-counter options failed to attract a following because they were cumbersome and illiquid. In the absence of an exchange, all trades were done by phone. To make matters worse, investors had no way of knowing what the real market for a given contract was. Instead, the put-call dealer functioned only to match the buyer and seller. Operating without a fixed commission, the dealer simply kept the spread between the price paid and the price sold. There was no limit to the size of this spread. Worse yet, all option contracts had to be exercised in person. If the holder of the option somehow missed the 3:15 pm deadline, the option would expire worthless regardless of its intrinsic value. Chicago Board of Trade In the late 1960s, as exchange volume for commodities began to shrink, the Chicago Board of Trade (CBOT) explored opportunities for diversification into the option market. Joseph W. Sullivan, Vice President of Planning for the CBOT, studied the over-the-counter option market and concluded that two key ingredients for success were missing. First, Sullivan believed that existing options had too many variables. To correct this, he proposed standardizing the strike price, expiration, size, and other relevant contract terms. Second, Sullivan recommended the creation of an intermediary to issue contracts and guarantee settlement and performance. This intermediary is now known as the Options Clearing Corporation. To replace the put-call dealers, who served only as intermediaries, the CBOT created a system in which market makers were required to provide two-sided markets. At the same time, the presence of multiple market makers made for a competitive atmosphere in which buyers and sellers alike could be assured of getting the best possible price. Chicago Board Options Exchange (CBOE) After four years of study and planning, the Chicago Board of Trade established the Chicago Board Options Exchange (CBOE) and began trading listed call options on 16 stocks on April 26, 1973. The CBOE's first home was actually a smoker's lounge at the Chicago Board of Trade. After achieving first-day volume of 911 contracts, the average daily volume skyrocketed to over 20,000 the following year. Along the way, the new exchange achieved several important milestones.

As the number of underlying stocks with listed options doubled to 32, exchange membership doubled from 284 to 567. About the same time, new laws opened the door for banks and insurance companies to include options in their portfolios. For these reasons, option volume continued to grow. By the end of 1974, average daily volume exceeded 200,000 contracts. The newfound interest in options also caught the attention of the nation's newspapers, which voluntarily began carrying listed option prices. That's quite an accomplishment considering that the CBOE initially had to purchase news space in The Wall Street Journal in order to publish quotes. The Emergence of Put Trading After repeated delays by the SEC, put trading finally began in 1977. Determined to monitor the situation closely, the SEC only permitted puts to be traded on five stocks. Despite the rapid acceptance of puts and the rising interest in options, the SEC imposed a moratorium halting the listing of additional options. Nevertheless, annual volume at the CBOE reached 35.4 million in 1979. Today, more than ever, option volume and open interest continues to climb. In 1999 alone, option volume at the CBOE doubled. By the end of 1999, the number of open contracts reached almost 60 million. Today, options on all sorts of financial instruments are also traded at the Chicago Mercantile Exchange, the CBOT, and other exchanges. Employee Stock Options With the rapid growth in Internet companies over the past few years and the enormous wealth created by employee stock options, more and more people are developing an interest in the concept of owning and trading options. Although there are fundamental differences between the options granted to an employee by a company and the options traded on the floor of an exchange, there are important similarities. When a company grants stock options to an employee, it gives that person the right to buy a certain number of shares at a price often well below market value. Although the options granted by a company eventually expire, they are usually good for extended periods (e.g., 10 years). Generally speaking, options issued by a company are not transferable. Therefore, they cannot be sold or traded to a third party. However, if the company is publicly traded, the employee can exercise the options and convert it to stock. This stock can then be sold on the open market. For example, the person might have options to buy 1,000 shares at an exercise (strike) price of 120 per share when the stock (in the case of a public company) is actually trading at 250. In this case, the person pays Rs.120,000 for stock that is worth Rs.250,000 on the open market. Not a bad deal at all.

Exchange Traded Options Although there are a variety of different types of options (e.g., stock options, index options), this section will focus exclusively on stock options. Once you understand the basic principles, they can easily be applied to the other financial instruments. Exchange-traded stock options, also known as equity options, differ from those granted to employees by their company in a number of important ways. First, they typically have shorter-term expirations. Options granted by companies are often good for several years. During that period, they can be exercised (converted to stock) at any point. However, employee stock options cannot usually be sold or transferred. In contrast, exchange traded options (with the exception of LEAPS) are generally valid for only a few months and can be bought or sold at any time prior to expiration. To many people, it seems odd that exchange-traded options are not issued by the companies themselves. Instead, they are issued by the Exchange Options Clearing (EOC). By centralizing and standardizing options trading, the EOC has created a more liquid market. Unless otherwise specified, each option contract controls 100 shares of stock. In simplest terms, an option holder has the right, but not the obligation, to buy or sell a particular stock at a set price (strike) on or before the day of expiration (assignment). For example, someone holding a Nifty June 1120 Call would have the right to buy 200 units of Nifty for 1120 per unit. Likewise, a Nifty June 1120 Put gives the holder the right to sell 200 units of Nifty for 1120 per unit.

Options Trading Strategy Guide: Introduction to Basics

WHAT IS AN OPTION? We all know many opportunities exist in trading today. Everywhere you turn, someone is waiting to inform you of the tremendous profits to be realized in the stock and futures markets. However, many people are unaware of the derivative trading possibilities that are available within and across several different markets. Option trading is just one of the many ways to participate in these secondary markets. And contrary to popular belief, this potential trading arena is not limited strictly to the practice of selling or writing options. Options are an important element of investing in markets, serving a function of managing risk and generating income. Unlike most other types of investments today, options provide a unique set of benefits. Not only does option trading provide a cheap and effective means of hedging one's portfolio against adverse and unexpected price fluctuations, but it also offers a tremendous speculative dimension to trading.

One of the primary advantages of option trading is that option contracts enable a trade to be leveraged, allowing the trader to control the full value of an asset for a fraction of the actual cost. And since an option's price mirrors that of the underlying asset at the very least, any favorable return in the asset will be met with a greater percentage return in the option provides limited risk and unlimited reward. With options, the buyer can only lose what was paid for the option contract, which is a fraction of what the actual cost of the asset would be. However, the profit potential is unlimited because the option holder possesses a contract that performs in sync with the asset itself. If the outlook is positive for the security, so too will the outlook be for that asset's underlying options. Options also provide their owners with numerous trading alternatives. Options can be customized and combined with other options and even other investments to take advantage of any possible price dislocation within the market. They enable the trader or investor to acquire a position that is appropriate for any type of market outlook that he or she may have, be it bullish, bearish, choppy, or silent. While there is no disputing that options offer many investment benefits, option trading involves risk and is not for everyone. For the same reason that one's returns can be large, so too can the losses - leverage. Also, while the potential for financial success does exist in option trading, the means of realizing such opportunities are often difficult to create and to identify. With dozens of variables, several pricing models, and hundreds of different strategies to choose from, it is no wonder that options and option pricing have been a mystery to the majority of the trading public. Most often, a great deal of information must be processed before an informed trading decision can be reached. Computers and sophisticated trading models are often relied upon to select trading candidates. However, as humans, we like things to be as simple as possible. This often creates a conflict when deciding what, when, and how to trade a particular investment. It is much easier to buy or sell an asset outright than to contend with the many extraneous factors of these derivative markets.* If an investor thinks an asset's value will appreciate, he or she can simply buy the security; if an investor thinks an asset's value will depreciate, he or she can simply sell the security. In these scenarios, the only thing an investor must worry about is the value of the investment relative to the value of the prevailing market. If only options were that easy! * A derivative security is any security, in whole or in part, the value of which is based upon the performance of another (underlying) instrument, such as an option, a warrant, or any hybrid securities. Typically, option trading is more cumbersome and complicated than stock trading because traders must consider many variables aside from the direction they believe the market will move. The effects of the passage of time, variables such as delta, and the underlying market volatility on the price of the option are just some of the many items that traders need to gauge in order to make informed decisions. If one is not prudent in one's investment decisions, one could potentially lose a lot of money trading options. Those who disregard careful consideration and sound money management techniques often find out the hard way that these factors can quickly and easily erode the value of their option portfolios.

Because of these risks and benefits, options offer tremendous profit potential above and beyond trading in any other instrument, including the underlying security itself. This is the juncture at which option theoreticians enter the picture. Once the benefits have been defined, it is now a matter of determining how to best attain them. Up to now, the vast majority of option techniques have been elaborate mathematical models designed to help identify when option-writing or -selling opportunities exist. However, we hope to break new ground by introducing simple market-timing techniques that will enable traders to buy options with greater confidence and with greater success. TYPE OF OPTIONS Call Options A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Example: An investor buys One European call option on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised. The investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100). Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) - Premium}. In another scenario, if at the time of expiry stock price falls below Rs. 3500 say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which should be the profit earned by the seller of the call option. Put Options A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell. Example: An investor buys one European Put option on Reliance at the strike price of Rs. 300/- , at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than

Rs. 300, the option can be exercised as it is 'in the money'. The investor's Break-even point is Rs. 275/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275. Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}. In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ -, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option. (Please see table) The Options Game Option holder

buyer

or

option

Option writer

seller

or

option

Call Option Buys the right to buy the underlying asset at the specified price Has the obligation to sell the underlying asset (to the option holder) at the specified price

Put Option Buys the right to sell the underlying asset at the specified price Has the obligation to buy the underlying asset (from the option holder) at the specified price

Options are different from Futures There are significant differences in Futures and Options. Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset. Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas options have asymmetric risk profile. In options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer. The futures contracts prices are affected mainly by the prices of the underlying asset. Prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract and volatility of the underlying asset. It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium.

BASIC OPTION TERMINOLOGY Underlying - The specific security / asset on which an options contract is based. Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or sell. Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ predetermined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless. Exercise Date - is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option) Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment. Open Interest - The total number of options contracts outstanding in the market at any given point of time. Option Holder - is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer. Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited. Option Class - All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex Put Options Option Series - An option series consists of all the options of a given class with the same expiration date and strike price. E.g. BSXCMAY3600 is an options series which includes all Sensex Call options that are traded with Strike Price of 3600 & Expiry in May. (BSX Stands for BSE Sensex (underlying index), C is for Call Option, May is expiry date and strike Price is 3600)

HOW TO START TRADING OPTIONS? Before we devote our attention to more sophisticated option applications, it is important that we introduce a basic option foundation. While this introduction to options will be descriptive in its scope, its coverage will by no means be exhaustive. The sheer magnitude of option terminology and strategy could comprise an entire book on its own, and that is not our primary focus. For us to give our interpretation of existing material is much like making an entire career out of singing covers of popular songs of the past. Therefore, we will only be addressing the items necessary to understanding option basics and the techniques we will be presenting throughout the book. This simple introduction is tailored to those who are unfamiliar with options. Whether they apply to stocks, indices, or futures, all options work in the same manner. Simply stated, an option is a financial instrument that allows the owner the right, but not the obligation, to acquire or to sell a predetermined number of shares of stock or futures contracts in a particular asset at a fixed price on or before a specified date. With each option contract, the holder can make any of three possible choices: exercise the option and obtain a position in the underlying asset; trade option, closing out the trader's position in the contract by performing an offsetting trade; or let the option expire if the contract lacks value at expiration, losing only what was paid for the option. We will discuss the benefits and implications of each action later in this chapter. Option contracts are identified using quantity, asset expiration date, strike price, type, and premium. With the exception of the option's premium, each of these items is standardized upon issuance of a listed option contract. In other words, once an option contract is created, its rights are static; the price that one would pay for those rights is not; it is dynamic and determined by market forces. Seeing as there are many items which make up the definition of an option contract, it is important that each be addressed before moving on. The first aspects of an option contract is the option's quantity. The number of shares or contracts that can be obtained upon exercising an exchange-listed option contract is standardized. Each stock option contract allows the holder of that option to control 100 shares of the underlying security while each futures option contract can be exercised to obtain one contract in the underlying futures contract.* *Futures are leveraged assets typically representing a large, standardized quantity of an underlying security which expire at some predetermined date in the future. Each futures option contract allows the holder to control the total number of units that comprise the futures contract until the option is liquidated, but no later than its expiration date. Another item that identifies the option contract is the asset itself. The asset refers to the type of investment that can be obtained by the option holder. This asset could be a futures contract, shares of stock in a company, or a cash settlement in the case of an index contract. The type of option is critical in determining the trader's market outlook. Unlike trading stocks or futures themselves, option trading is not simply being long a particular market or short a particular market. Rather, there are two types of options, call options and put options, and two sides to each type, long or short, allowing the trader to take any of four possible positions. One

can buy a call, sell a call, buy a put, sell a put, or any combination thereof. It is important to understand that trading call options is completely separate from trading put options. For every call buyer there is a call seller; while for every put buyer there is a put seller. Also keep in mind that option buyers have rights, while option sellers have obligations. For this reason, option buyers have a defined level of risk and option sellers have unlimited risk. A call option is a standardized contract that gives the buyer the right, but not the obligation, to purchase a specific number of shares or contracts of an underlying security at the option's strike prices, or exercise price, sometime before the expiration date of the contract. Buying a call contract is similar to taking a long position in the underlying asset, and one would purchase a call option if one believed that the market value of the asset was going appreciate before the date the option expires. The most trader can lose by purchasing a call option is simply the price that he or she pays for the option; the most the trader can make is unlimited. On the other side of the transaction, the seller, or writer, of a call options has the obligation, not the right, to sell a specific number of shares or contracts of an asset to the option buyer at the strike price, if the option is exercised prior to its expiration date. Selling a call contract acts as a proxy for a short position in the underlying asset, and one would sell a call option if one expected that the market value of the asset would either decline or move sideways. (See Payoff Diagram) The most an option seller can make on the trade is the price he or she initially receives for the option contract; the most the trader can lose is unlimited. In order to offset a long position in a call option contract, one must sell a call option of the same quantity, type, expiration date, and strike price. Similarly, in order to offset a short position in a call option contract, one must buy a call option of the same quantity, type, expiration date, and strike price. Long With respect to this booklet's usage of the word, long describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account. For example, if you have purchased the right to buy 100 shares of a stock, and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock, and are holding that right in your account, you are long a put contract. If you have purchased 1,000 shares of stock and are holding that stock in your brokerage account, or elsewhere, you are long 1,000 shares of stock. When you are long an equity option contract: You have the right to exercise that option at any time prior to its expiration. Your potential loss is limited to the amount you paid for the option contract.

PAYOFF DIAGRAM: Profit diagrams for a Long Call and a Long Put LONG CALL OUTLOOK = S = STRIKE BEP = BREAK-EVEN-POINT DR = DEBIT = INITIAL OPTION COST MAXIMUM GAIN = UNLIMITED

Stock

= STRIKE BREAK-EVEN-POINT INITIAL OPTION COST

GAIN = UNLIMITED Stock

BEARISH PRICE = S-DR = MAXIMUM LOSS

Price

With respect to this booklet's usage of the word, short describes a position in options in which you have written a contract (sold one that you did not own). In return, you now have the obligations inherent in the terms of that option contract. If the owner exercises the option, you have an obligation to meet. If you have sold the right to buy 100 shares of a stock to someone else, you are short a call contract. If you have sold the right to sell 100 shares of a stock to someone else, you are short a put contract. When you write an option contract you are, in a sense, creating it. The writer of an option collects and keeps the premium received from its initial sale. When you are short (i.e., the writer of ) an equity option contract: •

•

You can be assigned an exercise notice at any time during the life of the option contract. All option writers should be aware that assignment prior to expiration is a distinct possibility. Your potential loss on a short call is theoretically unlimited. For a put, the risk of loss is limited by the fact that the stock cannot fall below zero in price. Although technically limited, this potential loss could still be quite large if the underlying stock declines significantly in price.

PAYOFF DIAGRAM Profit diagrams for a Short Call and a Short Put SHORT CALL OUTLOOK = BEARISH S = STRIKE PRICE BEP = BREAK-EVEN-POINT = S+CR CR = CREDIT = INITIAL OPTION PAYMENT RECEIVED = MAXIMUM GAIN

MAXIMUM

LOSS

= Stock

SHORT OUTLOOK = BULLISH S = STRIKE PRICE BEP = BREAK-EVEN-POINT = S-CR CR = CREDIT = INITIAL OPTION PAYMENT RECEIVED = MAXIMUM GAIN

MAXIMUM

LOSS

=

UNLIMITED

Stock

A put option is a standardized contract that gives the buyer the right, but not the obligation, to sell a predetermined number of shares or contracts of an underlying security at the option's strike price, or exercise price, sometime before the expiration date of the contract. A put contract is similar to taking a short position in the underlying asset, and one could purchase a put option contract if one believed that the market price of the asset was going to decline at some point before the date the option expires. The most a trader can lose by purchasing a put option is simply the price that he or she pays for the option; the most the trader can make is unlimited (in reality, it is the full value of the underlying asset which is realized if its price declines to zero). Conversely, the seller, or writer, of a put option has the obligation, not the right, to buy a specific number of shares or contracts of an asset to the option buyer at the strike price, assuming the option is exercised prior to its expiration date. Selling a put contract acts as a substitute for a long position in the underlying asset, and a trader would sell a put contract if he or she expected the market value of the asset to either increase or move sideways. Again, the most an option seller can make on the trade is the price he or she initially receives for the option contract; the most the seller can lose is unlimited (in reality, the most one can lose is the full value of the underlying asset which is realized if its price declines to zero). (See Payoff Diagram) In order to offset a long position in a put option contract, one must sell a put option of the same quantity, type, expiration date, and strike price. Similarly, in order to offset a short position in a put option contract, one must buy a put option of the same quantity, type, expiration date, and strike price. Open An opening transaction is one that adds to, or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, consider both: • •

Opening purchase - a transaction in which the purchaser's intention is to create or increase a long position in a given series of options. Opening sale - a transaction in which the seller's intention is to create or increase a short position in a given series of options.

Close A closing transaction is one that reduces or eliminates an existing position by an appropriate offsetting purchase or sale. With respect to an option transaction: •

Closing purchase - a transaction in which the purchaser's intention is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as "covering" a short position.

•

Closing sale - a transaction in which the seller's intention is to reduce or eliminate a long position in a given series of options.

Note: An investor does not close out a long call position by purchasing a put, or vice versa. A closing transaction for an option involves the purchase or sale of an option con-tract with the same terms, and on any exchange where the option may be traded. An investor intending to close out an option position must do so by the end of trading hours on the option's last trading day. Just remember, call buyers want the market price of the underlying security to go higher so the option will gain in value and they can make money; and call writer want the market to go sideways or lower so the option will expire worthless and they can make money. Put buyers want the market price of the underlying security to go lower so the option can gain in value and they can make money; and put sellers want the market price to go higher or sideways so the option will expire worthless and they can make money. Also remember, option buyers can choose whether they wish to exercise their options; option sellers cannot. The strike price or exercise price is simply the price at which the underlying security can be obtained or sold if one were to exercise the option. For a call option, the strike price is the price at which the holder can buy the security from the option writer upon exercising the option. For a put option, the strike price is the price at which the holder can sell the security to the option writer upon exercising the option. These option strike prices are standardized, with the strike increments determined by the asset's price. Newly created contracts can only be issued with strike prices that straddle the current market price of the security; however, at any one time, several different previously existing strike prices trade on the open option market. Which of the standardized strike prices the trader chooses depends upon his or her investment needs and capital outlay. Obviously, depending upon the prevailing underlying market price, the rights to some option strike prices will cost more than others. Strike prices for futures options contracts are different than those for stock options. Much like options on stock, the trader can choose from any of the standardized futures option strike prices that are issued. However, the strike prices that are set for the futures options are more contractspecific, contingent upon the market price of the underlying contract, how the future is priced, and how it trades. For obvious reasons, the issued strike prices for Treasury bond options will be different than those for soybean options. Because strikes vary depending on the commodity, it is important that traders familiarize themselves with the option contract and the underlying security before they initiate an option position. The expiration date refers to the length of time through which the option contract and its rights are active. At any time up to and including the expiration date, the holder of an option is entitled to the contract's benefits, which include exercising the option (taking a position in the underlying asset), trading the option (closing one's position in the contract by trading it away to another individual), or letting it expire worthless (if the contract lacks value at expiration). While the trader can choose from any of the listed option expiration months he or she wishes to purchase (or sell), the trader cannot choose the specific date the option will expire. This date is standardized and is determined when the option is listed on the exchange on which it is traded. For most options on equity securities, the final trading day occurs on the third Friday of each

month. The actual expiration occurs the following day, the Saturday following the third Friday of the month. The expiration date for futures options is more complicated than that for stock options and depends upon the contract that is being traded. Some futures option contracts expire the Saturday before the third Wednesday of the expiration month while others expire the month before the expiration month. Since an option's expiration date depends upon the type of asset that is traded, it is important for a trader to know the specific date the contract will expire before investing in the option. The majority of listed options are issued with expiration dates approximately nine months into the future. In addition to these standard options, there are also options that possess a longer life than the nine-month maximum for regular stock options. These are called long-term equity anticipation options, or LEAPS. LEAPS are issued each January with an expiration up to 36 months into the future. LEAPS allow traders to position themselves for market movement that is expected over a longer period of time: weeks, months, even years. They are more expensive than standard options because the added life increases the likelihood that the option will have value at some point prior to expiration. However, LEAPS can be traded only on stocks, indices, and interest rate classes and not every security offers them and currently are available in United States and not in India. American Style of options An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry. European Style of options The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that. Leverage and Risk Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment's percentage loss. Options offer their owners a predetermined, set risk. However, if the owner's options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk. In-the-money, At-the-money, Out-of-the-money An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls.

A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is 'in-the-money', when the spot Sensex is at 4100 as the call option has value. The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price. On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at 3700. (Please see table) Striking the price

Call Option

Put Option

In-the-money

Strike Price less than Strike Price greater Spot Price of than Spot Price of underlying asset underlying asset At-the-money Strike Price equal to Strike Price equal to Spot Price of Spot Price of underlying asset underlying asset Out-of-the-money Strike Price greater Strike Price less than than Spot Price of Spot Price of underlying asset underlying asset

A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at 4100. When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of 4100. Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at 4800. The put no longer has positive exercise value. Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price. The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium. This does not mean, however, these options can be obtained at no cost. Any amount by which an option's total premium exceeds intrinsic value is called the time value portion of the premium.

It is the time value portion of an option's premium that is affected by fluctuations in volatility, interest rates, dividend amounts and the passage of time. There are other factors that give options value, therefore affecting the premium at which they are traded. Together, all of these factors determine time value. Option Premium = Intrinsic Value + Time Value FACTORS THAT AFFECT THE VALUE OF AN OPTION PREMIUM There are two types of factors that affect the value of the option premium: Quantifiable Factors: • • • • •

Underlying stock price, The strike price of the option, The volatility of the underlying stock, The time to expiration and; The risk free interest rate.

Non-Quantifiable Factors: • • • •

Market participants' varying estimates of the underlying asset's future volatility Individuals' varying estimates of future performance of the underlying asset, based on fundamental or technical analysis The effect of supply & demand- both in the options marketplace and in the market for the underlying asset The "depth" of the market for that option - the number of transactions and the contract's trading volume on any given day.

Different pricing models for options The theoretical option pricing models are used by option traders for calculating the fair value of an option on the basis of the earlier mentioned influencing factors. An option pricing model assists the trader in keeping the prices of calls & puts in proper numerical relationship to each other & helping the trader make bids & offer quickly. The two most popular option pricing models are: • •

Black Scholes Model which assumes that percentage change in the price of underlying follows a normal distribution. Binomial Model which assumes that percentage change in price of the underlying follows a binomial distribution.

Options Premium is not fixed by the Exchange. The fair value/ theoretical price of an option can be known with the help of pricing models and then depending on market conditions the price is determined by competitive bids and offers in the trading environment.

An option's premium / price is the sum of Intrinsic value and time value (explained above). If the price of the underlying stock is held constant, the intrinsic value portion of an option premium will remain constant as well. Therefore, any change in the price of the option will be entirely due to a change in the option's time value. The time value component of the option premium can change in response to a change in the volatility of the underlying, the time to expiry, interest rate fluctuations, dividend payments and to the immediate effect of supply and demand for both the underlying and its option. Covered and Naked Calls A call option position that is covered by an opposite position in the underlying instrument (for example shares, commodities etc), is called a covered call. Writing covered calls involves writing call options when the shares that might have to be delivered (if option holder exercises his right to buy), are already owned. For example, a writer writes a call on Reliance and at the same time holds shares of Reliance so that if the call is exercised by the buyer, he can deliver the stock. Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares already owned at below their market value. When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have to purchase the underlying asset to meet his call obligation and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call. Intrinsic Value of an option The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market. For a call option: Intrinsic Value = Spot Price - Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price The intrinsic value of an option must be a positive number or 0. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value. Time Decay Generally, the longer the time remaining until an option's expiration, the higher its premium will be. This is because the longer an option's lifetime, greater is the possibility that the underlying

share price might move so as to make the option in-the-money. All other factors affecting an option's price remaining the same, the time value portion of an option's premium will decrease (or decay) with the passage of time. Note: This time decay increases rapidly in the last several weeks of an option's life. When an option expires in-the-money, it is generally worth only its intrinsic value. Expiration Day The expiration date is the last day an option exists. For list-ed stock options, this is the Saturday following the third Friday of the expiration month. Please note that this is the deadline by which brokerage firms must submit exercise notices to Stock Exchange Clearing; however, the exchanges and brokerage firms have rules and procedures regarding deadlines for an option holder to notify his brokerage firm of his intention to exercise. This deadline, or expiration cutoff time, is generally on the third Friday of the month, before expiration Saturday, at some time after the close of the market. Please contact your brokerage firm for specific deadlines. The last day expiring equity options generally trade is also on the third Friday of the month, before expiration Saturday. If that Friday is an exchange holiday, the last trading day will be one day earlier, Thursday. Exercise If the holder of an American-style option decides to exercise his right to buy (in the case of a call) or to sell (in the case of a put) the underlying shares of stock, the holder must direct his brokerage firm to submit an exercise notice to Stock Exchange Clearing. In order to ensure that an option is exercised on a particular day other than expiration, the holder must notify his brokerage firm before its exercise cut-off time for accepting exercise instructions on that day. Note: Various firms may have their own cut-off times for accepting exercise instructions from customers. These cut-off times may be specific for different classes of options and different from Stock Exchange Clearing's requirements. Cut-off times for exercise at expiration and for exercise at an earlier date may differ as well. Once Stock Exchange Clearing has been notified that an option holder wishes to exercise an option, it will assign the exercise notice to a Clearing Member - for an investor, this is generally his brokerage firm - with a customer who has written (and not covered) an option contract with the same terms. Stock Exchange Clearing will choose the firm to notify at random from the total pool of such firms. When an exercise is assigned to a firm, the firm must then assign one of its customers who has written (and not covered) that particular option. Assignment to a customer will be made either randomly or on a "first-in first-out" basis, depending on the method used by that firm. You can find out from your brokerage firm which method it uses for assignments. Assignment The holder of a long American-style option contract can exercise the option at any time until the option expires. It follows that an option writer may be assigned an exercise notice on a short

option position at any time until that option expires. If an option writer is short an option that expires in-the-money, assignment on that contract should be expected, call or put. In fact, some option writers are assigned on such short contracts when they expire exactly at-the-money. This occurrence is generally not predictable. To avoid assignment on a written option contract on a given day, the position must be closed out before that day's market close. Once assignment has been received, an investor has absolutely no alternative but to fulfill his obligations from the assignment per the terms of the contract. An option writer cannot designate a day when assignments are preferable. There is generally no exercise or assignment activity on options that expire out-of-the-money. Owners generally let them expire with no value. What's the Net? When an investor exercises a call option, the net price paid for the underlying stock on a per share basis will be the sum of the call's strike price plus the premium paid for the call. Likewise, when an investor who has written a call contract is assigned an exercise notice on that call, the net price received on a per share basis will be the sum of the call's strike price plus the premium received from the call's initial sale. When an investor exercises a put option, the net price received for the underlying stock on per share basis will be the sum of the put's strike price less the premium paid for the put. Likewise, when an investor who has written a put contract is assigned an exercise notice on that put, the net price paid for the underlying stock on per share basis will be the sum of the put's strike price less the premium received from the put's initial sale. Early Exercise / Assignment For call contracts, owners might exercise early so that they can take possession of the underlying stock in order to receive a dividend. Check with your brokerage firm and/or tax advisor on the advisability of such an early call exercise. It is therefore extremely important to realize that assignment of exercise notices can occur early - days or weeks in advance of expiration day. As expiration nears, with a call considerably in-the-money and a sizeable dividend payment approaching, this can be expected. Call writers should be aware of dividend dates, and the possibility of an early assignment. When puts become deep in-the-money, most professional option traders will exercise them before expiration. Therefore, investors with short positions in deep in-the-money puts should be prepared for the possibility of early assignment on these contracts. Volatility Volatility is the tendency of the underlying security's market price to fluctuate either up or down. It reflects a price change's magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option's premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater

possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa. OPTION GREEKS-DELTA, GAMMA, VEGA, THETA, RHO The price of an Option depends on certain factors like price and volatility of the underlying, time to expiry etc. The Option Greeks are the tools that measure the sensitivity of the option price to the above-mentioned factors. They are often used by professional traders for trading and managing the risk of large positions in options and stocks. These Option Greeks are: • • • • •

Delta: is the option Greek that measures the estimated change in option premium/price for a change in the price of the underlying. Gamma: measures the estimated change in the Delta of an option for a change in the price of the underlying Vega: measures estimated change in the option price for a change in the volatility of the underlying. Theta: measures the estimated change in the option price for a change in the time to option expiry. Rho: measures the estimated change in the option price for a change in the risk free interest rates.

How the greeks help in hedging? Spreading is a risk-management strategy that employs options as the hedging instrument, rather than stock. Like stock, options have directional risk (deltas). Unlike stock, options carry gamma, vega, and theta risks as well. Therefore, if a position involves any combination of gamma, vega, and/or theta risk, this can be reduced or eliminated by adding one or more options positions. Table 8-4 summarizes the possible hedges and their gamma, vega and theta impact for each of the six building blocks. Notice that owning option contracts be they puts or calls, means that you are adding positive gamma, positive vega, and negative theta. Being short either of these contracts means acquiring negative gamma, negative vega, and positive theta. This statement points out that as far as these Greeks are concerned, you get a package deal. By owning options, your position responds favorably to stock-price movement (the position gets longer as the stock price increases and gets shorter as the stock price decreases). The position responds positively to increases in implied volatility (and negatively to decreases in implied volatility) and will lose value over time. By being short options, your position responds adversely to stock-price movement (the position gets shorter as the stock price increases and gets longer as the stock price decreases). The position also responds negatively to increases in implied volatility (and positively to decreases in implied volatility) and will gain value over time as the time premium of the short option decays. POSSIBLE HEDGING STRATEGIES WITH THE GREEKS

Building Block

Hedge

Hedge Delta Long Stock Sell Call Negative Sell Stock Negative Positive delta, no Buy Put Negative gamma, no vega, no theta Short Stock Buy Call Positive Buy Stock Positive Negative delta, no Sell Put Positive gamma, no vega, no theta Long Call Sell Call Negative Buy Put Negative Positive delta, positive Sell Stock Negative gamma, positive vega, negative theta Short Call Buy Call Positive Sell Put Positive Negative delta, Buy Stock Positive negative gamma, negative vega, positive theta Long Put Sell put Positive Buy Call Positive Negative delta, positive Buy Stock Positive gamma, positive vega, negative theta Short Put Buy put Negative Sell Call Negative Positive delta, negative Sell Stock Negative gamma, negative vega, positive theta

Hedge Hedge Gamma Vega Negative Negative None None Positive Positive

Hedge Theta Positive None Negative

Positive Positive Negative None None None Negative Negative Positive Negative Negative Positive Positive Positive Negative None None None Positive Positive Negative Negative Negative Positive None None None

Negative Negative Positive Positive Positive Negative None None None Positive Positive Negative Negative Negative Positive None None None

BENEFITS OF OPTIONS TRADING Besides offering flexibility to the buyer in form of right to buy or sell, the major advantage of options is their versatility. They can be as conservative or as speculative as one's investment strategy dictates. Some of the benefits of Options are as under: • • • •

High leverage as by investing small amount of capital (in form of premium), one can take exposure in the underlying asset of much greater value. Pre-known maximum risk for an option buyer Large profit potential and limited risk for option buyer One can protect his equity portfolio from a decline in the market by way of buying a protective put wherein one buys puts against an existing stock position.

This option position can supply the insurance needed to overcome the uncertainty of the marketplace. Hence, by paying a relatively small premium (compared to the market value of the stock), an investor knows that no matter how far the stock drops, it can be sold at the strike price of the Put anytime until the Put expires. E.g. An investor holding 1 share of Infosys at a market price of Rs 3800/-thinks that the stock is over-valued and decides to buy a Put option' at a strike price of Rs. 3800/- by paying a premium of Rs 200/If the market price of Infosys comes down to Rs 3000/-, he can still sell it at Rs 3800/- by exercising his put option. Thus, by paying premium of Rs 200,his position is insured in the underlying stock. How can you use options for short-term trading? If you anticipate a certain directional movement in the price of a stock, the right to buy or sell that stock at a predetermined price, for a specific duration of time can offer an attractive investment opportunity. The decision as to what type of option to buy is dependent on whether your outlook for the respective security is positive (bullish) or negative (bearish). If your outlook is positive, buying a call option creates the opportunity to share in the upside potential of a stock without having to risk more than a fraction of its market value (premium paid). Conversely, if you anticipate downward movement, buying a put option will enable you to protect against downside risk without limiting profit potential. Purchasing options offer you the ability to position yourself accordingly with your market expectations in a manner such that you can both profit and protect with limited risk. Risks of an options buyer The risk/ loss of an option buyer is limited to the premium that he has paid. Risks for an Option writer The risk of an Options Writer is unlimited where his gains are limited to the Premiums earned. When a physical delivery uncovered call is exercised upon, the writer will have to purchase the underlying asset and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call. The writer of a put option bears a risk of loss if the value of the underlying asset declines below the exercise price. The writer of a put bears the risk of a decline in the price of the underlying asset potentially to zero. Option writing is a specialized job which is suitable only for the knowledgeable investor who understands the risks, has the financial capacity and has sufficient liquid assets to meet applicable margin requirements. The risk of being an option writer may be reduced by the purchase of other options on the same underlying asset thereby assuming a spread position or by acquiring other types of hedging positions in the options/ futures and other correlated markets. In

the Indian Derivatives market, SEBI has not created any particular category of options writers. Any market participant can write options. However, margin requirements are stringent for options writers. STOCK INDEX OPTIONS The Stock Index Options are options where the underlying asset is a Stock Index for e.g. Options on NSE Nifty Index / Options on BSE Sensex etc. Index Options were first introduced by Chicago Board of Options Exchange in 1983 on its Index 'S&P 100'. As opposed to options on Individual stocks, index options give an investor the right to buy or sell the value of an index which represents group of stocks. Uses of Index Options Index options enable investors to gain exposure to a broad market, with one trading decision and frequently with one transaction. To obtain the same level of diversification using individual stocks or individual equity options, numerous decisions and trades would be necessary. Since, broad exposure can be gained with one trade, transaction cost is also reduced by using Index Options. As a percentage of the underlying value, premiums of index options are usually lower than those of equity options as equity options are more volatile than the Index. Index Options are effective enough to appeal to a broad spectrum of users, from conservative investors to more aggressive stock market traders. Individual investors might wish to capitalize on market opinions (bullish, bearish or neutral) by acting on their views of the broad market or one of its many sectors. The more sophisticated market professionals might find the variety of index option contracts excellent tools for enhancing market timing decisions and adjusting asset mixes for asset allocation. To a market professional, managing risks associated with large equity positions may mean using index options to either reduce risk or increase market exposure. Options on individual stocks Options contracts where the underlying asset is an equity stock are termed as Options on stocks. They are mostly American style options cash settled or settled by physical delivery. Prices are normally quoted in terms of the premium per share, although each contract is invariably for a larger number of shares, e.g. 100. Benefits of options in specific stocks to an investor •

•

Options can offer an investor the flexibility one needs for countless investment situations. An investor can create hedging position or an entirely speculative one, through various strategies that reflect his tolerance for risk. Investors of equity stock options will enjoy more leverage than their counterparts who invest in the underlying stock market itself in form of greater exposure by paying a small amount as premium.

•

•

Investors can also use options in specific stocks to hedge their holding positions in the underlying (i.e. long in the stock itself), by buying a Protective Put. Thus they will insure their portfolio of equity stocks by paying premium. ESOPs (Employees' stock options) have become a popular compensation tool with more and more companies offering the same to their employees. ESOPs are subject to lock in periods, which could reduce capital gains in falling markets - Derivatives can help arrest that loss along with tax savings. An ESOPs holder can buy Put Option in the underlying stock & exercise the same if the market falls below the strike price & lock in his sale prices.

The equity options traded on exchange are not issued by the companies underlying them. Companies do not have any say in selection of underlying equity for options. Holder of the equity options contracts do not have any of the rights that owners of equity shares have - such as voting rights and the right to receive bonus, dividend etc. To obtain these rights a Call option holder must exercise his contract and take delivery of the underlying equity shares. Leaps - Long Term Equity Anticipation Securities (Currently not available in India) Long-term equity anticipation securities (Leaps) are long-dated put and call options on common stocks or ADRs. These long-term options provide the holder the right to purchase, in case of a call, or sell, in case of a put, a specified number of stock shares at a pre-determined price up to the expiration date of the option, which can be three years in the future. Exotic Options (Currently not available in India) Derivatives with more complicated payoffs than the standard European or American calls and puts are referred to as Exotic Options. Some of the examples of exotic options are as under: Barrier Options: where the payoff depends on whether the underlying asset's price reaches a certain level during a certain period of time. CAPS traded on CBOE (traded on the S&P 100 & S&P 500) are examples of Barrier Options where the payout is capped so that it cannot exceed $30. A Call CAP is automatically exercised on a day when the index closes more than $30 above the strike price. A put CAP is automatically exercised on a day when the index closes more than $30 below the cap level. Binary Options: are options with discontinuous payoffs. A simple example would be an option which pays off if price of an Infosys share ends up above the strike price of say Rs. 4000 & pays off nothing if it ends up below the strike. Over-The-Counter Options: are options are those dealt directly between counter-parties and are completely flexible and customized. There is some standardization for ease of trading in the busiest markets, but the precise details of each transaction are freely negotiable between buyer and seller.

Contract specifications of BSE Sensex Options BSE's first index options is based on BSE 30 Sensex. The Sensex options would be European style of options i.e. the options would be exercised only on the day of expiry. They will be premium style i.e. the buyer of the option will pay premium to the options writer in cash at the time of entering into the contract. The underlying for the index options is the BSE 30 Sensex, which is the benchmark index of Indian Capital markets, comprising 30 scrips. Like stocks, options and futures contracts are also traded on any exchange. In Bombay Stock Exchange, stocks are traded on BSE On Line Trading (BOLT) system and options and futures are traded on Derivatives Trading and Settlement System (DTSS). The Premium and Options Settlement Value (difference between Strike and Spot price at the time of expiry), will be quoted in Sensex points The contract multiplier for Sensex options is INR 50 which means that monetary value of the Premium and Settlement value will be calculated by multiplying the Sensex Points by 50. For e.g. if Premium quoted for a Sensex options is 50 Sensex points, its monetary value would be Rs. 2500 (50*50). There will be at-least 5 strikes (2 In the Money, 1 Near the money, 2 Out of the money), available at any point of time. The expiration day for Sensex option is the last Thursday of Contract month. If it is a holiday, the immediately preceding business day will be the expiration day. There will be three contract month series (Near, middle and far) available for trading at any point of time. The settlement value will be the closing value of the Sensex on the expiry day. The tick size for Sensex option is 0.1 Sensex points (INR 5). This means the minimum price fluctuation in the value of the option premium can be 0.1.In Rupee terms this translates to minimum price fluctuation of Rs 5. (Tick Size * Multiplier =0.1* 50). OPTIONS WITH OPTIONS As we briefly touched upon earlier, an option contract holder is bestowed with three choices exercise the option, let the option expire, or trade the option. But how does a trader decide which of the three alternatives to choose? A large portion of this decision is contingent upon the value of the option contract (or lack thereof) as well as the amount of time remaining before the option expires. When an option lacks value, meaning it is out-of-the-money, the trader can simply let the option expire worthless. When an option has value, meaning it is in-the-money, the trader can choose whether to trade the contract to another individual or exercise the contract and obtain the underlying asset. The ultimate decision that is made depends upon the individual investor, his or her trading style, his or her trading needs, and the situation at hand. Exercise the Option

As we just mentioned, one will only exercise a long option contract when one stands to make money from that position, otherwise one could simply let the option expire and lose the premium.* When an option buyer exercises an option, he or she is choosing to take a position in the underlying instrument. Naturally, the position is determined by the option type and whether it is a call or a put. In exercising a stock or futures call option, the holder agrees to purchase standardized quantity of the underlying asset from the option writer at the predetermined strike price. Because of their contract, the writer is obligated to sell the asset to the buyer at the strike price, regardless of the price at which the market is currently trading. This transaction gives the buyer a long position in the asset and gives the writer a short position in the asset.# Option is a contract which has a market value like any other tradable commodity. Once an option is bought there are following alternatives that an option holder has: • •

You can sell an option of the same series as the one you had bought and close out /square off your position in that option at any time on or before the expiration. You can exercise the option on the expiration day in case of European Option or; on or before the expiration day in case of an American option. In case the option is 'Out of Money' at the time of expiry, it will expire worthless.

#Please note that while options provide the right to acquire the underlying instrument, the owner must still produce the necessary funds for the asset itself. In exercising a stock or futures put option, the option holder agrees to sell the standardized quantity of the underlying asset to the option writer at the predetermined strike price. Because of their contract, the writer must purchase the asset from the option holder at the strike price, regardless of the price at which the market is currently trading. This transaction gives the buyer a short position in the asset and gives the seller long position in the asset. Exercising an index option, be it a call or a put, is handled differently because index options are settled in cash as opposed to the physical asset. When a call option buyer or put option buyer exercises an index option, the holder is simply credited to the amount by which the option is inthe-money, less any commission that applies. On the other hand, the call option writer or the put option writer is debited the amount by which the option is in-the-money, plus any commission that applies. For obvious reasons, an index option holder would choose to exercise his or her position only if it were profitable to do so, meaning the contract were in-the-money. The majority of index options today are European-style options, meaning that exercise can only occur at the end of the contract's life. However, the most widely traded index option, the NSE Nifty option which covers the Nifty 30, is an American-style contract, meaning exercise can occur at any point during the life of the option. On the whole, most traders choose not to exercise an option prior to expiration. Doing so only entitles the investor to the intrinsic value of the option and sacrifices the added effect of time value. Exercising one's option before the expiration date is not common when it comes to futures. Unless the option is deep in-the-money, where time value has a much lower impact, it generally makes more sense to trade out of the position. Exercising before the expiration date

does occur more frequently when it comes to equity call options. Because option holders are not entitled to cash dividends, call options are usually exercised right before a stock goes exdividend so no contract value will be lost. Defining the profit In each of these cases, exercise will only occur when it is profitable to do so - when the option is in-the-money. However, any time an individual exercises an option, that individual loses the full cost of the premium. Because of this, any gains on the trade will be offset by the losses on the cost of the option. One does not really make a profit on the transaction until the premium is recovered. Therefore, there is a break-even-point that occurs with options that are exercised. With call options, the break-even-point occurs when the underlying asset has increased in price to a point where the intrinsic value is equal to the initial cost of the option - in other words, the strike price of the option plus the call premium. Any price above this break-even-point would produce a profit on the transaction, if exercised, and any price below this break-even-point would produce a loss on the transaction, if exercised. With put options, the break-even-point occurs when the underlying asset has decreased in price to a point where the intrinsic value is equal to the initial cost of the option - in other words, the strike price of the option minus the put premium. Any price below this break-even-point would produce a profit on the transaction, if exercised, and any price above this break-even-point would produce a loss on the transaction, if exercised. Because the trader must lose money in order to lock-in profits, some people choose to forego the exercising of their options and instead turn to the second option alternative. Trade the Option The second choice the holder of an option can make is to trade out of the option position before the option expires. Trading one's option is exactly the same as trading any other asset. To close out a position, one must perform the opposite side of the trade in the same asset. To offset a long position, be it a call or a put, the holder must sell an option of the same type, expiration month, and strike price. To offset a short position, be it a call or a put, holder must buy an option of the same type, expiration month, and strike price. When one initiates a long option trade, the premium that is paid for the option is the entry price and when one liquidates a long option trade, the premium that is received for the option is the exit price. Obviously, if the exit price is greater than the entry price, the holder will profit on the trade. When one initiates a short option trade, the premium that is received for the option is the entry price and the premium that is paid for the option is closing price. In this case, if the exit price is less than the entry price, the writer will profit on the trade. Trading versus exercising There is a common misconception that the most profitable way to make money with options is by exercising the contract when it is in-the-money, when in reality, trading out of one's option

can be far more lucrative. There are three reasons why this is so. The primary reason is that exercising an option can only provide the investor with the intrinsic value of the trade, while trading an option position can entitle the investor to the intrinsic value as well as additional time value. How much more the time value will provide is determined by the factors we mentioned earlier, such as time to expiration, volatility, dividend rates, and interest rates. A second reason is that trading one's position does not force the option buyer to incur the full cost of the premium, which is what occurs when one exercises an option. Since the gains from trading an option are not used to cover the cost of the premium, there is no break-even-point, there is simply the entry price and the exit price. Finally, by trading out of one's option(s), the trader saves on commission costs. This is particularly helpful when a trader has a large option position. With the tremendous growth that will occur in the option markets over the years, it should come as no surprise that options provide an excellent trading opportunity. As you have probably been able to gather thus far, buying options responsibly can provide a greater level of security to traders, allowing them to rest easy during the day and sleep better at night. Options give traders more time to think about their positions without worrying about how much they could potentially lose. As one family friend puts it, buying options enables the trader to leave the computer screen and hit golf balls. If traders were to take positions in the actual security, or sell options, they must closely monitor their positions and only watch others hit golf balls on ESPN. Let the Option Expire A final alternative available to the option holder is to let the option expire. Simply put, the trader can do nothing with the option and lose only what he or she paid in premium. Naturally, an option buyer will only let the contract expire if it lacks value at expiration, meaning it is out-ofthe-money. Once the expiration occurs, the option buyer no longer controls the underlying asset and loses all rights conveyed by the contract. Doing nothing is a luxury that is afforded only to option traders. This eliminates the necessity of offsetting a losing position, thereby serving as an inherent stop loss on the trade. Trading any other type of asset obligates the investor to eventually offset the position, regardless of whether it is profitable to do so. In comparison, by trading out of the option position the option holder was able to realize a greater profit on the trade. This is usually the case with options. However, the closer to expiration on the option gets, the less a trader will be able to retrieve in premium by trading out of his or her position. It is important that a trader compare the two processes before making a decision as to what to do with the option position.

Options Trading Strategy Guide: Option Trading Strategies As we described earlier, four possible option selections exist for a trader: (1) long a call, (2) long a put, (3) short a call, and (4) short a put. These four can be used independently, together, or in conjunction with other financial instruments to create a number of option-trading strategies. These combinations enable a trader to develop an option-trading model which meets the trader's specific trading needs, expectations, and style, and enables him or her to anticipate every

conceivable situation in the market. This trading structure can be adapted to handle any type of market outlook, whether it be bullish, bearish, choppy, or neutral. Options are unique trading instruments. They can be used for a multitude of purposes, providing tremendous versatility and utility. Among their multiple applications are the following: to speculate on the movement of an asset; to hedge an existing position in an asset; to hedge other option positions; to generate income by writing options against different quantities of options strategies that arise from these applications and the fact that the scope of this book is limited, we will devote coverage to a cursory explanation of two of the most popular strategies which are designed to take advantage of market movement: spreads and straddles. SPREADS Option spreads are hedged positions that can be utilized to control a trade's risk, while at the same time limiting gains. They accomplish this goal by simultaneously taking positions on both sides of the market. A call option spread is the simultaneous purchase and sale of call options with different strike prices, different expiration dates, or with both different strike prices and different expiration dates. Likewise, a put option spread is the simultaneous purchase and sale of a put option with different strike prices, different expiration dates, or with both different strike prices and different expiration dates. Spreads with different strike prices are referred to as price spreads or vertical spreads because the strike prices are stacked vertically on top of each other in financial listings. Spreads with different expiration months are referred to as calendar spreads, horizontal spreads, or time spreads because the options expire at different times. A spread where both the strike price and expiration month are different is referred to as a diagonal spread. Option spreads can be used when one has an inclination as to where the underlying market is heading, but is somewhat uncertain. Because the position is hedged, a spread allows the trader to participate in the market while effectively containing risk, sometimes even more so than with single option positions. Option spread can also be used when a trader has particular price targets in mind - because spreads limit gains as well as losses, spreads can be initiated that will enable the trader to take advantage of these targets while at the same time keeping risk at a minimum. Vertical / Price Spreads As is the case with options, any of four possible vertical option spreads can be selected depending on what a trader expects will happen in the market: one can buy a call spread, one can sell a call spread, one can buy a put spread, or one can sell a put spread. A long call spread and short put spreads are considered bull spreads because they are used when a trader's market outlook is positive, or bullish. A short call spread and long put spreads are considered bear spreads because they are used when a trader's outlook is negative, or bearish. Horizontal / Time Spreads The four types of spreads just mentioned were vertical spreads, or price spreads. Another group of spreads is referred to as horizontal spreads, time spreads, or calendar spreads. Whereas vertical spreads are used to take advantage of price movements in the underlying security, horizontal spreads are used to take advantage of time erosion and the pricing discrepancies that arise from movements in the underlying market. A horizontal spread involves

the simultaneous purchase and sale of an option contract of the same asset, type, and strike price but with different expiration dates. As we indicated earlier, the option's time value erodes toward zero as time passes toward option expiration. The erosion occurs more rapidly as the option's life decreases and the expiration date comes into view. A calendar spread is intended to take advantage of this decline in an option's premium. Typically, a trader will sell an option with the closer expiration month and purchase an option with the distant expiration month to take advantage of the fact that the latter position will retain more of its value. Since the near-month option has less time to expiration than the back-month option, the premium the trader receives will be less than the premium the trader must pay for the spread. Therefore, this spread is considered a debit spread. Also, because one option expires before the other, oftentimes one or both legs of the calendar spread are offset by trading out of the position. SELECTING AN OPTION TRADE Given the wide assortment of possible option expirations and strike prices, which is the preferable option contract selection for a trader? This answer is not black and white and varies depending upon the goals of the trader. For those option traders who believe that the trend of an underlying security has been or soon will be established for some time to come, they may wish to hold the option until it approaches expiration and a significant profit is captured. These individuals are referred to as position traders. Other traders are not concerned with long-term projections in the underlying security and are only interested in what will occur on a particular trading day. These individuals are referred to as day traders. Position traders and day traders have two very different approaches and attitudes when selecting the appropriate option contract to trade. Most position traders typically choose an expiration month and a strike price matches their price target and the time frame in which they believe that target will be reached. Day traders, on the other hand, are not concerned with which expiration month or strike price they should choose, all they are concerned with is being on the right side of the market in the option that will bring them the greatest return. When day trading options, various time and price considerations are not as important as they would be to a long-term option trader. Since option positions are held for such a short period of time, the impact of time decay is negligible when day trading and does not really work for or against the trader (unless it is the day of option expiration or one or two trading days before expiration, where time premium typically erodes more rapidly). Although our opinion is by no means absolute, we suggest that when one wishes to day trade options or intends to hold an option position for no more than one to two trading days, that one trade the nearby (closest expiration month) option contract which is at- or slightly in-the-money, when the underlying security has, or is just about to, exceed the exercise price. As we discussed earlier, as the price of the underlying security trades through the exercise price and proceeds to move in-the-money, the time value initially contracts and then begins to move almost one for one in lockstep with the price of the underlying security. Because the impact of time premium is generally minimal, day trading an at-the-money or slightly in-the-money option

is essentially the same as trading the underlying asset, only for much less money, with a greater profit potential, and with a defined level of risk. Another factor that must be considered when deciding which option contract to day trade is option liquidity. Typically, the nearby, closest to at-the-money option is the most actively traded option and has the greatest volume and open interest. This liquidity is important, not only when entering the trade, but also when exiting the trade as well, especially for a day trader. Inactive, light-volume, and low-liquidity markets are difficult to trade and large concessions must be made by the trader to obtain market positions, since the spread between bid and risk in these situations is typically wide and the increment within which a trader is able to transact is small. We cannot stress enough the significance of the market liquidity to a day trader in the selection of option trading candidates. A familiarity with the recent volume and open interest for a particular option is crucial in determining the size of the commitment a trader should make to a specific option market. How much to buy? Perhaps the best advice we can provide to beginning traders is to manage your trades. This is especially true when trading options. One of the biggest problems option traders face is that they allow their emotions to dictate when they make their purchases and do so with reckless abandon. Since they are accustomed to paying so much more for other assets, they typically spend a comparable amount of money on options, leveraging their positions to the maximum, and hoping for the sizable price "pop" which will catapult their profits into orbit. However, this is the worst mistake an option buyer can make. If these large positions are not timed accurately, a trader can lose a large amount of money. Most people justify their option position size by rationalizing that they would have spent the same amount as they had on the underlying security, but now they are controlling more of the underlying security. What they don't always realize is that options do not retain their value like these other assets, because the passage of time will always have a negative effect upon the option. That is why options cannot be considered investments; they are simply trades. Our suggestion in determining how much of an option to purchase is this: a prudent option trader will limit his or her exposure to any particular trade. The prerequisite for proper money management is different for a day trader versus a trader who holds the option position overnight or longer. While it is not our role to determine a trader's exposure to a market, we feel it is crucial to address this matter, as we have seen a number of traders execute imprudent option trades and money management. A good rule of thumb is that a day trader should not risk more than 2 percent of his or her portfolio in any one trade, and a position trader should not risk more than 4 percent of his or her portfolio in any one trade. If traders prefer to exceed these prescribed limits, we recommend that the traders protect their positions with offsetting option trades and definitely with stop losses. Placing option orders Before participating in a market, regardless of which one, it is important that one become familiar with may of the trading nuances and aspects which apply to that specific market. This is

especially true when trading options. Once these variables are addressed and an option contract is selected, the trader must then place the order. When placing an option order, a trader must make certain to supply the following trading instructions to the broker: 1. Whether the option order is a buy or a sell 2. The number of option contracts the trader wishes to transact 3. The proper description of the option, including the specific option contract to be traded, the correct month and year, and the exercise price 4. The price at which the trader wishes to buy or to sell the option 5. The specific exchange the trader wishes to use to conduct the trade if more than one exchange lists the option 6. The stop loss level, or the price at which the trader wishes to exit an unprofitable trade 7. The type of option to be executed, that is, an opening purchase, a closing purchase, an opening sale, or a closing sale Reading an option price table Many major newspaper and trading publications today provide option-pricing tables so traders can track and follow the activity of certain listed options on a day-to-day basis. While the organization of these price table may differ slightly for stock options, they all usually contain the security that the option covers, the prior day's closing price of the underlying asset, the varying strike prices and expiration months, the prior day's volume and closing prices for each call option, and the prior day's volume and closing prices for each put option. Other option listings, such as those for indices, also include items such as the net price change of the option from the previous day's closing price and the open interest of the call or put option. When not to buy an option? It is also important to consider the time or the date at which one should enter the option market. While these option-buying suggestions are presented in the context of day trading options, they apply equally as well to option position trading. When day trading, a trader must give the market adequate time to perform. Consequently, eliminate day trading within the final hour of trading. If one is position-trading options, this suggestion should not be a concern. • •

• • • •

Avoid trading in an illiquid option market. Avoid purchasing call options just prior to a stock going ex-dividend. Avoid buying or selling options based upon anticipated news (buyouts in particular). Besides bordering on unethical trading, the information received is more likely to be rumor than correct. Avoid purchasing options well after the market has established a defined trend - this is especially true when day trading, as any option premium advantage will have dissipated. Avoid purchasing way out-of-the-money options when day trading, as any favorable price movement will have a negligible effect upon premium. Avoid purchasing call options when the underlying security is up for the day versus the prior day's close, unless one intends to take a trend-following stance. Avoid purchasing put options when the underlying security is down for the day versus the prior day's close, unless one intends to take a trend-following stance.

Be careful when holding long option positions beyond Friday's trading day's close unless one is option position trading. Many option theoreticians recalculate their volatility, delta, and time decay numbers once a week, usually after the close of trading on Fridays or over the weekend. The resulting adjustments in these values most often have a negative effect on the value of the long option, which may be acceptable when holding an option over an extended period of time but is detrimental when day trading. Each sample strategy is accompanied by a graph of profit and loss at the options' expiration. The X-axis represents the price level of an underlying stock. The Y-axis represents profit and loss, above and below the X-axis intersection respectively. Each graph will be labeled with a BreakEven Point (BEP) for the strategy being illustrated. These graphs are not drawn to any specific scale and are meant only for an illustrative and educational purpose. In addition, each strategy includes a discussion regarding an investor's alter-natives before and at expiration. The alternatives mentioned are only among the more basic possibilities. With a fuller understanding of option concepts, an investor will appreciate that alternatives available to him are many. It is beyond the scope of this booklet to make any specific recommendations as to maintaining your option positions. Note: Net profit and loss amounts discussed in the following strategy examples do not include taxes, commissions or transaction costs in their formulations. LONG CALL Purchasing calls has remained the most popular strategy with investors since listed options were first introduced. Before moving into more complex bullish and bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding call options.

Market Opinion? Bullish to very bullish. When to Use? Bullish Speculation This strategy appeals to an investor who is generally more interested in the Rupee amount of his initial investment and the leveraged financial reward that long calls can offer. The primary motivation of this investor is to realize financial reward from an increase in price of the

underlying security. Experience and precision are key to selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the call is the more bullish the strategy, as bigger increases in the underlying stock price are required for the option to reach the break-even point. As Stock Substitute An investor who buys a call instead of purchasing the under-lying stock considers the lower Rupee cost of purchasing a call contract versus an equivalent amount of stock as a form of insurance. The uncommitted capital is "insured" against a decline in the price of the call option's underlying stock, and can be invested elsewhere. This investor is generally more interested in the number of shares of stock underlying the call contracts purchased than in the specific amount of the initial investment - one call option contract for each 100 shares he wants to own. While holding the call option, the investor retains the right to purchase an equivalent number of underlying shares at any time at the predetermined strike price until the contract expires. Note: Equity option holders do not enjoy the rights due stockholders - e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of the underlying shares to be eligible for these rights. Benefit? A long call option offers a leveraged alternative to a position in the stock. As the contract becomes more profitable, increasing leverage can result in large percentage profits because purchasing calls generally requires lower up-front capital commitment than an outright purchase of the underlying stock. Long call contracts offer the investor a predetermined risk. Risk vs. Reward? Maximum Profit: Maximum Loss: Net Premium Upside Profit Stock Price at Expiration Assuming Stock Price Above BEP

at Strike

Unlimited Limited Paid Expiration: Price Premium

Paid

Your maximum profit depends only on the potential price increase of the underlying security; in theory, it is unlimited. At expiration an in-the-money call will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in rupee amount, it can be as much as 100% of the premium initially paid for the call. Whatever your motivation for purchasing the call, weigh the potential reward against the potential loss of the entire premium paid. Break-Even Point BEP: Strike Price + Premium Paid

(BEP)

at

Expiration?

Before expiration, however, if the contract's market price has sufficient time value remaining, the BEP can occur at a lower stock price. Volatility? If Volatility Increases: If Volatility Decreases: Negative Effect

Positive

Effect

Any effect of volatility on the option's total premium is on the time value portion. Time Passage of Time: Negative Effect

Decay?

The time value portion of an option's premium, which the option holder has "purchased" by paying for the option, generally decreases, or decays, with the passage of time. This de-crease accelerates as the option contract approaches expiration. Alternatives before expiration? At any given time before expiration, a call option holder can sell the call in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option's premium, or to cut a loss. Alternatives at expiration? At expiration, most investors holding an in-the-money call option will elect to sell the option in the marketplace if it has value, before the end of trading on the option's last trading day. An alternative is to exercise the call, resulting in the purchase of an equivalent number of underlying shares at the strike price. LONG PUT A long put can be an ideal tool for an investor who wishes to participate profitably from a downward price move in the underlying stock. Before moving into more complex bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding put options. LONG PUT

Market Bearish.

Opinion?

When to Use? Purchasing puts without owning shares of the underlying stock is a purely directional strategy used for bearish speculation. The primary motivation of this investor is to realize financial reward from a decrease in price of the underlying security. This investor is generally more interested in the Rupee amount of his initial investment and the leveraged financial reward that long puts can offer than in the number of contracts purchased. Experience and precision are key in selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the put purchased is the more bearish the strategy, as bigger decreases in the underlying stock price are required for the option to reach the break-even point. Benefit? A long put offers a leveraged alternative to a bearish, or "short sale" of the underlying stock, and offers less potential risk to the investor. As with a long call, an investor who purchased and is holding a long put has predetermined, limited financial risk versus the unlimited upside risk from a short stock sale. Purchasing a put generally requires lower up-front capital commitment than the margin required to establish a short stock position. Regardless of market conditions, a long put will never require a margin call. As the contract becomes more profitable, increasing leverage can result in large percentage profits. Risk vs. Reward? Maximum Profit: Limited Only Maximum Loss: Premium Upside Profit Strike Price Stock Price Assuming Stock Price Below BEP

by

Stock

Declining Limited

to

Zero

Expiration: Premium

Paid

Paid at at

Expiration

The maximum profit amount can be limited by the stock's potential decrease to no less than zero. At expiration an in-the-money put will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in Rupee amount, it can be as much as 100% of the premium initially paid for the put. Whatever your motivation for purchasing the put, weigh the potential reward against the potential loss of the entire premium paid. Long Put Break-Even Point BEP: Strike Price - Premium Paid

(BEP)

at

Expiration?

Before expiration, however, if the contract's market price has sufficient time value remaining, the BEP can occur at a higher stock price. Volatility? If Volatility Increases: If Volatility Decreases: Negative Effect

Positive

Effect

Any effect of volatility on the option's total premium is on the time value portion. Time Passage of Time: Negative Effect

Decay?

The time value portion of an option's premium, which the option holder has "purchased" when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls. Alternatives before expiration? At any given time before expiration, a put option holder can sell the put in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option's premium, or to cut a loss. Alternatives at expiration? At expiration most investors holding an in-the-money put will elect to sell the option in the marketplace if it has value, before the end of trading on the option's last trading day. An alternative is to purchase an equivalent number of shares in the marketplace, exercise the long put and then sell them to a put writer at the option's strike price. The third choice, one resulting in considerable risk, is to exercise the put, sell the underlying shares and establish a short stock position in an appropriate type of brokerage account. MARRIED PUT

An investor purchasing a put while at the same time purchasing an equivalent number of shares of the underlying stock is establishing a "married put" position - a hedging strategy with a name from an old IRS ruling. MARRIED PUT

Market Opinion? Bullish to very bullish. When to Use? The investor employing the married put strategy wants the benefits of stock ownership (dividends, voting rights, etc.), but has concerns about unknown, near-term, downside market risks. Purchasing puts with the purchase of shares of the underlying stock is a directional and bullish strategy. The primary motivation of this investor is to protect his shares of the underlying security from a decrease in market price. He will generally purchase a number of put contracts equivalent to the number of shares held. Benefit? While the married put investor retains all benefits of stock ownership, he has "insured" his shares against an unacceptable decrease in value during the lifetime of the put, and has a limited, predefined, downside market risk. The premium paid for the put option is equivalent to the premium paid for an insurance policy. No matter how much the underlying stock decreases in value during the option's lifetime, the investor has a guaranteed selling price for the shares at the put's strike price. If there is a sudden, significant decrease in the market price of the underlying stock, a put owner has the luxury of time to react. Alternatively, a previously entered stop loss limit order on the purchased shares might be triggered at a time and at a price unacceptable to the investor. The put contract has conveyed to him a guaranteed selling price, and control over when he chooses to sell his stock. Risk vs. Reward? Maximum Maximum Stock Purchase

Price

Profit: Loss: -

Strike

Price

Unlimited Limited + Premium

Paid

Upside Profit at Gains in Underlying Share Value - Premium Paid

Expiration:

Your maximum profit depends only on the potential price increase of the underlying security; in theory it is unlimited. When the put expires, if the underlying stock closes at the price originally paid for the shares, the investor's loss would be the entire premium paid for the put. Break-Even Point (BEP) at Expiration? BEP: Stock Purchase Price + Premium Paid Volatility? If Volatility Increases: If Volatility Decreases: Negative Effect

Positive

Effect

Any effect of volatility on the option's total premium is on the time value portion. Time Passage of Time: Negative Effect

Decay?

The time value portion of an option's premium, which the option holder has "purchased" when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls. Alternatives before expiration? An investor employing the married put can sell his stock at any time, and/or sell his long put at any time before it expires. If the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining. Alternatives at expiration? If the put option expires with no value, no action need be taken; the investor will retain his shares. If the option expires in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put's strike price. Alternatively, the investor may sell the put option, if it has market value, before the market closes on the option's last trading day. The premium received from the long option's sale will offset any financial loss from a decline in underlying share value. PROTECTIVE PUT An investor who purchases a put option while holding shares of the underlying stock from a previous purchase is employing a "protective put."

PROTECTIVE PUT

Market Opinion? Bullish on the underlying stock. When to Use? The investor employing the protective put strategy owns shares of underlying stock from a previous purchase, and generally has unrealized profits accrued from an increase in value of those shares. He might have concerns about unknown, downside market risks in the near term and wants some protection for the gains in share value. Purchasing puts while holding shares of underlying stock is a directional strategy, but a bullish one. Benefit? Like the married put investor, the protective put investor retains all benefits of continuing stock ownership (dividends, voting rights, etc.) during the lifetime of the put contract, unless he sells his stock. At the same time, the protective put serves to limit downside loss in unrealized gains accrued since the underlying stock's purchase. No matter how much the underlying stock decreases in value during the option's lifetime, the put guarantees the investor the right to sell his shares at the put's strike price until the option expires. If there is a sudden, significant decrease in the market price of the underlying stock, a put owner has the luxury of time to react. Alternatively, a previously entered stop loss limit order on the purchased shares might be triggered at both a time and a price unacceptable to the investor. The put contract has conveyed to him a guaranteed selling price at the strike price, and control over when he chooses to sell his stock. Risk vs. Reward? Maximum Profit: Unlimited Maximum Loss: Limited Strike Price Stock Purchase Price + Premium Upside Profit at Expiration: Gains in Underlying Share Value Since Purchase -Premium Paid

Paid

Potential maximum profit for this strategy depends only on the potential price increase of the underlying security; in theory it is unlimited. If the put expires in-the-money, any gains realized

from an increase in its value will offset any decline in the unrealized profits from the underlying shares. On the other hand, if the put expires at- or out-of-the-money, the investor will lose the entire premium paid for the put. Break-Even Point (BEP) at Expiration? BEP: Stock Purchase Price + Premium Paid Volatility? If Volatility Increases: If Volatility Decreases: Negative Effect

Positive

Effect

Any effect of volatility on the option's total premium is on the time value portion. Time Decay? Passage of Time: Negative Effect The time value portion of an option's premium, which the option holder has "purchased" when paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls. Alternatives before expiration? The investor employing the protective put is free to sell his stock and/or his long put at any time before it expires. For instance, if the investor loses concern over a possible decline in market value of his hedged underlying shares, the put option may be sold if it has market value remaining. Alternatives at expiration? If the put option expires with no value, no action need be taken; the investor will retain his shares. If the option closes in-the-money, the investor can elect to exercise his right to sell the underlying shares at the put's strike price. Alternatively, the investor may sell the put option, if it has market value, before the market closes on the option's last trading day. The premium received from the long option's sale will offset any financial loss from a decline in under-lying share value. COVERED CALL The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock. If this stock is purchased simultaneously with writing the call con-tract, the strategy is commonly referred to as a "buywrite." If the shares are already held from a previous purchase, it is commonly referred to an

"overwrite." In either case, the stock is generally held in the same brokerage account from which the investor writes the call, and fully collateralizes, or "covers," the obligation conveyed by writing a call option contract. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership. COVERED CALL

Market Opinion? Neutral to bullish on the underlying stock. When to Use? Though the covered call can be utilized in any market condition, it is most often employed when the investor, while bullish on the underlying stock, feels that its market value will experience little range over the lifetime of the call con-tract. The investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value. Benefit? While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership. Risk Profit Loss Upside Premium Price

Profit Received and

vs. Reward? Potential: Limited Potential: Unlimited at Expiration If Assigned: + Difference (if any) Between Strike Stock Purchase Price

Upside Profit at Expiration Any Gains in Stock Value + Premium Received

If

Not

Assigned:

Maximum profit will occur if the price of the underlying stock you own is at or above the call option's strike price, either at its expiration or when you might be assigned an exercise notice on the call before it expires. The risk of real financial loss with this strategy comes from the shares of stock held by the investor. This loss can become substantial if the stock price continues to decline in price as the written call expires. At the call's expiration, loss can be calculated as the original purchase price of the stock less its current market price, less the premium received from initial sale of the call. Any loss accrued from a decline in stock price is offset by the premium you received from the initial sale of the call option. As long as the underlying shares of stock are not sold, this would be an unrealized loss. Assignment on a written call is always possible. An investor holding shares with a low cost basis should consult his tax advisor about the tax ramifications of writing calls on such shares. Break-Even Point (BEP) at Expiration? BEP: Stock Purchase Price - Premium Received Volatility? If Volatility Increases: If Volatility Decreases: Positive Effect

Negative

Effect

Any effect of volatility on the option's price is on the time value portion of the option's premium. Time Decay? Passage of Time: Positive Effect With the passage of time, the time value portion of the option's premium generally decreases - a positive effect for an investor with a short option position. Alternatives before expiration? If the investor's opinion on the underlying stock changes significantly before the written call expires, whether more bullish or more bearish, the investor can make a closing purchase transaction of the call in the marketplace. This would close out the written call contract, relieving the investor of an obligation to sell his stock at the call's strike price. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock. If the written call position is closed out in this manner, the investor can decide whether to make another option transaction to either generate income from and/or protect his shares, to hold the stock unprotected with options, or to sell the shares. Alternatives at expiration?

As expiration day for the call option nears, the investor considers three scenarios and then accordingly makes a decision. The written call contract will either be in-the-money, at-themoney or out-of-the-money. If the investor feels the call will expire in-the-money, he can choose to be assigned an exercise notice on the written contract and sell an equivalent number of shares at the call's strike price. Alternatively, the investor can choose to close out the writ-ten call with a closing purchase transaction, canceling his obligation to sell stock at the call's strike price, and retain ownership of the underlying shares. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock. If the investor feels the written call will expire outof-the-money, no action is necessary. He can let the call option expire with no value and retain the entire premium received from its initial sale. If the written call expires exactly at-the-money, the investor should realize that assignment of an exercise notice on such a contract is possible, but should not be assumed. Consult with your brokerage firm or a financial advisor on the advisability of what action to take in this case. COVERED PUT According to the terms of a put contract, a put writer is obligated to purchase an equivalent number of underlying shares at the put's strike price if assigned an exercise notice on the written contract. Many investors write puts because they are willing to be assigned and acquire shares of the underlying stock in exchange for the premium received from the put's sale. For this discussion, a put writer will be considered "covered" if he has on deposit with his brokerage firm a cash amount (or other approved collateral) sufficient to cover such a purchase. COVERED PUT

Market Opinion? Neutral to slightly bullish. When to Use? There are two key motivations for employing this strategy: either as an attempt to purchase underlying shares below current market price, or to collect and keep premium from the sale of puts which expire out-of-the-money and with no value. An investor should write a covered put

only when he would be comfortable owning underlying shares, because assignment is always possible at any time before the put expires. In addition, he should be satisfied that the net cost for the shares will be at a satisfactory entry point if he is assigned an exercise. The number of put contracts written should correspond to the number of shares the investor is comfortable and financially capable of purchasing. While assignment may not be the objective at times, it should not be a financial burden. This strategy can become speculative when more puts are written than the equivalent number of shares desired to own. Benefit? The put writer collects and keeps the premium from the put's sale, no matter how much the stock increases or decreases in price. If the writer is assigned, he is then obligated to purchase an equivalent amount of underlying shares at the put's strike price. The premium received from the put's sale will partially offset the purchase price for the stock, and can result in a purchase of shares below the current market price. If the underlying stock price declines significantly and the put writer is assigned, the purchase price for the shares can be above current market price. In this case, the put writer will have an unrealized loss due to the high stock purchase price, but will have upside profit potential if retaining the purchased shares. Risk vs. Reward? Maximum Profit: Premium Received Maximum Loss: Upside Profit at Premium Received from Net Stock Purchase Price Strike Price - Premium Received from Put Sale

Limited Unlimited Expiration: Put Sale If Assigned:

If the underlying stock increases in price and the put expires with no value, the profit is limited to the premium received from the put's initial sale. On the other hand, an outright purchase of underlying stock would offer the investor unlimited upside profit potential. If the underlying stock declines below the strike price of the put, the investor might be assigned an exercise notice and be obligated to purchase an equivalent number of shares. The net stock purchase price would be the put's strike price less the premium received from the put's sale. This price can be less than current market price for the stock when assignment is made. The loss potential for this strategy is similar to owning an equivalent number of underlying shares. Theoretically, the stock price can decline to zero. If assignment results in the purchase of stock at a net price greater than the current market price, the investor would incur a loss unrealized as long as ownership of the shares is retained. Break-Even Point (BEP) BEP: Strike Price - Premium Received from Sale of Put Volatility?

at

Expiration?

If Volatility Increases: Negative Effect If Volatility Decreases: Positive Effect Any effect of volatility on the option's total premium is on the time value portion. Time Decay? Passage of Time: Positive Effect With the passage of time, the time value portion of the option's premium generally decreases - a positive effect for an investor with a short option position. Alternatives before expiration? If the investor's opinion about the underlying stock changes before the put expires, the investor can buy the same con-tract in the marketplace to "close out" his position at a realized loss. After this is done, no assignment is possible. The investor is relieved from any obligation to purchase underlying stock. Alternatives at expiration? If the short option has any value when it expires, the investor will most likely be assigned an exercise notice and be obligated to purchase an equivalent number of shares. If owning the underlying shares is not desired at this point, the investor can close out the written put by buying a contract with the same terms in the marketplace. Such a purchase would have to occur before the market closes on the option's last trading day, and could result in a realized loss. On the other hand, the investor is obliged to take delivery of the underlying shares at a possible unrealized loss. BULL CALL SPREAD Establishing a bull call spread involves the purchase of a call option on a particular underlying stock, while simultaneously writing a call option on the same underlying stock with the same expiration month, at a higher strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bull call spread, as any spread, can be executed as a "unit" in one single transaction, not as separate buy and sell transactions. For this bullish vertical spread, a bid and offer for the whole package can be requested through your brokerage firm from an exchange where the options are listed and traded. BULL CALL SPREAD

Market Opinion? Moderately bullish to bullish. When to Use? Moderately Bullish An investor often employs the bull call spread in moderately bullish market environments, and wants to capitalize on a modest advance in price of the underlying stock. If the investor's opinion is very bullish on a stock it will generally prove more profitable to make a simple call purchase. Risk Reduction An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long call alone, or with the conviction of his bullish market opinion. Benefit? The bull call spread can be considered a doubly hedged strategy. The price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price. Thus, the investor's investment in the long call, and the risk of losing the entire premium paid for it, is reduced or hedged. On the other hand, the long call with the lower strike price caps or hedges the financial risk of the written call with the higher strike price. If the investor is assigned an exercise notice on the written call and must sell an equivalent number of underlying shares at the strike price, those shares can be purchased at a predetermined price by exercising the purchased call with the lower strike price. As a trade-off for the hedge it offers, this written call limits the potential maximum profit for the strategy. Risk vs. Reward? Upside Difference

Maximum Between Strike

Profit: Prices -

Net

Limited Debit

Paid

Maximum Net Debit Paid

Loss:

Limited

A bull call spread tends to be profitable when the under-lying stock increases in price. It can be established in one transaction, but always at a debit (net cash outflow). The call with the lower strike price will always be purchased at a price greater than the offsetting premium received from writing the call with the higher strike price. Maximum loss for this spread will generally occur as the underlying stock price declines below the lower strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost. The maximum profit for this spread will generally occur as the underlying stock price rises above the higher strike price, and both options expire in-the-money. The investor can exercise the long call, buy stock at its lower strike price, and sell that stock at the written call's higher strike price if assigned an exercise notice. This will be the case no matter how high the underlying stock has risen in price. If the underlying stock price is in between the strike prices when the calls expire, the long call will be in-the-money and worth its intrinsic value. The written call will be out-of-the-money, and have no value. Break-Even Point (BEP) at Expiration? BEP: Strike Price of Purchased Call + Net Debit Paid Volatility? If Volatility Increases: If Volatility Decreases: Effect Varies

Effect

Varies

The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration. Time Passage of Time: Effect Varies

Decay?

The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the lower strike price of the long call, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the written call, profits generally increase at a faster rate as time passes. Alternatives before expiration?

A bull call spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. This is generally the manner in which investors close out a spread before its options expire, in order to cut a loss or realize profit. Alternatives at expiration? If both options have value, investors will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and transaction costs from a transfer of stock resulting from either an exercise of and/or an assignment on the calls. If only the purchased call is in-the-money as it expires, the investor can either sell it in the marketplace if it has value or exercise the call and purchase an equivalent number of shares. In either of these cases, the transaction(s) must occur before the close of the market on the options' last trading day. BEAR PUT SPREAD Establishing a bear put spread involves the purchase of a put option on a particular underlying stock, while simultaneously writing a put option on the same underlying stock with the same expiration month, but with a lower strike price. Both the buy and the sell sides of this spread are opening transactions, and are always the same number of contracts. This spread is sometimes more broadly categorized as a "vertical spread": a family of spreads involving options of the same stock, same expiration month, but different strike prices. They can be created with either all calls or all puts, and be bullish or bearish. The bear put spread, as any spread, can be executed as a "package" in one single transaction, not as separate buy and sell transactions. For this bearish vertical spread, a bid and offer for the whole package can be request-ed through your brokerage firm from an exchange where the options are listed and traded. BEAR PUT SPREAD

Market Moderately bearish to bearish. When Moderately Bearish

Opinion? to

Use?

An investor often employs the bear put spread in moderately bearish market environments, and wants to capitalize on a modest decrease in price of the underlying stock. If the investor's opinion is very bearish on a stock it will generally prove more profitable to make a simple put purchase. Risk Reduction An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long put alone, or with the conviction of his bearish market opinion. Benefit? The bear put spread can be considered a doubly hedged strategy. The price paid for the put with the higher strike price is partially offset by the premium received from writing the put with a lower strike price. Thus, the investor's investment in the long put and the risk of losing the entire premium paid for it, is reduced or hedged. On the other hand, the long put with the higher strike price caps or hedges the financial risk of the written put with the lower strike price. If the investor is assigned an exercise notice on the written put, and must purchase an equivalent number of underlying shares at its strike price, he can sell the purchased put with the higher strike price in the marketplace. The premium received from the put's sale can partially offset the cost of purchasing the shares from the assignment. The net cost to the investor will generally be a price less than current market prices. As a trade-off for the hedge it offers, this written put limits the potential maximum profit for the strategy. Risk vs. Reward? Downside Maximum Difference Between Strike Maximum Loss: Net Debit Paid

Profit: Prices -

Net Limited

Limited Debit

Paid

A bear put spread tends to be profitable if the underlying stock decreases in price. It can be established in one transaction, but always at a debit (net cash outflow). The put with the higher strike price will always be purchased at a price greater than the offsetting premium received from writing the put with the lower strike price. Maximum loss for this spread will generally occur as the underlying stock price rises above the higher strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost. The maximum profit for this spread will generally occur as the underlying stock price declines below the lower strike price, and both options expire in-the-money. This will be the case no matter how low the underlying stock has declined in price. If the underlying stock is in between the strike prices when the puts expire, the purchased put will be in-the-money, and be worth its intrinsic value. The written put will be out-of-the-money, and have no value.

Break-Even Point (BEP) at Expiration? BEP: Strike Price of Purchased Put - Net Debit Paid Volatility? If Volatility Increases: If Volatility Decreases: Effect Varies

Effect

Varies

The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration. Time Passage of Time: Effect Varies

Decay?

The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the higher strike price of the purchased put, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the lower strike price of the written put, profits generally increase at a faster rate as time passes. Alternatives before expiration? A bear put spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. This is generally the manner in which investors close out a spread before its options expire, in order to cut a loss or realize profit. Alternatives at expiration? If both options have value, investors will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and trans-action costs from a transfer of stock resulting from either an exercise of and/or an assignment on the puts. If only the purchased put is in-the-money and has value as it expires, the investor can sell it in the marketplace before the close of the market on the option's last trading day. On the other hand, the investor can exercise the put and either sell an equivalent number of shares that he owns or establish a short stock position. COLLAR A collar can be established by holding shares of an underlying stock, purchasing a protective put and writing a covered call on that stock. The option portions of this strategy are referred to as a combination. Generally, the put and the call are both out-of-the-money when this combination is established, and have the same expiration month. Both the buy and the sell sides of this combination are opening transactions, and are always the same number of contracts. In other

words, one collar equals one long put and one written call along with owning 100 shares of the underlying stock. The primary concern in employing a collar is protection of profits accrued from underlying shares rather than increasing returns on the upside.

COLLAR * Graph assumes accrued stock profit when establishing combination Market Opinion? Neutral, following a period of appreciation. When to Use? An investor will employ this strategy after accruing unrealized profits from the underlying shares, and wants to protect these gains with the purchase of a protective put. At the same time, the investor is willing to sell his stock at a price higher than the current market price so an outof-the-money call contract is written, covered in this case by the underlying stock. Benefit? This strategy offers the stock protection of a put. However, in return for accepting a limited upside profit potential on his underlying shares (to the call's strike price), the investor writes a call contract. Because the premium received from writing the call can offset the cost of the put, the investor is obtaining downside put protection at a smaller net cost than the cost of the put alone. In some cases, depending on the strike prices and the expiration month chosen, the premium received from writing the call will be more than the cost of the put. In other words, the combination can sometimes be established for a net credit; the investor receives cash for establishing the position. The investor keeps the cash credit, regardless of the price of the underlying stock when the options expire. Until the investor either exercises his put and sells the underlying stock, or is assigned an exercise notice on the written call and is obligated to sell his stock, all rights of stock ownership are retained. See both Protective Put and Covered Call strategies presented earlier in this book. Risk vs. Reward?

This example assumes an accrued profit from the investor's underlying shares at the time the call and put positions are established, and that this unrealized profit is being protected on the downside by the long put. Therefore, discussion of maximum loss does not apply. Rather, in evaluating profit and/or loss below, bear in mind the underlying stock's purchase price (or cost basis). Compare that to the net price received at expiration on the downside from exercising the put and selling the underlying shares, or the net sale price of the stock on the upside if assigned on the written call option. This example also assumes that when the combined position is established, both the written call and purchased put are out-of-the-money. Net Upside Stock if Assigned on the Call's Strike Price + Net Credit or Call's Strike Price - Net Debit Paid for Combination

Sale Written Received for

Net Downside Stock if Exercising the Put's Strike Price + Net Credit or Put's Strike Price - Net Debit Paid for Combination

Sale Long Received

for

Price Call: Combination

Price Put: Combination

If the underlying stock price is between the strike prices of the call and put when the options expire, both options will generally expire with no value. In this case, the investor will lose the entire net premium paid when establishing the combination, or keep the entire net cash credit received when establishing the combination. Balance either result with the underlying stock profits accrued when the combination was established. Break-Even Point (BEP) at Expiration? In this example, the investor is protecting his accrued profits from the underlying stock with a sale price for the shares guaranteed at the long put's strike price. In this case, consideration of BEP does not apply. Volatility? If Volatility Increases: If Volatility Decreases: Effect Varies

Effect

Varies

The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration. Time Decay? Passage of Time: Effect Varies

The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the lower strike price of the long put, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the written call, profits generally increase at a faster rate as time passes. Alternatives before expiration? The combination may be closed out as a unit just as it was established as a unit. To do this, the investor enters a combination order to buy a call with the same contract and sell a put with the same contract terms, paying a net debit or receiving a net cash credit as determined by current option prices in the marketplace. Alternatives at expiration? If the underlying stock price is between the put and call strike prices when the options expire, the options will generally expire with no value. The investor will retain ownership of the underlying shares and can either sell them or hedge them again with new option contracts. If the stock price is below the put's strike price as the options expire, the put will be in-the-money and have value. The investor can elect to either sell the put before the close of the market on the option's last trading day and receive cash, or exercise the put nd sell the underlying shares at the put's strike price. Alternatively, if the stock price is above the call's strike price as the options expire, the short call will be in-the-money and the investor can expect assignment to sell the underlying shares at the strike price. Or, if retaining ownership of the shares is now desired, the investor can close out the short call position by purchasing a call with the same con-tract terms before the close of trading. QUICK SNAPSHOT OF OPTION TRADING STRATEGIES Please note: All or part of your investments using Bullish Strategies have greater risk of loss in falling market. Investments using Neutral Strategies have greater risk of loss in volatile markets Investments using Bearish Strategies have greater risk of loss in rising markets. BULLISH STRATEGIES LONG CALLS For aggressive investors who are bullish about the short-term prospects for a stock, buying calls can be an excellent way to capture the upside potential with limited inside risk. COVERED CALLS For conservative investors, selling calls against a long stock position can be an excellent way to generate income without assuming the risks associated with uncovered calls. In this case, investors would sell one call contract for each 100 shares of stock they own.

PROTECTIVE PUT For investors who want to protect the stocks in their portfolio from falling prices, protective puts provide a relatively low-cost form of portfolio insurance. In this case, investors would purchase one put contract for each 100 shares of stock they own. BULL CALL SPREAD For bullish investors who want to a nice low risk, limited return strategy without buying or selling the underlying stock, bull call spreads are a great alternative. This strategy involves buying and selling the same number of calls at different strike prices to minimize both the cash outlay and the overall risk. BULL PUT SPREAD For bullish investors who want a nice low risk, limited return strategy, bull put spreads are another alternative. Like the bull call spread, the bull put spread involves buying and selling the same number of put options at different strike prices. Since puts with the higher strike are sold, the trade is initiated for a credit. CALL BACK SPREAD For bullish investors who expect big moves in already volatile stocks, call back spreads are a great limited risk, unlimited reward strategy. The trade itself involves selling a call (or calls) at a lower strike and buying a greater number of calls at a higher strike price. NAKED PUT For bullish investors who are interested in buying a stock at a price below the current market price, selling naked puts can be an excellent strategy. In this case, however, the risk is substantial because the writer of the option is obligated to purchase the stock at the strike price regardless of where the stock is trading. BEARISH STRATEGIES LONG PUT For aggressive investors who have a strong feeling that a particular stock is about to move lower, long puts are an excellent low risk, high reward strategy. Rather than opening yourself to enormous risk of short selling stock, you could buy puts (the right to sell the stock). While risk is limited to the initial investment, the profit potential is unlimited. NAKED PUT Selling naked calls is a very risky strategy which should be utilized with extreme caution. By selling calls without owning the underlying stock, you collect the option premium and hope the

stock either stays steady or declines in value. If the stock increases in value this strategy has unlimited risk. PUT BACKSPREAD For aggressive investors who expect big downward moves in already volatile stocks, backspreads are great strategies. The trade itself involves selling a put at a higher strike and buying a greater number of puts at a lower strike price. As the stock price moves lower, the profit potential is unlimited. BEAR CALL SPREAD For investors who maintain a generally negative feeling about a stock, bear spreads are a nice low risk, low reward strategies. This trade involves selling a lower strike call, usually at or near the current stock price, and buying a higher strike, out-of-the-money call. This spread profits when the stock price decreases and both calls expire worthless. BEAR PUT SPREAD For investors who maintain a generally negative feeling about a stock, bear spreads are another nice low risk, low reward strategy. This trade involves buying a put at a higher strike and selling another put at a lower strike. Like bear call spreads, bear put spreads profit when the price of the underlying stock decreases. NEUTRAL STRATEGIES REVERSAL Primarily used by floor traders, a reversal is an arbitrage strategy that allows traders to profit when options are underpriced. To put on a reversal, a trader would sell stock and use options to buy an equivalent position that offsets the short stock. CONVERSION Primarily used by floor traders, a conversion is an arbitrage strategy that allows traders to profit when options are overpriced. To put on a conversion, a trader would buy stock and use options to sell an equivalent position that offsets the long stock. THE COLLAR For bullish investors who want to nice low risk, limited return strategy to use in conjunction with a long stock position, collars are a great alternative. In this case, the collar is created by combining covered calls protective puts. LONG STRADDLE

For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long straddle is an excellent strategy. This position involves buying both a put and a call with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment. The potential profit is unlimited as the stock moves up or down. SHORT STRADDLE For aggressive investors who don't expect much short-term volatility, the short straddle can be a risky, but profitable strategy. This strategy involves selling a put and a call with the same strike price, expiration, and underlying. In this case, the profit is limited to the initial credit received by selling options. The potential loss is unlimited as the market moves up or down. LONG STRANGLE For aggressive investors who expect short-term volatility yet have no bias up or down (i.e., a neutral bias), the long strangle is another excellent strategy. This strategy typically involves buying out-of-the-money calls and puts with the same strike price, expiration, and underlying. The potential loss is limited to the initial investment while the potential profit is unlimited as the market moves up or down. SHORT STRANGLE For aggressive investors who don't expect much short-term volatility, the short strangle can be a risky, but profitable strategy. This strategy typically involves selling out-of-the-money puts and calls with the same strike price, expiration, and underlying. The profit is limited to the credit received by selling options. The potential loss is unlimited as the market moves up or down. THE BUTTERFLY Ideal for investors who prefer limited risk, limited reward strategies. When investors expect stable prices, they can buy the butterfly by selling two options at the middle strike and buying one option at the higher and lower strikes. The options, which must be all calls or all puts, must also have the same expiration and underlying. RATIO SPREAD For aggressive investors who don't expect much short-term volatility, ratio spreads are a limited reward, unlimited risk strategy. Put ratio spreads, which involve buying puts at a higher strike and selling a greater number of puts at a lower strike, are neutral in the sense that they are hurt by market movement. CONDOR Ideal for investors who prefer limited risk, limited reward strategies. The condor takes the body of the butterfly - two options at the middle strike - and splits between two middle strikes. In this sense, the condor is basically a butterfly stretched over four strike prices instead of three.

CALENDAR SPREAD Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. Because they are not exceptionally profitable on their own, calendar spreads are often used by traders who maintain large positions. Typically, a long calendar spread involves buying an option with a long-term expiration and selling an option with the same strike price and a short-term expiration. OPTION TRADING STRATEGY FORMULAS MARRIED PUT (Stock Price - Strike Price) + Put Price = Maximum Loss PROTECTING UNREALIZED PROFIT (Strike Price - Put Price) - Initial Stock Purchase = Unrealized Profit COVERED CALL POTENTIAL (Call Price + Strike Price) - Stock Price = Covered Call Potential BULL SPREAD (LONG Difference between Strike Prices (The debit Paid is the maximum loss.)

CALL Debit Paid

BULL SPREAD (SHORT Difference between Strike Prices (The credit received is the maximum profit.) BEAR SPREAD (LONG Difference between Strike Prices (The debit Paid is the maximum loss.)

=

PUT Credit =

Debit

BEAR SPREAD (SHORT Difference between Strike Prices (The credit received is the maximum profit.)

PUT Paid

CALL Credit =

SPREAD) Maximum Profit SPREAD) Maximum Loss

=

SPREAD) Maximum Profit SPREAD) Maximum Loss

RATIO BULL A short call spread plus a long OTM call

SPREAD

(LONG)

RATIO BULL A long call spread plus a short OTM call

SPREAD

RATIO BEAR A short put spread plus a long OTM put

SPREAD

(LONG)

RATIO BEAR A long put spread plus a short OTM put

SPREAD

(SHORT)

(SHORT)

LONG STRADDLE Strike Price - (Call Price + Put Price) = Low Strike Price + (Call Price + Put Price) = High Break-even Point

Break-even

Point

SHORT STRADDLE Strike Price - (Call Price + Put Price) = Low Strike Price + (Call Price + Put Price) = High Break-even Point

Break-even

Point

LONG STRANGLE OTM Put Strike Price - (OTM Call Price + OTM Put Price) = Low Break-even Point OTM Call Strike Price + (OTM Call Price + OTM Put Price) = High Break-even Point SHORT STRANGLE OTM Put Strike Price - (OTM Call Price + OTM Put Price) = Low Break-even Point OTM Call Strike Price + (OTM Call Price + OTM Put Price) = High Break-even Point LONG BUTTERFLY Buy One + Sell Two + Buy One = Total Debit SHORT BUTTERFLY Sell One + Buy Two + Sell One = Total Credit LONG IRON BUTTERFLY Sell ATM Straddle - Buy OTM Strangle = Receive a credit SHORT IRON Buy ATM Straddle - Sell OTM Strangle = Total Debit

BUTTERFLY

LONG CONDOR Buy One + Sell One + Sell One + Buy One = Total Debit paid SHORT CONDOR Sell One + Buy One + Buy One + Sell One = Credit received RISK COLLAR / FENCE (RISK CONVERSION) Long Underlying Security = Purchasing OTM Put + Selling the OTM call RISK COLLAR / FENCE (RISK REVERSAL) Short Underlying Security = Purchasing OTM Call + Selling the OTM Put INTRINSIC AND PREMIUM FORMULAS The intrinsic value of an option corresponds to the relationship between the option's strike price and the current price of the underlying asset. The intrinsic value is the amount that an option is in-the-money (ITM). Out-of-the-money (OTM) options have no intrinsic value.

CALL INTRINSIC Current Stock Price - Strike Price = Call Intrinsic Value

VALUE

PUT INTRINSIC Strike Price - Current Stock Price = Put Intrinsic Value

VALUE

All options include premiums or values over and above the option's intrinsic value. Premium values vary based on three factors: the market anticipation of the volatility of the underlying security; the time remaining until the option's expiration; and current interest rates. (Premium value is also known as time value or extrinsic value.) CALL PREMIUM Call Option Price - Call Intrinsic Value = Call Premium Value

VALUE

PUT PREMIUM Put Option Price - Put Intrinsic Value = Put Premium Value

VALUE

RULES FOR BUYING CALLS AND PUTS Rule No. 1: Buy calls when the overall market is down; buy puts when the overall market is up. By and large, when the stock market rallies, most stocks rally, and when the stock market declines, most stocks perform likewise. The extent of this movement can easily be measured by observing stock indices. We recommend using the advance/decline index as a proxy for the overall market. However, if this is unavailable, one could also use the net price change of a comprehensive market average, such as the BSE SENSEX and NSE NIFTY. For the overall market to rally, the majority of individual stocks must rally, too. Sure there are days in which the market is rallying even though the number of advancing issues is less than the declining issues but this cannot last long if the stock market is to mount a sustainable advance. Similarly, on the downside, the market cannot undergo an extended decline unless the numbers of declining stocks outnumber the advancing stocks. When the overall market trades lower, call option premiums typically decrease. Therefore, by requiring the market index to be down for the day at the time a call is purchased, the prospects for a decline in a call's premium are enhanced. Similarly, when the overall market trades higher, put option premiums typically decrease. Therefore, by requiring the advance/decline market index to be up for the day at the time a put is purchased, the prospects for a decline in a put's premium are enhanced similarly. Since most stocks rise and fall with the general market - with the possible exception of gold stocks - this provides a measure of much-needed discipline and helps prevent emotional, uncontrolled option buying. Rule No. 2: Buy calls when the industry group is down; buy puts when the industry group is up. Just as most stocks move in phase with the market, most industry group components move in sync with their counterparts within their specific industry as well. Therefore, when one stock within an industry group is down, chances are the others are down as well. It's the exception when one component of an industry advances while all the other members decline, or vice versa, especially over an extended period of time. For example, situations can arise where a buyout

occurs and the accumulation of one company's stock causes it to outperform the others within the industry group. However, announcements such as these typically cause the other stocks within the same industry group to participate in the movement since the market's perception is that all companies within the group are likely acquisition candidates and their stocks are "in play," so to speak. Rule No. 3: Buy calls when the underlying security is down; buy puts when the underlying security is up. In order to time the purchase of calls, we look for the price of the underlying security to be down relative to the previous trading day's close. If the stock's current market price is less than the previous day's close, most traders extrapolate that the downtrend will continue. It is also possible to relate the stock's current price with its opening price level to make this rule more stringent. Either relationship, that is, current price versus yesterday's close or current price versus the current day's open, can be applied or a combination of the two can be used to insure that the composite outlook for the market is perceived bearish by most traders. In order to time the purchase of puts, we look for the price of the underlying security to be up relative to the previous trading day's close. If the stock's current market price is greater than the previous day's close, most traders extrapolate that the up trend will continue. It is also possible to relate the stock's current price with its opening price level to make this rule more stringent. Either relationship, that is, current price versus yesterday's close or current price versus the current day's open, can be applied or a combination of the two can be used to insure that the composite outlook for the market is perceived bullish by most traders. Rule No. 4: Buy calls when the option is down; buy puts when the option is down. Just as the previous series of rules required that specific relationships be fulfilled, so too must this prerequisite be met. In fact, of all rules listed, this requirement is singularly the most important. The option's price, be it a call or a put, must be less than the previous day's close. As an additional requirement, it may also be less than the current day's opening price level as well. Obviously, if an option's price is inevitably going to rally, it is smarter to buy as low as possible. Further, if the call or the put unexpectedly continues to decline to zero, then the loss incurred is nevertheless less than if one had chased the price upside and purchased the option when it was trading above the previous day's close. The combination of the preceding rules serves to remove a degree of emotionalism from operating in the options markets and instills a level of discipline in the trading process. We can't tell you how long it took to acquire and apply these important rules to our trading regimen. Obviously, the risk always exists that despite the fact that all the previously described rules may be met, option prices may continue to decline, and as a result purchasing the call options or the put options will translate into a losing proposition. That's a concern that can only be diminished by introducing a series of sentiment measures or various market-timing indicators to confirm option buying at a particular point in time. The integration of these together with market sentiment information comparing put and call volume and the information regarding various indicators presented in the other chapters within this book enhance the timing and selection results further by concentrating upon ideal candidates which are low-risk opportunities based upon all four requirements.

Options Trading Strategy Guide: The World of Options Trading OPTIONS PLAYERS Options: Not a Zero-Sum Game With the possible exception of futures contracts, trading is not a zero-sum game. In other words, for every winner there doesn't have to be a loser. Therefore, because there are so many different combinations and ways options can be hedged against each other, it doesn't make sense to look at overall figures (e.g., the number of options that expire worthless) and reach conclusions about how many people made or lost money. For simplicity, let's take the case of a spread. The fact that one person made money buying a butterfly does not automatically mean that someone else lost. Instead, the person who sold the butterfly may have traded out of the position using spreads or by selling individual options. For every person who is long a butterfly, call spread, put spread, or whatever, there are not necessarily people who are short the corresponding position. As such, the profitability of their positions will necessarily differ. Know your competition In many respects, option trading is a game of strategy not unlike competitive sports or chess tournaments. The main difference is that in trading there are more players and multiple agendas. To succeed, it's important to have a knowledge and appreciation of the other players. In general terms, you must gain an appreciation for the behavior and motivations of the different players. In the option markets, the players fall into four categories: • • • •

The Exchanges Financial Institution Market Makers Individual (Retail) Investors

What follows is a brief overview of each group along with insights into their trading objectives and strategies. The Exchanges The exchange is a pblace where market makers and traders gather to buy and sell stocks, options, bonds, futures, and other financial instruments. Since 1973 when the Chicago Board Options Exchange first began trading options, a number of other players have emerged. At first, the exchanges each maintained separate listings and therefore didn't trade the same contracts. In recent years this has changed. Now that BSE and NSE both these exchanges list and trade the same contracts, they compete with each other. Nevertheless, even though a stock may be listed on multiple exchanges, one

exchange generally handles the bulk of the volume. This would be considered the dominant exchange for that particular option. The competition between exchanges has been particularly valuable to professional traders who have created complex computer programs to monitor price discrepancies between exchanges. These discrepancies, though small, can be extraordinarily profitable for traders with the ability and speed to take advantage. More often than not, professional traders simply use multiple exchanges to get the best prices on their trades. Deciding between the two would be simply a matter of choosing the exchange that does the most trading in this contract. The more volume the exchange does, the more liquid the contract. Greater liquidity increases the likelihood the trade will get filled at the best price. Financial Institutions Financial institutions are pbrofessional investment management companies that typically fall into several main categories: mutual funds, hedge funds, insurance companies, stock funds. In each case, these money managers control large portfolios of stocks, options, and other financial instruments. Although individual strategies differ, institutions share the same goal-to outperform the market. In a very real sense, their livelihood depends on performance because the investors who make up any fund tend to be a fickle group. When fund don't perform, investors are often quick to move money in search of higher returns. Where individual investors might be more likely to trade equity options related to specific stocks, fund managers often use index options to better approximate their overall portfolios. For example, a fund that invests heavily in a broad range of tech stocks will use NSE Nifty Index options rather than separate options for each stock in their portfolio. Theoretically, the performance of this index would be relatively close to the performance of a subset of comparable high tech stocks the fund manager might have in his or her portfolio. Market Makers Market makers are the traders on the floor of the exchanges who create liquidity by providing two-sided markets. In each counter, the competition between market makers keeps the spread between the bid and the offer relatively narrow. Nevertheless, it's the spread that partially compensates market makers for the risk of willingly taking either side of a trade. For market makers, the ideal situation would be to "scalp" every trade. More often than not, however, market makers don't benefit from an endless flow of perfectly offsetting trades to scalp. As a result, they have to find other ways to profit. In general, there are four trading techniques that characterize how different market makers trade options. Any or all of these techniques may be employed by the same market maker depending on trading conditions. • • •

Day Traders Premium Sellers Spread Traders

•

Theoretical Traders

Day traders Day traders, on or off the trading screen, tend to use small positions to capitalize on intra-day market movement. Since their objective is not to hold a position for extended periods, day traders generally don't hedge options with the underlying stock. At the same time, they tend to be less concerned about delta, gamma, and other highly analytical aspects of option pricing. Premium Sellers Just like the name implies, premium sellers tend to focus their efforts selling high priced options and taking advantage of the time decay factor by buying them later at a lower price. This strategy works well in the absence of large, unexpected price swings but can be extremely risky when volatility skyrockets. Spread Traders Like other market makers, spread traders often end up with large positions but they get there by focusing on spreads. In this way, even the largest of positions will be somewhat naturally hedged. Spread traders employ a variety of strategies buying certain options and selling others to offset the risk. Some of these strategies like reversals, conversions, and boxes are primarily used by floor traders because they take advantage of minor price discrepancies that often only exist for seconds. However, spread traders will use strategies like butterflies, condors, call spreads, and put spreads that can be used quite effectively by individual investors. Theoretical Traders By readily making two-sided markets, market makers often find themselves with substantial option positions across a variety of months and strike prices. The same thing happens to theoretical traders who use complex mathematical models to sell options that are overpriced and buy options that are relatively underpriced. Of the four groups, theoretical traders are often the most analytical in that they are constantly evaluating their position to determine the effects of changes in price, volatility, and time. Individual (Retail) As option volume increases, the role of individual investors becomes more important because they account for over 90% of the volume. That's especially impressive when you consider that option volume in February 2000 was 56.2 million contracts-an astounding 85% increase over February 1999 The Psychology of the Individual Investor From a psychological standpoint, individual investors are in interesting group because there are probably as many strategies and objectives as there are individuals. For some, options are a

means to generate additional income through relatively conservative strategies such as covered calls. For others, options in the form of protective puts provide an excellent form of insurance to lock in profits or prevent losses from new positions. More risk tolerant individuals use options for the leverage they provide. These people are willing to trade options for large percentage gains even knowing their entire investment may be on the line. In a sense, taking a position in the market automatically means that you are competing with countless investors from the categories described above. While that may be true, avoid making direct comparisons when it comes to your trading results. The only person you should compete with is yourself. As long as you are learning, improving, and having fun, it doesn't matter how the rest of the world is doing. HOW TO HEDGE RISK AND PROTECT PROFITS WITH OPTIONS? Market making Professional traders (known in the industry as market makers or market operators), often think that for the beginning investor, option trading must seem similar to putting together a puzzle without the aid of a picture. You can find the picture if you know where to look. Looking through the eyes of a professional market maker is one of the best ways to learn about trading options under real market conditions. This experience will help you understand how real-world changes in option pricing variables affect an option's value and the risks associated with that option. Furthermore, because market makers are essentially responsible for what the option market looks like, you need to be familiar with their role and the strategies that they use in order to a regulate a liquid market and ensure their own profit. We will provide an overview of the practices of market makers and explore their mindset as the architects of the option business. First, we will consider the logistics of a market maker's responsibilities. How do market makers respond to supply and demand to ensure a liquid market? How do they assess the value of an option based on market conditions and demands? In the second part of this chapter, we will consider the profit-oriented objectives of a market maker. How is market making like any other business? How does a market maker profit? What does it mean to hedge a position, and how does a market maker use hedging to minimize risk? Who are market makers? The image of an electronic trading terminal is not unfamiliar to the Indian imagination, but many people might not know who the players behind the screen are. Market makers, brokers, fund managers, retail traders and investors occupy trading terminals across India. Thousands of trading terminals across 250 cities of India are combined, they represent the marketplace for option trading. The exchange itself provides the location, regulatory body, computer technology, and staff that are necessary to support and monitor trading activity. Market makers are said to actually make the option market, whereas brokers represent the public orders. In general, market makers might make markets in up 30 or more issues and compete with one another for customer buy and sell orders in those issues. Market makers trade using either their

own capital or trade for a firm that supplies them with capital. The market maker's activity, which takes place increasingly through computer execution, represents the central processing unit of the option industry. If we consider the exchange itself as the backbone of the industry, the action in the Mumbai's broking offices represents the industry's brain and industry, heart. As both a catalyst for trading and a profiteer in his or her own right, the market maker's role in the industry is well worth closer examination. Individual trader versus market maker The evaluation of an option's worth by individual traders and market makers, respectively, is the foundation of option trading. Trader and market maker alike buy and sell the products that they foresee as profitable. From this perspective, no difference exists between a market maker and the individual option trader. More formally, however, the difference between you and the market maker is responsible for creating the option industry, as we know it. Essentially, market makers are professional, large-volume option traders whose own trading serves the public by creating liquidity and depth in the marketplace. On a daily basis, market makers account for up to half of all option trading volume, and much of this activity is responsible for creating and ensuring a two-sided market made up of the best bids and offers for public customers. A market maker's trading activity takes place under the conditions of a contractual relationship with an exchange. As members of the exchange, market makers must pay dues and lease or own a seat on the floor in order to trade. More importantly, a market maker's relationship with the exchange requires him or her to trade all of the issues that are assigned to his or her primary pit on the option floor. In return, the market maker is able to occupy a privileged position in the option market - market makers are the merchants in the option industry; they are in a position to create the market (bid and ask) and then buy on their bid and sell on their offer. The main difference between a market maker and retail traders is that the market maker's position is primarily dictated by customer order flow. The market maker does not have the luxury of picking and choosing his or her position. Just like the book makers in Las Vegas casinos who set the odds and then accommodate individual betters who select which side of the bet that they want, a market maker's job is to supply a market in the options, a bid and an offer, and then let the public decide whether to buy or sell at those prices, thereby taking the other side of the bet. As the official option merchants, market makers are in a position to buy option wholesale and sell them at retail. That said, the two main differences between market makers and other merchants is that market makers commonly sell before they buy, and the value of their inventory fluctuates as the price of stock fluctuates. As with all merchants, though, a familiarity with the product pays off. The market maker's years of experience with market conditions and trading practices in general - including an array of trading strategies - enables him or her to establish an edge (however slight) over the market. This edge is the basis for the market maker's potential wealth. Smart trading styles of market operators

Throughout the trading day, market makers generally use one of two trading styles: scalping or position trading. Scalping is a simpler trading style that an ever-diminishing number of traders use. Position trading, which is divided into a number of subcategories, is used by the greatest percentage of all market makers. As we have discussed, most market maker's position are dictated to them by the public's order flow. Each individual market maker will accumulate and hedge this order flow differently, generally preferring one style of trading over another. A market maker's trading style might have to do with a belief that one style is more profitable then another or might be because of a trader's general personality and perception of risk. The scalper generally attempts to buy an option on the bid and sell it on the offer (or sell on the offer and buy on the bid) in an effort to capture the difference without creating an option position. Scalpers profit from trading what is referred to as the bid / ask spread, the difference between the bid price and the ask price. For example, if the market on the Nifty July 1130 puts is 15 (bid) - 15.98 (ask), this trader will buy an option order that comes into the trading pit on the bid along with the rest of the crowd. This trader is now focused on selling these puts for a profit, rather than hedging the options and creating a position. Due to the lack of commission paid by market makers, this trader can sell the first 15.20 bid that enters the trading crowd and still make a profit, known in the financial industry as a scalp. The trader has just made a profit without creating a position. Sometimes holding and hedging a position is unavoidable, however. Still this style of trading is generally less risky, because the trader will maintain only small positions with little risk. The scalper is less common these days because the listing of options on more than one exchange (dual listing) has increased competition and decreased the bid/ask spread. The scalper can make money only when customers are buying and selling options in equal amounts. Because customer order-flow is generally one-sided (either customers are just buying or just selling) the ability to scalp options is rare. Scalpers, therefore, are generally found in trading pits trading stocks that have large option order flow. The scalper is a rare breed on the trading floor, and the advent of dual listing and competing exchanges has made scalpers an endangered species. The position trader generally has an option position that is created while accommodating public order flow and hedging the resulting risk. This type of trading is more risky because the market maker might be assuming directional risk, volatility risk, or interest rate risk, to name a few. Correspondingly, market makers can assume a number of positions relative to these variables. Generally the two common types of position traders are either backspreaders or frontspreaders. BACKSPREADER Essentially, backspreaders are traders who accumulate (buy) more options than they sell and, therefore, have theoretically large or unlimited profit potential. For example, a long straddle would be considered a backspread. In this situation, we purchase the 50 level call and put (an ATM strike would be delta neutral). As the underlying asset declines in value, the call will increases in value. In order for the position to profit, the value of the rising option must increase

more than the value of the declining option, or the trader must actively trade stock against the position, scalping stock as the deltas change. The position could also profit from an increase in volatility, which would increase the value of both the call and put. As volatility increases, the trader might sell out the position for a profit or sell options (at the higher volatility) against the ones she owns. The position has large or unlimited profit potential and limited risk. As we know from previous chapters, there is a multitude of risks associated with having an inventory of options. Generally, the greatest risk associated with a backspread is time decay. Vega is also an important factor. If volatility decreases dramatically, a backspreader might be forced to close out his position at less than favorable prices and may sustain a large loss. The backspreader is relying on movement in the underlying asset or an increase in volatility. FRONTSPREADER The opposite of a backspreader, the frontspreader generally sells more options then he or she owns and, therefore, has limited profit potential and unlimited risk. Using the previous example, the frontspreader would be the seller of the 150 level call and put, short the 150 level straddle. In this situation, the market maker would profit from the position if the underlying asset failed to move outside the premium received for the sale prior to expiration. Generally, the frontspreader is looking for a decrease in volatility and/or little to no movement in the underlying asset. The position also could profit from a decrease in volatility, which would decrease the value of both the call and put. As volatility decreases, the trader might buy in the position for a profit or buy options (at the lower volatility) against the ones he or she is short. The position has limited profit potential and unlimited risk. When considering these styles of trading, it is important to recognize that a trader can trade the underlying stock to either create profit or manage risk. The backspreader will purchase stock as the stock decreases in value and sell the stock as the stock increase, thereby scalping the stock for a profit. Scalping the underlying stock, even when the stock is trading within a range less than the premium paid for the position, cannot only pay for the position but can create a profit above the initial investment. Backspreaders are able to do this with minimal risk because their position has positive gamma (curvature). This means that as the underlying asset declines in price, the positions will accumulate negative deltas, and the trader might purchase stock against those deltas. As the underlying asset increases in price, the position will accumulate positive deltas, and the trader might sell stock. Generally, a backspreader will buy and sell stock against his or her delta position to create a positive scalp. Similarly, a frontspreader can use the same technique to manage risk and maintain the profit potential of the position. A frontspread position will have negative gamma (negative curvature). Staying delta neutral can help a frontspreader avoid losses. A diligent frontspreader can descalp (scalping for a loss) the underlying asset and reduce her profits by only a small margin. Barring any gap in the underlying asset, disciplined buying and selling of the underlying asset can keep any loss to a minimum.

To complicate matters further, a backspreader or frontspreader might initiate a position that has speculative features. Two examples follow. DIRECTIONAL TRADERS These traders put on a position that favors one directional move in the underlying asset over another. This trader is speculating that the stock will move either up or down. This type of trading can be extremely risky because the trader favors one direction to the exclusion of protecting the risk that is associated with movement to the other side. For example, a trader who believes that the underlying asset has sold off considerably might buy calls and sell puts. Both of these transactions will profit from a rise in the underlying asset; however, if the underlying asset were to continue downward, the position might lose a great deal of money. VOLATILITY TRADERS Volatility traders will generally make an assumption about the direction of the option volatility. For these traders, whether or not to buy or sell a call or put is based on an assessment of option volatility. Forecasting changes in volatility is typically an option trader's biggest challenge. As discussed previously, volatility is important because it is one of the principal factors used to estimate an option's price. A volatility trader will buy options that are priced below his or her volatility assumption and sell options that are trading above the assumption. If the portfolio is balanced as to the number of options bought and sold (options with similar characteristics such as expiration date and strike), the position will have little vega risk. However, if the trader sells more volatility than he or she buys, or vice versa, the position could lose a great deal of money on a volatility move. HOW MARKET OPERATORS WILL TRAP THE PUBLIC? In general, the market maker begins his or her assessment by using a pricing formula to generate a theoretical value for an option and then creating a market around that value. This process entails creating a bid beneath the market maker's fair value and an offer above the market maker's fair value of the option. Remember that the market maker has a legal responsibility to ensure a liquid marketplace through supplying a bid/risk spread. The trading public then can either purchase or sell the options based on market-maker listings, or it can negotiate with the market maker for a price that is between the posted bid/risk prices (based on his or her respective calculations of the option's theoretical value). In most cases, the difference between market maker and individual investor bids and offers are a matter of pennies (what we might consider fractional profits). For the market maker, however, the key is volume. Like a casino, the market maker will manage risk so that she can stay in the game time after time and make a Rs.1 here and a Rs.5 there. These profits add up. Like the casino, a market maker will experience loss occasionally; however, through risk management, he or she attempts to stay in the business long enough to win more than he or she loses. Another analogy can be found in the relationship between a buyer and used car dealer. A car dealer might make a bid on a used car for an amount that is less than what he is able to resell the

car for in the marketplace. He or she can make a profit by buying the car for one price and selling it for a greater price. When determining the amount that he or she is willing to pay, the dealer must make an assumption of the future value of the car. If he is incorrect about how much someone will purchase the car for, then the dealer will take a loss on the transaction. If correct, however, the dealer stands to make a profit. On the other hand, the owner of the car might reject the dealer's original bid for the car and ask for a greater amount of money, thereby coming in between the dealer's bid/risk market. If the dealer assesses that the price that the owner is requesting for the car still enables a profit, he or she might buy the car regardless of the higher price. Similarly, when a market maker determines whether he or she will pay (or sell) one price over another, he or she determines not only the theoretical value of the option buy also whether or not the option is a specific fir for risk-management purposes. There might be times when a market maker will forego the theoretical edge or trade for a negative theoretical edge for the sole purpose of risk management. Before proceeding with our discussion of the market maker's trading activity in detail, let us again refer to the casino analogy. The house at a casino benefits largely from its familiarity with the business of gambling and the behavior of betters. As an institution, it also benefits from keeping a level head and certainly from being well (if not better) informed than its patrons about the logistics of its games and strategies for winning. Similarly, a market maker must be able to assess at a moment's notice how to respond to diverse market conditions that can be as tangible as a change in interest rates or as intangible as an emotional trading frenzy based on a news report. Discipline, education, and experience are a market maker's best insurance. We mention this here because, as an individual investor, you can use these guidelines to help you compete wisely with a market maker and to become a successful options trader. Market making as a business In the previous section, we addressed rather conceptually, how a market maker works in relation to the market (and, in particular, in relation to you, the individual trader). A market maker's actual practices are dictated by a number of bottom-line business concerns, however, which require constant attention throughout the trading day. Like any business owner, a market maker has to follow business logic, and he or she must consider the wisest uses of his or her capital. There are number of factors that you should consider when assessing whether an option trade is a good or bad business decision. At base, the steps that a market maker takes are as follows: 1. Determining the current theoretical fair value of an option. (As we have discussed, the market maker can perform this task with the use of a mathematical pricing model.) 2. Attempting to determine the future value of an option. Buying the option if you think that it will increase in value or selling the option if you think that it will decreases in value. This is done through the assessment of market factors that may affect the value of an option. These factors include : Interest rates • • •

Volatility Dividends Price of the underlying stock

3. Determining whether the capital can be spent better elsewhere. For example, if the interest saved through the purchase of a call (instead of the outright purchase of the stock) exceeds the dividend that would have been received through owning the stock, then it is better to purchase the call. 4. Calculating the long stock interest that is paid for borrowing funds in order to purchase the stocks and considering whether the money used to purchase the underlying stock would be better invested in an interest-bearing account. If so, would buying call options instead of the stock be a better trade? 5. Calculating whether the interest received from the sale of short stock is more favorable than purchasing puts on the underlying stock. Is the combination of owning calls and selling the underlying stock a better trade than the outright purchase of puts? 6. Checking for arbitrage possibilities. Like the preceding step, this task entails determining whether one trade is better than another. In the section on synthetics, we explored the possibility of creating a position with the same profit/loss characteristics as another by using different components. At times, it will be more cost effective to put on a position synthetically. Arbitrage traders take advantage of price differentials between the same product on different markets or equivalent products on the same market. For example, a differential between an option and the actual underlying stock can be exploited for profit. The three factors to base this decision on are as follows: • •

The level of the underlying asset. The interest rate.

For example, if you buy a call option, you save the interest on the money that you would have had to pay for the underlying stock. Conversely, if you purchase a put, you lose the short stock interest that you could be receiving from the sale of the underlying stock. The dividend rate. If you buy a call option, you lose the dividends that you would have earned by actually holding the stock. 7. Finally, determining the risk associated with the option trade. As previously discussed, all of the factors that contribute to the price of the option are potential risk factors to an existing position. As we know, if the factors that determine the price of an option change, then the value of an option will change. This risk associated with these changes can be alleviated through the direct purchase or sale of an offsetting option or the underlying stock. This process is referred to as hedging. A market maker's complex positioning As we mentioned earlier, the bulk of a market maker's trading is not based on market speculation but on the small edge that can be captured within each trade. Because the market maker must trade in such large volumes in order to capitalize on fractional profits, it is imperative that he or

she manage the existing risks of a position. For example, in order to retain the edge associated with the trade, he or she might need to add to the position when necessary by buying or selling shares of an underlying asset or by trading additional options. In fact, it is not uncommon that once the trade has been executed, the trader an opposite market position in the underlying security or in any other available options. Over time, a large position consisting of a multitude of option contracts and a position in the underlying stock is established. The market maker's job at this point is to continue to trade for theoretical edge while maintaining a hedged position to alleviate risk. In the following section, we will review the basics of risk management in the form of hedging. Although market makers are the masters of hedging, hedged positions are essential for the risk management for all option traders. It will be equally important for you to understand how to use these strategies. THE TRUMP CARD OF MARKET OPERATORS: HEDGING Thus far, we have overviewed the logistics of the market maker's business model and have seen how it functions to both serve the trading public and the market maker simultaneously. Now we will consider how market makers work to secure their edge against the ongoing risks presented to their many positions. An investor who chooses to invest in a particular market is exposed to the risks that are inherent in that market. The specific risk is high if the investor concentrates on one security only. The more a portfolio is diversified, the lesser the specific risk. Hedging is the most basic strategy that an investor can use in order to guard against loss. A hedge position is taken with the specific intent of lowering risk. As we have learned, option positions are susceptible to more than just simple directional price risks, and therefore, a trader must be concerned with more than simple delta neutral trading. There is risk associated with each of the variables that determine an option's value (from interest rates to time until expiration). In order to minimize the effect of these risks to an option's value, a trader will establish a position with offsetting characteristics. Just as you hedge a bet by betting against your original bet too a lesser degree, market makers try to take on complementary positions (in stock or options) with characteristics that can potentially buffer against exposure to loss. A hedge, then, is a position that is established for the sole purpose of protecting an existing position. Determining what risks an option position might be exposed to is one of the first steps towards determining how best to hedge risk. We have learned that six risks are associated with an option position: Directional risk (delta risk) is the risk that an option's value will change as the underlying asset changes in value. All other factors aside, as the price of an underlying asset decreases, the value of a call will decrease while the price of the put will increase. Conversely, as the underlying asset increases in value, a call will increases in value as the put decreases in value. Delta risk can easily be offset through the purchase or sale of an option or stock with opposing directional characteristics. Directional hedges are illustrated in Tables 1 and 2.

Table 1: Delta Effects When the Underlying Increase in Decrease in Security... Value Value The Long Call will�. Increase in Value Decrease in Value The Short Call will�. Decrease in Value Increase in Value The Long Put will�. Decrease in Value Increase in Value The Short Put will�. Increase in Value Decrease in Value

Table 2: Position hedges Option Position

Hedge Position

Long Call � Increases in value as the Short Underlying underlying increases in value Short Call Long Put Short Call � Decreases in value as the Long Underlying underlying increases in value Long Call Short Put Long Put � Decreases in value as the Long Underlying underlying increases in value Short Put Long Call Short Put � Increases in value as the Short Underlying underlying decreases in value Long Put Short Call

Gamma risk is the risk that the delta of an option will change. The holder of options is long gamma (backspreader) and the seller of options is short gamma (frontspreader). Sometimes referred to as curvature, gamma can be offset through the purchase or sale of options with opposing gammas. Volatility risk (vega risk) is the risk that the volatility assumption used in pricing the options will change. If the option volatility rises, the value of the calls and puts will increase. The holder of any options might benefit from an increase in volatility whereas the seller might incur a loss. This risk can be offset through the purchase or sale of option contracts that have an opposing vega value. For example, we know that options decrease in value as volatility decreases. Therefore, selling options (that benefit as volatility decreases) might be the best hedge for a trader who is looking to offset vega risk.

Time decay (theta risk) is a positions exposure to the effects of a change in the amount of time remaining to expiration. We know that time moves forward and as it does, the time value of an option decreases. This exposure can be offset through the purchase or sale of options with opposite theta characteristics. The effects of time decay on an options value are illustrated below. Effects of Theta As Time Moves Forward... Underlying Security

Value remains constant

Long Call

Decrease in Value

Short Call

Increase in Value

Long Put

Decrease in Value

Short Put

Increase in Value

Interest rate risk (rho risk) is negligible to most traders. Its impact can be substantial if a position contains a large amount of long or short stock or long-term options. Decreasing the stock position, replacing stock with options is the most efficient way to reduce rho risk. Remember, longer-term options are more interest rate sensitive. Dividend risk can be offset through the purchase or sale of options or the underlying stock. An increase in the dividend will make the call decrease in value because the holder of the call does not receive the dividend. In this situation, it is more advantageous to own the underlying asset over owning the call. Conversely, the put will increase in value when the dividend is increased because the short stock seller must pay the dividend to the lender of the stock, which makes owning the put more desirable than shorting the underlying asset. Table 4 illustrates the effects of changing input variables on an option's theoretical value. Varying market conditions As market Rise in Interest Volatilit Passag conditions price of the Dividend rates y e of change the underlying. s Rise... Rise... Rise... time... values of... .. Long Underlying Increase

No effect No effect No effect Increase

Short Underlying Decrease

No effect No effect No effect Decrease

Long Call

Increase

Increase

Short Call

Decrease

Decrease Decrease Increase Increase

Long Put

Decrease

Decrease Increase Decrease Increase

Short Put

Increase

Increase

Increase Decrease Decrease

Decrease Increase Decrease

Knowing the risks involved with options trading is the first step to successful trading while hedging these risks to create a profitable position is the second step. We have learned that there are different ways to hedge each trade, providing a market maker with the important task of determining the best hedge possible for each trade he or she executes. Determining which hedge is the best is based on knowing not only the risks of the original trade but also the corresponding risk of the hedge. Observing actual positions under a multitude of conditions is by far the best way to learn the complex nuances of options. The next two chapters will guide the reader through the fundamentals of the marketplace and setting up a trading station, giving the investor the ability to begin trading on his or her own. HOW TO SELECT AN OPTIONS BROKER Once you've made the decision to trade online, it's important to identify a brokerage firm that will meet, and preferably exceed, your expectations. This is especially true in the options trading arena because there are potentially many more factors involved than in a straightforward stock transaction. With stocks, once you have determined what stock to trade, it really becomes a question of how much to buy or sell and when. With options, the decision is much more complicated because the following factors must be considered: • • • •

Will you buy (or sell) calls or puts? What strike price(s)? What month(s)? What is your strategy?

Given this level of complexity, there are a few important issues to consider before you choose an on-line broker: Real Time Option Quotes Whether an online broker provides real time option quotes is, perhaps, the most important consideration for even semi-serious option traders. On-line brokerage firms, especially those that specialize in stocks, are sometimes lacking in this critical area. While they might be able to provide real time quotes on individual options, the option chains (the charts showing the bid-ask, volume, and other critical information for all strike prices and expirations) are often not accurate. Commissions With the efficiency of the exchanges and the standardization of the contracts, there is no longer a reason for option traders to pay higher commissions on option trades vs. stock trades; it's no more difficult to execute an options trade than it is to execute a stock trade. Access to Analytics Advanced analytical tools like implied volatilities and deltas are important to serious option traders. However, most traditional brokers do not provide customers access to this nformation. Instead, their customers are forced to trade in the dark.

Choosing an exchange (i.e., BSE or NSE) When options are traded on multiple exchanges, it's often possible to get a slightly better price on one of the exchanges. While these discrepancies don't last very long, 0.50 or 0.25 can make a significant difference on a large block of trade. However, brokerage firms that make it difficult to execute basic spread orders are even less likely to offer customers a choice as to where their trades are executed. In fact, many customers probably aren't even aware of potential price discrepancies across exchanges. For investors who make larger trades, this can be a significant issue. POSITION MANAGEMENT Before establishing any position it's important to establish a few guidelines for yourself: • • • • • •

Are you trading with money you can afford to lose? Is the position you intend to put on sufficiently small that it won't have a major impact on your portfolio? What is your specific objective for this position? What is your exit strategy? What is your downside risk? Are you trading with money you can afford to lose?

The importance of this cannot be overstressed. If you have already earmarked the money for another use, it is not advisable to invest it in a risky position--even for a short term trade. Every day the market extracts money from people who can't afford to lose it. Don't be one of them. Is the position you intend to put on sufficiently small that it won't have a major impact on your portfolio? This is a guideline novice traders routinely violate. Experienced traders caution people against putting on positions that will have devastating results if the market moves the wrong way. Some traders go so far as to say that positions should be so small that putting them on seems almost meaningless. Typically, the percentage of your portfolio associated with this would be 1/2% to 1%. Keep in mind though that this applies to traders more than long-term investors. This is not to say that investors wouldn't benefit from the same advice. They probably would. It's just that a disciplined approach is particularly beneficial to option traders who could easily lose their entire investment. What is your specific objective for this position? What is your exit strategy? These issues are inter-related so we will examine them together. First, whenever you put on a position, it's important to set a price target along with a strategy for what happens when you get there. For example, if you are convinced a particular Internet stock is hugely overvalued (imagine that!) and due for a correction, you might decide to buy a long put

either at-the-money or slightly out-of-the-money. If the market behaves as you predict and the price drops, you have to decide how far to let your profits run and at what point to take profits. If the stock drops 50% and your put is now deep in-the-money, this might be a good time to take profits. On the other hand, if you think the stock is still overvalued, you could buy a slightly out of the money call and let the put ride. For example, if the stock dropped from 250 to 150 and you own the 240 put, you could lock in your profit by buying a 150 call. This way, if the stock goes back up, what you lose in the put will be made up by the call. If the stock continues to drop as you hope, the put will increase in value and the call will expire worthless. Whatever you decide, it's good to have your strategy thought out in advance. This helps to take the emotion out of it. What is your downside risk? With option spreads and other advanced strategies, your maximum loss may be more than your initial investment. Before entering into any trade, it's important to know your maximum profit, maximum loss, and break-even. Trading surprises are seldom pleasant. Modifying and Managing a Position Depending on market conditions, option investors may need to modify their positions either to lock in profits or protect themselves from adverse moves. Protecting your profits and limiting your losses Taking the easiest example, let's imagine you bought a long call and watched with interest as the stock rallied. How can you protect what is now a paper profit? Considering the additional stock commissions involved in exercising the option, we'll disregard this as a strategy and focus on other alternatives. The dilemma whenever a position makes money is when to take profits and when to let profits ride. By selling the call, you lock in profits, but you may miss additional upside. On the other hand, if you sit tight, the stock could pull back below the strike price. In this case, you would lose your additional investment as well as your paper profit. Fortunately, there are other alternatives. The important point to note is that the riskiest course of action is to do nothing because your initial investment remains at risk along with any paper profits you have generated. SEVEN MYTHS ABOUT STOCK OPTIONS For years, the options market was shrouded in mystery as transactions took place with obscure options dealers who set the prices and terms of options contracts known as Jhota Phatak. The BSE and NSE created "listed options" that became the standard, and option prices were set in an auction market nearly identical to the stock exchanges. For the first time, this allowed the option holder to choose to sell his contract on the open market before it expired. Trading volume in listed options has exploded in the United States and option trading on more than 1,900 different equities and indices now accounts for the equivalent of 70 million shares of stock trading each day. But many of the myths associated with options have lingered.

Unfortunately, these myths have caused many investors to remain on the sidelines while they could be utilizing options profitably or for reducing risk. Myth 90% of Options Expire Worthless

#1:

This "statistic" is often bandied about by those who have no experience trading options. According to the CBOE, about 30% of all options expired worthless -- a far cry from 90%. Myth Options are Much Riskier Than Stocks or Mutual Funds

#2:

This assumes that the investor is trading options with the same amount of capital that he would devote to stocks or mutual funds. On a "rupee for rupee" basis, options are riskier. Here at STOCKWHIZO Research, we never recommend trading options in this manner. Instead we show our subscribers that options are a cheap way to reduce their overall risk. How? First, by limiting their total rupee exposure to a fraction of what they would invest in stocks or mutual funds. Second, by diversifying their options portfolio among different underlying equities. And third, by purchasing both call and put options, since put options are profitable when the underlying stock declines in prices. Myth Option Sellers Make Profits at the Expense of Option Buyers

#3:

Unlike the gambling casino (or the lottery or the race track) which has built-in percentage advantages for the "house," option trading is a "zero sum game" in which option sellers and buyers are always at a standoff in total. Option buying and selling differ only in the distribution of their outcomes, not in their relative profitability. Although option buyers can have more losing than winning trades, they never lose more than their original investment and their profit potential is unlimited. Option sellers profit most of the time but their potential losses are unlimited. STOCKWHIZO has always been dedicated to maximizing profit potential through option buying -- by taking full advantage of the unlimited profit potential and limited risk of this strategy. Myth Options are Too Complicated

#4:

Nonsense! Anyone who is familiar with stocks can easily learn how to trade options. The approach to option trading that we use at STOCKWHIZO is very simple. If we are bullish on a stock, we advise you to buy a call option on that stock. For a fraction of the underlying stock price, you "rent" any appreciation in the stock above a particular price for a specified time. If we are bearish on a stock, we advise you to buy a put option. Here you "rent" any decline in the underlying stock below a particular price for a specified time. It's that simple! Myth #5: Stockbrokers Don't Understand Options and are not interested in Options Business.

While this may have been a problem in the beginning, the brokerage landscape will significantly changed for the better. A number of brokerage firms now specialize exclusively in options. Many large brokers will become "option trader friendly." As time passes by with experience. Some traditional full-service firms will developed expertise in options and the desire for options business. While we do not recommend any specific firm, STOCKWHIZO subscribers receive a list of firms that are interested in options business and have the expertise to meet the needs of option traders. Myth You can't Beat the "Option Pricing Model."

#6:

Since options are a "zero-sum game," and option prices are based upon a mathematical "option pricing model," some say it is impossible to profit from buying options in the long run. WE STRONGLY DISAGREE. First, prices for exchange-listed options are set in the marketplace by buyers and sellers, although the computerized pricing models do exert a strong influence. But more importantly, these models are based upon the mistaken assumption that all stock price movement is "random." Clearly, there are always certain stocks that are moving in well-defined price trends, as opposed to moving randomly. If you can identify those stocks whose price trends are likely to continue, you can beat the option pricing model! Much of our research has been devoted to developing indicators to determine stocks that will continue moving in such price trends, so our subscribers can profit from buying undervalued options on these stocks. Myth Options Trading Requires Too Much Time

#7:

Amateurs are rarely successful trading options because they don't have the time, information, expertise or the discipline to compete in this fast-moving market. But STOCKWHIZO subscribers have a big edge over these amateurs. First, our staff of professionals here at STOCKWHIZO Research have the information and expertise to make you a successful options trader. And second, we give you the disciplined trading rules that help you make big money and also minimize your time commitment to your options trading! We tell you how much to pay, when, and at what price to sell. And you can often leave these instructions with your broker, so your options portfolio can appreciate on "automatic pilot!" TRADERS PSYCHOLOGY Discipline Anyone seriously interested in trading would do well to buy a copy of Jack Schwager's books Market Wizards The New Market Wizards. Through interviews and conversations with America's top traders, Jack extracts the wisdom that separates successful traders from those who, through their trading, simply add to the wealth of successful traders. Keeping Your Trades Small

One of the key factors mentioned by almost every good trader is discipline. Discipline, as you might imagine, takes a variety of forms. For beginning traders, one of the toughest challenges is to keep trades small. Believe it or not, more than a few top traders don't allow any one position to account for more than 1% of their total portfolio. Professionals attribute much of their success to managing risk in this way. Limiting Your Losses Another aspect of trading that involves discipline is limiting your losses. Here, there isn't a magic formula that works for everyone. Instead, you have to determine your own threshold for pain. Whatever you decide, stick to it. One of the biggest mistakes people make is to take a position with the intention that it be a short-term trade. Then, when the position goes against them, they make a seamless and unprofitable transition from trader to long-term investor. More than a few people have gone broke waiting for the trend to reverse so they could get out at break-even. If you are going to trade, you have to be willing to accept losses--and keep them limited! Letting Your Profits Run Another mistake novice traders make is getting out of profitable positions too quickly. If the position is going well, it isn't healthy to worry about giving it all back. If that's a concern, you might want to liquidate part of the position or use options to lock in your profit. Then, let the rest of it ride. Emotion It isn't uncommon for people to view trading as a fast-paced, exciting endeavor. Fast-paced? Absolutely. Exciting? Now that's a matter of opinion. The Importance of Remaining Cool-Tempered More than a few traders interviewed in The New Market Wizards emphasize the importance of remaining unemotional and cool-tempered. To these people, trading is a game of strategy that has nothing to do with emotion. Emotion, for these traders, would only cloud their judgment. In the book Jack talks about one trader who was extremely emotional. Although Jack was able to show him how to be less emotional and more detached, it became quickly apparent didn't enjoy being emotionally unattached. He found it boring. Unfortunately, emotion involvement in trading comes at a high price. Before too long, that trader went broke. The morale of the story is simple: If you insist on being emotionally attached to your trading, be prepared to be physically detached from your money. Acceptance and Responsibility One of the biggest mistakes traders can make is to agonize over mistakes. To beat yourself up for something you wish you hadn't done is truly counterproductive in the long run. Accept what happens, learn from it and move on. For the same reason, it's absolutely crucial to take responsibility for your trades and your mistakes. If you listen to someone else's advice, remember that you, and you alone, are responsible if you act on the advice.

Another Way to View Losses Perhaps the most striking example of emotional distance in trading is a reaction to positions that go against thinking to yourself, "Hmmm, look at that." If only we could all be that calm! Of all the emotions we could possibly experience, fear and greed are possibly the two most damaging. Fear Of all the emotions that can negatively impact your trading, fear may be the worst. According to many of the traders interviewed in The New Market Wizards, trading with scared money is an absolute recipe for disaster. If you live with the constant fear that the position will go against you, you are committing a cardinal sin of trading. Before long, fear will paralyze your every move. Trading opportunities will be lost and losses will mount. To help deal with your fear, keep in mind what fear is False Evidence Appearing Real The flip side of fear is confidence. This is a quality that all great traders have in abundance. Great traders don't worry about their positions or dwell on short-term losses because they know they will win over the long term. They don't just think they'll win. And they don't just believe they'll win. They KNOW they'll win. It should never bother to lose, because one should always believe that one would make it right back. That's what it takes. To Talk or Not to Talk For many traders, sharing opinions and taking a particular stance only magnifies the stress. As a result, they begin to fear being wrong as much as they fear losing money. Although it may be one of the hardest lessons to learn, the ability to change your opinion without changing your opinion of yourself is an especially valuable skill to acquire. If that's too hard to do, the alternative may prove much easier: Don't talk about your trades. Greed Greed is a particularly ugly word in trading because it is the root cause of more than a few problems. It's greed that often leads traders to take on positions that are too large or too risky. It's greed that causes people to watch once profitable positions get wiped out because they never locked in profits and instead watched the market take it all back. Part of the remedy for greed is to have, and stick to, a trading plan. If you faithfully set and adjust stop points, you can automate your trading to take the emotion out of the game. For example, let's say you are long the 150 calls in a stock that rises more rapidly than you ever expected. With the stock at 240, the dilemma is fairly obvious. If you sell the calls, you lock in the profit but you eliminate any additional upside potential. Rather than sell the calls, you might buy an equal number of 230 puts. The Rs.90 profit per call that you just locked in will more than offset the cost of the puts. At the same time, you've left yourself open to additional upside profit.

Gradual Entry and Exit Another strategy successful traders use is to gradually get in and out of positions. In other words, rather than putting on a large trade all at once, buy a few contracts and see how the position behaves. When it's time to get out, you can use the same strategy. Psychologically, the problem people have implementing this strategy is that it takes away the "right" and "wrong" of the decision making process. It's impossible to be completely right or completely wrong using this strategy because, by definition, some of the trades will be put on at a better price than others. Awareness and Instincts For professional traders especially, instincts often play a crucial role in trading. To truly appreciate this, just close your eyes and imagine making trades in a fast market with dozens if not hundreds of people screaming around you. In this environment, it becomes absolutely essential to maintain a high level of awareness about everything going on around you. Then, to have the confidence to pull the trigger when necessary, you have to trust your instincts. It's absolutely amazing to see how some professional traders, even in a busy market, know exactly who is making what trades. For these traders, expanded awareness is often a necessary prerequisite to fully developing and trusting their instincts. The same is true for professional traders as well. Watching how markets behave and developing a feel for the price fluctuations is truly time well spent. Unfortunately, in this era of technology, people have become so removed from their natural instincts that many are no longer in touch with their intuition. This is unfortunate because intuition functions as a wonderful inner guidance system for those who know how to use it. One trader interviewed by Jack Schwager in The New Market Wizards relies so heavily on his intuition that he didn't want his name in the book for fear his clients would be uncomfortable with his strategy and move their money elsewhere. Speaking anonymously, he described in detail how he establishes a rhythm and "gets in sync" with the markets. In this way, he has learned to distinguish between what he "wants to happen" and what he "knows will happen." In his opinion, the intuition knows what will happen. With this knowing, the ideal trade is effortless. If it doesn't feel right, he doesn't do it. When he doesn't feel in sync with the markets, this trader will paper trade until he feels back in rhythm. But even here, he keeps his ego and emotion out of it. His definition of out of sync is completely quantifiable. Being wrong three times in a row is out of sync. Three mistakes and it's back to the paper trading. Now there's a strategy almost everyone can benefit from. Trading is a performance-oriented discipline and every great athlete, trader, or Performer will occasionally hit performance blocks. Every Olympic contender trained hard physically, but the difference between the ones who made the Olympic team and those who did not was the emphasis put on mental coaching by the winners. Much of a trader's early education is concentrated on strategies and market analysis. But what are the necessary ingredients for peak performance? What are the tools for both mastering the mental side of the game and busting out of the inevitable slumps that can occur along the way?

Mindset First - what is the mindset necessary for peak performance? How does one ultimately get in the groove? There is no better feeling than being in the "flow" - especially with trading. That is what many of us live for and what keeps us in the game, because trading can be a very tough business with long hours. There are several key common ingredients when you are performing your best, no matter what the field. EXPECT success. It begins initially with your self-talk. Do you get down on yourself when you make a mistake? - or do you say to yourself - next time I will do better because I have great trade management and am a superior trader! Be your own best motivator and believer in yourself. Positive Self Talk leads to positive BELIEFS. If you believe you can do something, you WILL eventually find a way. When you have a positive belief system that the eventual outcome will be OK, then you are more mentally and physically relaxed. You then have better concentration, which leads to smoother execution, which of course leads to peak performance. Now, on the flip side of the coin, negative self-talk sows seeds of doubt. This lowers selfconfidence, which leads to a negative belief system. This then creates anxiety, which leads to disrupted concentration. Now the trader becomes tense and tentative which in turn leads to poor performance. Talk about a vicious cycle! SECRETS OF TOP TRADING PERFORMANCE KEY INGREDIENTS TO PERFORMING YOUR BEST PASSION You must be passionate about what you are doing and having fun. Passion first, then performance. CONFIDENCE Top performance comes from having a high degree of confidence. You must have the confidence that you can take control and face adversity. You must also be confident that you will have a favorable outcome over time. CONCENTRATION Peak performance comes from exceptional CONCENTRATION. You must concentrate on the process, though, not the outcome. A sprinter who is in the lead is thinking about the wind on their face, how relaxed their arms are, feeling the perfect stride�they are totally in the moment. The person who does NOT have the edge is thinking, "Oh, that runner is pulling ahead of me�I don't know if I have enough wind to catch the leader�" They are tense and tight because they are thinking about the outcome, not the process. RESILIENCY

Great performances come from being able to rebound quickly and forget about mistakes. CHALLENGE Great performance comes from pushing yourself and trying to overcome limitations. Staying in the safe zone becomes a monkey on your back. Challenge yourself to take that hard trade. Manage it. If it does not work out, so what�your risk was limited and you can pat yourself on the back for taking the hard trade in the first place. SEE AND DO ... DON'T THINK! Great performance comes from turning off the brain and becoming automatic. This is being in the Zone �in the groove. You can't overanalyze the markets during the trading day. RELAXATION When you are relaxed, your reflexes and timing are superior because you are loose. POSITIVE SELF TALK There are some concrete tools to break the cycle and bust out of the slump? The number one tool for starters is POSITIVE SELF TALK. We all talk to ourselves in our own head. Be aware of the things you are saying to yourself. The written word is also a powerful tool. Read affirmations and books on positive thinking. Norman Vincent Peale, Napoleon Hill ... Arnold Schwarzenagger's autobiography are a few. Richard Marcinko wrote a book called the Rogue Warrior. He talked about the Will to WIN and the belief that ANY circumstances could be overcome. This is a great inspirational book for traders. Next - act like you are already where you want to be. Assume the mannerisms, posture and talk of a top trader. In addition to self-talk and reading written words, develop mental pictures. Visualize what you are going to do with your wealth or how it is that you want to live. Think of the power that money would give you to start any organization you want or to make other people's lives better. Visualize your dream house. Program your subconscious as though you are already there. Dare to dream. OK - talk, words and pictures�what is next? Look at your environment that you have surrounded yourself with. Your success in trading will also be a product of your environment and I am not just talking about office space. Look at the people you surround yourself with. Do they support your activities? Surround yourself with people who believe in you, who smile, and who are enthusiastic in anything they try or do. The top Olympic athletes had friends and family cheering them on every step of the way. BE PREPARED FOR A SURPRISE EVERYDAY! All of the above factors deal with external factors and internal belief systems. Now let's get down to the DOING part! Every trader should be prepared before the markets open because they already did their homework - right?! One of the most impressive points in the Rogue Warrior book was this veteran navy seal's obsession for being totally prepared for Mr. Murphy! There

was always a backup plan for everything and this is what kept him alive. Prepare your daily game plan by looking for both new setups and preparing strategies for managing existing positions. So, assuming that you have done your daily homework as a trader, the next step is to learn how to get into the groove. There is no better tool for this than having routines and rituals. Pre-market rituals help calm the nerves, get you into a rhythm, and also help to turn off the logical part of your brain - the part that wants to overanalyze everything. If you have a chattering monkey sitting behind your ear, routines and rituals are one of the best things to shut that monkey up. Maybe there is an opening sequence of tasks you do before the market opens. Perhaps in the middle of the day you draw swing charts or take periodic readings of the market's action. Maybe you keep a journal and make notes to yourself. At the end of the day, what type of record keeping do you do for your trading activity? What do you do to unwind? Salesmen are taught to do small rituals before cold calling clients. It controls the anxieties and fears of rejection. Cricket opening Batsmen have a pre-warm up ritual. It calms their minds and puts their body on the autopilot mode. It keeps them involved in the PROCESS and not thinking about the outcome. One of the more common rituals on the trading floors was to wear the same disgusting lucky tie every day. If the mind BELIEVED that the tie was lucky, this was all the traders needed to keep the long term odds in their favor. Here is another helpful factor: A healthy body keeps a healthy mind. EXERCISE! This gets oxygen to the brain and keeps the blood flowing. How can you expect to be a peak performer when you are eating junk food and going through insulin swings? Or perhaps you drank too much wine the night before or are jittery from drinking too much coffee. How can you concentrate well if you are not getting a full decent night's sleep? Sure, most of these are minor factors but they can all add up to major bumps in your performance. One moment of sloppiness can lead to forgetting to place stops or letting a bad trade go too long. Then when damage is done, your confidence gets chipped away. You must treat your confidence level as something to be protected. Good habits will keep your confidence level high. Once you have good habits, it will allow you to increase your trading size. If you want to push yourself to the next level in your trading and are wondering how to increase your size, you MUST have a foundation of good habits. If you are running into a mental block in this area, it is your subconscious's way of telling you that either you have not done adequate preparation or you are not satisfied with your money management habits. GOAL SETTING There is one more extremely important thing that contributes to your success and that is GOAL SETTING. When you set your goals, they must be concrete and measurable. You must also break them down into bite size pieces. Perhaps your larger goal is to make 8 digits over the next three years, but how do you get there? Put together a more detailed business plan that is NOT Rupee oriented but will help you eventually reach your Rupee-oriented goal. Maybe it includes how many trades you should make per week, how much time you should devote each evening to preparation and studying charts, and plans for controlling risk. Both short term and long term goals help achieve peak performance.

You must also have concrete ways to measure those goals. Top cricketers know the splits that they run. They know if they are ON or OFF according to how practice goes. They know their unforced error percentage, their personal best, and their competition's stats. The same should apply to you in your trading. Know your weekly win/loss ratios, your trade frequency, and the average amount of profit or loss each month. Only by having something to measure can you tell if you are improving or not and moving closer to your goal! The battleground isn't the markets but what's within you. The more you talk with other traders, the more you realize that everyone goes through various common experiences. Everyone makes many of the same classic mistakes. But what distinguishes the ones who can ultimately overcome them? CORRECT ATTITUDE Remember that ATTITUDE is everything. How you frame out an individual experience or event will affect your success in the long run. Do you see a trading loss or bad drawdown period as a major setback, or do you see it as a learning experience from which you can figure out how to be on the RIGHT side of a trade instead of the wrong side the next time around. Many great traders use periods after drawdowns to go back to the drawing board. Some of the best systems and trading ideas have come after periods of adversity. What incentive is there to learn and improve ourselves when everything is smooth sailing and we are fat and happy? But when times are tough, that is when we can rise to the occasion and prove that we can overcome any obstacle set down in our path. So many great athletes have been able to come from behind when they are down because they have learned how to seize that one opening or opportunity and CONVERT. They latch on to the tiniest shift in momentum and milk it for all it is worth. Latch on to that next winning trade and convert. The first small moral victory is the first step towards reaching the top of Mt. Everest. And if you keep making small steady steps, you will eventually reach the top. Sometimes for a trader, the greatest feeling in the world can be making back those losses, no matter how long it takes, because once you have done that, you realize you can do anything. DESIRE The most successful players are the ones who have a burning desire to win DEFY FAILURE! Don't check out of the game. Never give up! CONSISTENCY Improve your consistency. Stay active, stay involved, and keep your feet moving. PATIENCE Be patient. Do not force a trade that isn't there. Wait for the play to set up.

MANAGEMENT When you get a good trade, go for it. Manage it. Trail a stop. Don't be too eager to get out. FLEXIBILITY Be flexible - if what you are doing isn't working, change what you are doing! CONFIDENCE When down, get a little rhythm and confidence going. Don't worry about being too ambitious. CONCENTRATION Stay with your game. Don't let outside distractions bother you. They take energy and break your concentration. KNOW YOURSELF Match your particular strengths to the type of market conditions. CLEAN UP YOUR ACT Hate making stupid mistakes and unforced errors. This includes not getting out of a bad trade when you know you are wrong. STAY POSITIVE Many players will play their best game when they are coming from behind.

Options Trading Strategy Guide: Money Management After graduating from college, Rohit Shah was eager to make big cash by day trading. He heard many stories about market operators making thousands of rupees a day flipping in and out of stocks. Rohit believed that all he needed to do was catch a couple of waves a day trading software stocks. If he did this, he would make anywhere from five to ten points, or ten to twenty thousand rupees, per day using 1,000-share lots. Rohit went to a broking office in his local area and plunked down his money, Rs.25,000, plus another Rs.25,000 he borrowed from his father. With the Rs.50,000 he would qualify for 8 to 10 times intraday positions, providing him with Rs500,000 of buying power. He estimated this would be enough to allow him to trade high-flier Tech stocks such as Satyam, Zee, or Himachal.

On his first day of trading, Rohit was briefly up Rs.4,000 on a 1,000-share position in Satyam. Then the stock turned against him and he was quickly down Rs.8,000 - a Rs.12,000 reversal. Instead of cutting his losses, Avi bought another 1,000 shares, in order to "average down." Satyam sold off another 7 points and suddenly Rohit was down Rs.15,000, or 30 percent of his Rs.50,000, in less than two hours. Unable to take the pain anymore, Rohit sold his 2,000 shares at the bottom of the move. Within three weeks Rohit had lost all of his Rs,50,000 Rupees, and on top of that he owed the firm Rs.3,000. If he had understood the principles of risk control, his chances for success would have increased dramatically. Risk control is the foundation of survival for all traders. It is one of the few aspects of the marketplace that a trader has control over. The most common error made by beginning traders is a disregard for risk control by taking overly large positions. Unreasonable expectations can cause beginners to gamble 50 to 100 percent of their portfolios on a single trade. Taking wild shots with huge positions is not trading - it's gambling. Successful trading is developed over time, by winning consistently and conserving capital. Trading positions that are too large often results in huge losses; it is the most common reason beginning traders go broke quickly. Large positions go hand in hand with large emotions: The bigger the position, the more intense the feeling of either greed or fear. The large profit and loss swings associated with big positions usually cause traders who are just beginning to abandon discipline and to trade subjectively and emotionally. On one hand, it is harder for them to take profits run on a position that's too big. Traders end up cutting their profits short and letting their losses run - the opposite of what they should be doing in order to be successful.

Trade only with money you can afford to lose Sun Tzu said that "Every battle is decided before it is ever fought." He meant that through meticulous planning and preparation before a conflict, a person should be able to get into a position such that victory is assured. When the battle occurs, it will take place against an opponent that is already defeated - a result of the prior planning. The same methodology should be applied to trading. Before trading, traders should put themselves into a position such that the victory can be assured by substantially reducing the meaning of their losses. The emotional pitfalls of trading are magnified exponentially when you have to trade successfully in order to survive. The most successful traders have an almost complete disregard for money. The need to make money forces a person to be attached to the outcome. This attachment normally influences the decision-making process for the worse, because fear is magnified, distorting reality. Traders must be comfortable with the worst-case scenario before they even consider the best. The most successful traders have become comfortable with the idea that they can lose it all; paradoxically, that idea provides them with a sense of security. Only you can determine how much money you can afford to lose. The money you trade with should be money that you are comfortable with never seeing again. If you decide to invest in a career as a day trader, ponder this question carefully. Sun Tzu, The Art of War. By James Clavell, ed. Delacorte Press

Smaller is larger The importance of financial management when applied to position size cannot be overemphasized. Dalal Street is filled with stories about experienced traders who went broke after long and successful careers because they ignored the oldest and most important rule of money management: Don't take positions that are too big for your financial comfort level. The urge to make money quickly will always tug at you when you're trading. Fight this urge so you don't have to learn a painful lesson the hard way. Successful trading is first and foremost about survival through financial preservation and consistency, not about hitting home-run trades with huge positions. It takes strict discipline and careful preparation to match your positions to your risk profile. The smaller your positions, the easier it will be to maneuver in and out of trades, whether you are adding to a winner, cutting a loss, or taking a profit. There is a direct correlation between correct position size and higher profitability. Losses are inevitable; but smaller positions produce smaller losses, allowing quicker recovery and less emotional attachment. The key here is emotional attachment. Traders tend to develop a comfort zone for position size, given their financial capacity to take risk. If you trade a position that is too big, then your sense of detachment can be thrown out of whack, adversely effecting your ability to maintain objective discipline. What causes a trader whose comfort zone is 2,500 shares to buy 10,000 shares? Traders take positions that are too large for a variety of reasons: greed, lack of understanding of money management techniques, faulty trading tactics, the ever-present ego, and unrealistic expectations. Larger losses are the product of bigger positions. A big loss requires higher gain in the future to offset it, because of slippage, time, and commissions. It is much harder for a trader to trade out of a large hole than out of a smaller one. If a trader is down around 6 percent on the month, chances are that the trader's confidence and buying power will remain intact. Successful traders are not afraid of reasonable losses, because they have confidence that they will persevere to make back what they lost and more. However, if a trader is down 50 percent on the month, it will be a lot harder to regain confidence and stability. Large losses sting, and can cause a trader to be gun-shy in the future. It becomes increasingly difficult to recapture an unusually large loss when you trade position sizes that are not evenly distributed. In addition to making back the equivalent percentage lost on the bigger position, you'll have to make back the spread and commissions. Many traders who experience a skewed loss resulting from a position that was too big believe that the only way they can make it back is to take a large position again. When this occurs, a trader is operating at a disadvantage arising out of desperation. The result is that the risk profile is endangered, and the trader loses the best source of protection.

Trade with balanced position size Position size in trading should be adjusted for broadly uneven stock price levels. Uneven stock price levels result in uneven probabilities that a large percentage move will occur. If you hold

both a Rs.100 stock and a Rs.1000, a ten-point price change in each one will have an equal impact on the profit or loss of your portfolio if the position sizes are equal. However, a ten-point move in each stock would represent very different percentage changes. A ten-point move in the Rs.100 stock represents a 10 percent price move; a ten-point move in the Rs.1000 stock represents a 1 percent price move. The 1 percent price move in a stock is statistically less significant, and thus more likely to occur, than a 10 percent move. Therefore, it does not make sense for traders to take equal position sizes in stocks in terms of value that have price discrepancies, although they do it all the time. A Rs.1000 stock would have to move 100 points in order to yield an equivalent percentage change to a 1-point move in a Rs.100 stock. The 10-point move would have 10 times the Rupee impact on a portfolio if the position sizes were the same, an unbalanced risk allocation. Position sizes should be adjusted according to the price and number of stocks you are trading, such that an equal percentage price change will have an equal profit or loss impact on the portfolio.

THE 2 PERCENT RULE One of the principles of risk management is the 2 percent rule. The rule states that no more than 2 percent of a total portfolio should be lost on any individual trade. Ideally this figure should include the costs of commissions and slippage. This means that the largest loss you should tolerate on any single trade is 2 percent of your portfolio. Some people misinterpret this rule to mean that only 2 percent of your trading equity should be allocated to each trade, but that's not the case. The 2 percent rule is designed to limit a trader's losses while preserving capital. It is powerful insurance because it provides a trader with a number; you know before you enter a trade how much you can afford to lose. Applying this principle, a trader can afford to be wrong numerous times and still live to see the next trading day. Keeping your losses to 2 percent per trade often means that you will have to trade smaller positions. Many traders who are just starting scoff at the idea, thinking that bigger positions will allow them to strike it big and make a large monthly income through big profits. Nothing could be further from the truth. When beginning traders take on bigger positions, it often causes them to lose money faster because they have not built up the tolerance for accepting larger losses or bigger profits. They tend to take profits off the table faster when they are winning, because of the immediate gratification associated with being right. They also tend to let their losers run longer, because they are not willing to accept the pain associated with being wrong. It is not uncommon for traders to enter into positions not knowing beforehand how much they are willing to lose, because they think they are going to win. When expectations for a trade are not met and no exit strategy exists, a trader is often forced to cut a position based on either emotion or financial pain. The goal of a trader should be to accept losses without letting them affect his confidence. This is accomplished through preparation before the trade, budgeting for losses just as you budget for an insurance bill. The 2 percent rule is pivotal because the success of an individual is not necessarily correlated to the number of winning trades: Some of the most successful traders in the stock markets earn up to 80 percent of their profits from just 20 percent of their trades. This means that the majority of

their trades may not earn them the big money. The reason they are profitable as a trader is that they have learned to quickly accept and manage loss, not disregard or try to eliminate it. Successful traders aim to keep loss controlled. When losses are controlled a trader is free to focus on and add to winning trades. By limiting individual losses to 2 percent or less of your portfolio, you increase the odds that you will experience more break-even and winning trades. Over time, these trades tip the scales toward profitability, as long as are managed. The 2 percent rule is particularly beneficial for beginning traders. Your probabilities of success increase with the number of times you play. A 2 percent maximum loss guideline increases the life span of beginning traders, providing them with the opportunity to learn from their mistakes. A loss of 6 percent to 8 percent is the maximum a trader should accept for the entire month. A trader who has four consecutive 2 percent losses should stop trading for the month and evaluate what's going wrong. You can always begin anew the following month. Taking time off after a string of losses is beneficial, because it provides you with an opportunity to regain your confidence. A trading time-out is similar to a basketball time-out after the opposing team has scored a number of unanswered points. The time-out slows the winning team's momentum and helps the losing team regain confidence with a pep talk and a breather. If you enter a trading day lacking confidence, close the shop and begin again tomorrow. Confidence in yourself and what you are doing is your strongest ally.

Margin madness Using margin to increase buying power is an accepted and common practice among most day traders today. It is important for day traders to be aware of the risks of margin, and to learn how to handle the augmented buying power effectively if they choose to use it. Using excessive leverage through margin is a dangerous game. The sell-off in Internet stocks in the spring and summer of 1999 resulted in a huge number of margin calls for day traders and investors. The risks associated with margin require careful planning and tighter stop-loss criteria. Many investors are not aware of the risk inherent in using leverage, and should stay away from it. When the market turns against a highly leveraged position, a trader is often forced to liquidate it at the worst possible moment. Even the brightest and most highly regarded traders on Wall Street are not immune to the danger of trading with excessive margin. During the predicament in the global financial markets in September 1997, the Long Term Capital Management (LTCM) hedge fund reported that it had lost $2.3 billion in high-risk trades and was on the verge of bankruptcy. Fund founder John Meriwether and his partners, Nobel laureates Myron Scholes and Robert Merton, traded with ridiculously high levels of margin. (Myron Scholes is a Nobel Prize winner for his famous Black-Scholes Options Pricing Model) At times they took huge positions, putting only 5 percent down. Although they attempted to diversify the risk with long and short spreads in their bond funds, the bloated margin ultimately proved fatal. The amount of margin power that LTCM used is the equivalent of a stock trader buying $100,000 worth of stock with only $5,000 cash down. A small hiccup in price could easily wipe a trader out with such high degrees of leverage.

In our independent research and observation that it is not uncommon for some day trading firms to encourage day traders to borrow money from other traders in order to meet margin calls. This practice files in the face of the most basic risk management practices and should be avoided at all costs. It is a clear sign that the trader is acting out of financial desperation and that the end is near. When you choose to trade on margin, enforce strict risk-control standards geared to the amount of underlying cash you have to trade with. If you have Rs.100,000 to trade with and you are using leverage through margin, your risk standards should be focused around the Rs.50,000 in underlying cash, not the amount of buying power you are using. Applying the 2 percent rule, your maximum permissible loss will be Rs.2,000 per position. Success in day trading is first defined as survival. Your ability to survive as a day trader depends on your money management techniques. When you manage your money properly, you provide yourself with valuable risk insurance, which any business should have. The best way to control risk when trading is to manage your losses. Determine the most that you are willing to lose on any one position, which should not exceed 2 percent of your underlying equity. Keeping your individual losses to 2 percent of less often requires that you trade smaller positions to start. Smaller positions can be empowering because they allow you to trade with less attachment, permitting you to cut your losses sooner and easier. The key to success in trading is to have the least possible emotional attachment to your positions. If you are trading because you have to win, chances are that your attachment to the outcome will be high, adversely affecting your decision-making process. When you trade only with money that you can afford to lose, your attachment will be minimal and your results will be better. Risk control is a crucial component to successful trading. Improper risk standards result in trades that can easily wipe out even the most experienced traders. Traders last in the business because they have learned to manage their expectations and control their exposure. When addressing the risk factor, remember the importance of position size. Never allow yourself to trade a bigger position than you can afford. The temptation will always be there, but managing this urge through discipline is the mark of a successful trader. It is always better to start out small and add to your position, rather than starting out large and regretting it afterward. Remember the old saying: "Discipline weighs ounces while regret weighs tons"

FIVE STEPS TO DETERMINE THE PROPER POSITION SIZE Endurance in trading is the first step toward success. Especially when a trader is beginning, surviving means you can learn and become better. Living to see the next day in trading is the most basic and important goal of any trader. This sound simple, but its importance cannot be overemphasized. The outcome of any trade is not within a trader's control; how much money you lose is. Controlling loss is the only security a trader has; without that security, catastrophe can strike.

The way to maintain a 2 percent maximum loss risk profile is to determine beforehand the proper position size. Determining the proper position size involves five simple steps. These steps should be taken methodically, every day, before trading. STEP 1. ALLOCATE CAPITAL PER POSITION The first step is to determine the maximum capital per position, or the most money that should be invested in a single trade. This figure is calculated by dividing the total capital in your account by the number of positions you wish to take. If you have Rs.100,000 of risk capital to trade with and you want to take four positions, allocate an equal Rupee amount to each position: Capital per Position = (Risk Capital) / (Number of Positions) Risk Capital Number of Positions Capital per Positions = Rs.100,000 / 4 = Rs.25,000

= =

Rs.100,000 4

The maximum capital per position you should being willing to invest is Rs.25,000. STEP 2. CALCULATE MAXIMUM SHARES PER POSITION Once your capital per position is allocated, the next step is to calculate how many shares of each position to trade. Divide the risk capital per position, or Rs.25,000 in this example, by the share price. Assuming there are four stocks you want to trade with prices of Rs.1000, Rs.500, Rs.250 and Rs.100, the calculation is: Maximum Shares per Position = (Capital per Position) / (Stock Price) Capita per Position = Rs.25,000 Stock Price = Rs.100, Rs.50, Rs.25, and Rs.10 Maximum Shares per Position = Rs.25,000 / Rs.1000 = 25 shares Rs.25,000 / Rs.500 = 50 shares Rs.25,000 / Rs.250 = 100 shares Rs.25,000 / Rs.100 = 250 shares These figures are maximums that take into account your buying power per position. STEP 3. DETERMINE 2 PERCENT RUPEE RISK PER TRADE To determine the maximum amount of money you can withstand to lose per trade, multiply 2 percent times your capital per position. In the example, using Rs.25,000 per position: Maximum Rupee Risk = 2% X Capital per Position Capital per Position = Rs.25,000 Maximum Rupee Risk = 2% X Rs.25,000 = Rs.500 In this example, Rs.500 is the most you are willing to lose on a trade, given your capital allocation per position. Taking another example, if you have Rs.100,000 to trade with and decide that you want to take two positions, then your rupee risk per trade is Rs.1,000: Risk Capital Capital per Position = Number of Positions

Risk Capital = Rs.100,000 Number of Positions = 2 Capital per Positions = Rs.100,000 / 2 = Rs.50,000 Maximum Rupee Risk = .02 Capital per Position Capital per Position = Rs.50,000 Maximum Rupee Risk = .02 Rs.50,000 = Rs.1,000 STEP 4. DETERMINE THE STOP-LOSS POINTVarious stop-loss strategies will covered later in detail. For now we'll determine our stop-loss point from initial entry. Stop-loss exit points vary greatly given the different price of stocks. In our example, a ten-point move in the Rs.1000 stock (1%) would represent a small percentage change compared to a ten-point move in the Rs.100 stock (10%). It is prudent to use wider stops for higher-priced stocks and tighter stops for lower-priced stocks. Assume that, based on your calculations, you have identified a lower-priced stock with one point of risk. Using Rs.250 stock as an example, if the current market is quoted Rs.250 - Rs.251, then Rs.245 is the stop-loss exit point if you are trading from the long side with one point of risk. Adjusting for slippage on entry and exit can be difficult because many different elements determine what sort of executions you may receive, including liquidity, volatility, technology, the market environment, and the execution medium. Always provide enough room for a poor execution on exit. When adjusting for slippage, it is always better to prepare for the worst and be glad if you receive the best. For this example, we have factor in an extra 50 paise of a point on each side of the trade for slippage. STEP 5. CALCULATE MAXIMUM POSITION SIZE After determining the 2 percent maximum Rupee risk and the stop-loss, you can calculate the maximum position size: (2% Maximum Rupee Risk per Trade)/ Maximum Position Size = (Stop-Loss Point per Trade ) 2% Maximum Rupee Risk per Trade = Rs.500 Stop-Loss Point = 5 points Maximum Position Size = 100 shares X Rs.250 If you have Rs.25,000 allocated for a trade and you have picked a stock that you believe has 3 points of risk, then the maximum position size is 165 shares. If the price of the stock is Rs.250, you will use only Rs.25,000 of buying power (Rs.250 X 100 shares = Rs.25,000), which is appropriate given your Rs.5 stop-loss point and your Rs.500 maximum tolerance for loss. In our example, because you're using only Rs.25,000 of buying power for the Rs.250 stock, you free up Rs.75,000 in capital to allocate toward another position. Even though the maximum position size for a Rs.250 stock is 100 shares given your capital allocation, you would trade with that size because the loss you might sustain with a 5 point stoploss would be larger than your Rs.500 maximum loss risk tolerance. On the other hand, if you selected a Rs.100 stock with the same 5 point stop-loss risk profile, then your maximum position size should be limited to 250 shares, because that would be the maximum you could buy given your Rs.25,000 capital allocation. Higher-priced stocks also normally require wider stops. Chances are that the Rs.1000 stock would have a wider stop-loss point because of higher slippage and volatility. With the 25 share position in the Rs.1000 stock, the maximum stop-loss point would be Rs.20.

When you carefully prepare to manage risk before trading, the outcome will always be manageable. Trading with appropriate position sizes is extremely important for beginning and professional traders alike. Appropriate position size is determined by knowing beforehand how much you can afford to lose on any one position. When you know that figure, you can determine how large your position should be given your initial stop-loss point and the price of the stock.

HOW TO WIN WITH THE STOP-LOSS Being wrong about a trade is okay. In fact, the only way for a trader to become comfortable with the notion of loss in trading is to experience it regularly, while developing the discipline to cut it out quickly without even thinking about it. Some of the most profitable traders are right marginally more than they are wrong. The most successful traders have developed the ability to accept loss as part of the game, and to cut it out before it cuts them out. This allows them to spend their time focusing on the winners rather than the losers. "Substance is the inner quiet of mind, free of individual failings." ZEN SAYING Profit by managing loss Enter into trades only when you have established a sensible game plan, with a stop-loss exit strategy mapped out in case the trade is a loser. A stop-loss is your insurance if the stock does not perform the way you hoped. If and when that initial stop-loss point is reached, it is crucial to get out of the position without thinking about it. A protective stop can be entered on the actual terminals of the BSE and NSE. There will be times when a stock will turn around moments after you were stopped out, but keep in mind that in the long run, this makes absolutely no difference. Managing loss is what risk control is all about. Losing correctly requires inner strength, discipline, and resolution. It takes strict control to set a stop before you enter a trade. Setting a stop before trading means that you are considering the risk before going after the reward. The only way to last in trading is by preserving capital; adhering to predetermined stops will allow you to do this. After you enter a stop, do not adjust it to give yourself more leeway if the trade is not working out. Why a trade is not working doesn't matter; you can always find rationalizations and excuses for loss. Price action, however, does not warp reality. The sooner your stop announces to you that your position is faulty, the better off you second-guess yourself by going back and changing your answer, you will probably be incorrect. Moving stops or ignoring them is similar to secondguessing yourself on a test - your first choice for a stop-loss is probably the best, and you should adhere to it. There are different strategies for placing stops. With practice, most traders develop their own stop-loss strategies based on individual preferences. Initial stop-loss Initial stop-losses can be placed in many different areas. Depending on why you entered a position, the initial stop-loss will ensure that your original thought process remains intact. When a trade is initiated, a stop-loss should be placed immediately. There are various technical levels

to place a stop, but a general guideline for long positions is that the initial stop-loss should be placed 50 paise point beneath the previous day's low. For short positions, the initial stop-loss should be placed 50 paise point above the previous day's high. Only after you choose an initial stop-loss can you take the steps to determine your proper position size. The previous day's low and high prices represent the first technical price levels of daily support and resistance. Yesterday's low or high point was the furthest that the bears or bulls could push the stock before it changed direction. Stops tend to accumulate just below or above these price ranges. A move through the lows or highs of the previous day may trigger stops and tend to clear the path for further momentum. Break-even stop-loss After the initial stop-loss is set, the next stop-loss to use is a break-even stop-loss. After you have entered into a position and have your initial stop-loss protection in place, your objective would naturally turn toward implementing a superior exit strategy to use when the trade is earning you money. The first step toward exiting a winning trade is to protect your profits by moving the stop-loss order to your entry point. With a break-even stop, you are in a sense catching a free ride on the tail of the market, and the worst-case scenario is nothing lost, except for commissions. A tightened stop-loss does increase the possibility of being prematurely stopped out while the trade still has a shot to meet your original objectives, but you can always get back into the position. The break-even stop-loss provides peace of mind along with a sense of detachment. When the trade is working and the break-even stop-loss is in place, you have successfully created an opportunity with little or no cost to you. The best time to raise your stop-loss to the break-even level is subject to individual trading styles. A guideline that seems to work well when adjusting stops to the break-even point is the 2 percent move. The 2 percent move suggests that you should adjust your stop-loss to break-even after your position has moved at least 2 percent above your entry point. For example, assume you bought Satyam at 200 and your original stop-loss was 196. When Satyam moves 2 percent above 200 upto 204 points raise your stop to 200, you should slide your stop-loss up to your entry point of 20. The 2 percent adjustment yardstick is useful because it can be applied across the board to broadly ranging prices. The 2 percent break-even parameter is meant to be flexible according to each trader's individual style and comfort level. Some traders raise their break-even stops immediately after the stock has moved 5 points in their favor. Others wait for a move of at least 10 or more. Experiment with this parameter and utilize its psychological advantage. Trailing stop-loss If stocks have lingered in no-man's-land for the day - that is, they have not moved above the 2 percent break-even stop-loss barrier or have fallen beneath the initial stop-loss point - they require a trailing stop. A trailing stop is an adjustment of the initial stop taking into account the price action of the current day when the market has closed. Remember that you can always reenter a position after getting stopped out if you believe the trade still has potential. It's always

better to reexamine the position with a clear mind and nothing at stake. If you still like the position after stopped out, then your strategy was probably sound, based on objective reasons. Profit-taking stop Another type of stop-loss is one used to protect your profits. This is used when your position is working well and has moved at least 5 point above the 2 percent break-even stop-loss zone. At this point your break-even stop-loss is in place and it's time to preserve some of your gains. Your objective is to move your break-even stop to 1 point below the 2 percent profit-taking barrier. In our example, if after you go long Satyam at 200, it moves to 205, your break-even stop would be moved upward from 200 to 201. The 201 price represents a 1 point move above the break-even stop-loss entry zone. Locking in some profits using a stop-loss strategy is an effective way to trade without worrying about losing your gains. It helps a trader to let profits run longer while not missing out on a solid gain. Depending on the trader's style and the type of stock traded, the stop-loss level used to lock in some gains could be adjusted. More aggressive traders may use wider stops to protect profits, while less aggressive traders would use narrower ones. Developing a comfort level when using stops takes practice and discipline. Each stock has it own personality and reacts differently throughout the day. Some stocks advance and pull back quickly, while others may creep along steadily. After becoming familiar with the stock you're trading, you will be able to place stops more effectively. Stop-loss orders are protective measures and are not perfect. Market forces can swing prices through stop points, resulting in larger-than-anticipated losses. Stops are still the most effective form of insurance a trader has. Successful traders have learned to exit their positions quickly when their stops are hit, without thinking about it. They understand that tomorrow is another day and they will have another chance. Stops give traders breathing room, discouraging them from being "psyched" out of a position due to choppiness or indecision. Stops provide peace of mind because they represent a decision that was made before the trade. Placing a stop-loss order means there is one less decision traders have to make because of a prearranged stop, you are reinforcing discipline and confidence in your game plan. Remember to always stick to prearranged stops. Trade liquid names Properly evaluating the liquidity and the volatility of a stock may mean the difference between a successful or a hapless outcome for market makers and day traders alike. One of the toughest jobs a market maker has is to properly size a market. This means correctly assessing the proper risk, given the current liquidity and volatility of a stock. Market makers are constantly putting up risk for accounts to capture larger order flow. This involves either buying or selling a block of stock at or very close to the inside market. For example, if Zee's current inside market is 105 105.5, with 7500,000 shares traded on the day, what is the proper amount of stock the trader should be willing to buy or sell on the inside bid or offer? What is the most the trader should be willing to sell u or down 50 paise from the inside market? What kind of slippage, or movement, if any, would be involved before buying back or selling the size bought or sold?

A market that is oversized can easily lead to a large loss. If a market maker were putting up risk for a large order, the object of the next part of the trade would be to trade the order for a small profit, for a small loss, or flat. This would eliminate the up-front risk, allowing the market maker to trade the rest of the order for a profit, generally without risk. Day traders who are about to enter a trade should also be careful to judge how much slippage may be involved before they will be able to exit or enter the position. Diversity your positions Traders cab spread out their positions in order to minimize market risk while optimizing their chances for success. Many professional Dalal Street traders look for ways to increase their probabilities for success in a trade by diversifying the number of positions they take within a given sector. Diversification tends to increase the odds that if the sector does move in the anticipated direction, other stocks that the traders have selected will move that way too. Diversification among individual stocks within one sector spreads out the alpha, or individual, risk inherent in each stock. Every stock in the marketplace is subject to both market risk (beta) and stock-specific risk (alpha). The market risk (beta) of a stock refers to how it moves in conjunction with the motions of the broader market. The beta risk of a position is the risk that the broader market will turn against you, pulling the stock you are long with it. Some stocks have higher betas than others, which means more exposure to the fluctuations of the market. Stocks that have a beta of 1 should move in step with the market. If the market is up 2 percent, a stock with a beta of 2, then it moves at twice the rate of the broader market. If the market were up 2 percent, a stock with a beta of 2 would be up 4 percent. The alpha risk of a stock is the individual risk inherent in every issue. This includes risks that cannot be foreseen, such as fundamental news specific only to that stock. By selecting several issues within a given sector, traders protect their portfolios from the chance of having individual positions turn against them or alpha risk. Suppose a sector trader is bullish on the software sector, for example. Instead of putting all your money into one stock, you can go long in several stocks by allocating less money to each one. Instead of buying Rs.500,000 worth of Satyam, you would buy Rs.100,000 worth of five different stocks, such as Satyam, Wipro, Infosys, Digital, and SSI. The number of shares you purchased of each would depend on their prices. All five of the issues are correlated. This is called basket trading, and it reduces the alpha of a portfolio but not the beta risk. Basket trading involves added expense in terms of commissions and spreads, but it provides insurance against individual stock risk. Some traders look to reduce the beta risk as well. There are various ways to reduce the broader market risk, including hedging with futures and options, pair trading, diversifying among sectors, and using different long to short ratios. One way to reduce broader market exposure is to hold both long and short positions of correlated stocks. The ratio of your long to short exposure should be in accordance with the current underlying trend of the market, combined with individual stock selection. If the trend as you perceive it is up, and you want to reduce broader market risk, then your long to short exposure

ratio should be long by 2 to 1, but a minimum of 2 to 2. This means that for every two long positions you hold, you hold at least one short position. The long to short exposure ratio could be spread out among sectors so it would not adversely impact the conviction you have on a specific industry. Reducing the beta risk by taking concurrent long and short positions only works when the different sectors you have selected have similar betas. For example, if you like the software sector but don't especially like the software stocks, and you think the broader market will rally as a whole, your strategy might be to go long two hardware stocks and short one software stock. If you are more neutral on the market, then you might hold two longs in the hardware sectors and two shorts in the software stocks. Because the hardware and software sectors have similar betas, this strategy should reduce your beta risk. Stick to your game plan Sticking to your plan is the hardest thing to do as a trader. The reason it's so hard is that it takes strict discipline and an emotional detachment from the outcome. Knowing what to do and doing it are two separate issues. Trading involves so many unforeseen elements and market forces that mishaps and fuzzy thinking materialize even through this sea of uncontrollable elements is to have the discipline to stick to your game plan. Your plan is the shield that no market force can penetrate, unless you let it. The main reason experienced traders lose is that they fail to follow their own rules. There are hundreds of reasons and excuses for deviating from a trading plan - for breaking your rules. In the long run, the reasons make zero difference. In the end, people are judged by their results, not the quality of their excuses. In an unstructured environment with multiple sources of reason pulling you in different directions, rules become the cornerstone for success. A trading plan is predictable. It provides sources of reason given any number of existing circumstances. It filters out noise and encourages discipline. Remember that having a trading plan and sticking to it is invaluable. The simple recognition of this fact can provide the stimulus to adhere to your own plan. The association a person attaches to losing can be deep-seated. Feelings of unworthiness or shame usually have their roots in childhood and can cause people to act in unpredictable ways. Loss in trading is unavoidable. The best traders do not get upset when they lose; they maintain equilibrium. Seasoned traders do not perceive loss as a personal or professional setback. Instead they acknowledge loss as a necessary and important step on the path toward success. Do not be afraid to lose. Act quickly to cut your losses without thinking about it.

MIND GAMES THAT CREATE MILLIONS FOR MASTER TRADERS It is easy for trader to get hooked into subjective interpretations of what the market is doing, because their minds are playing tricks on them. Different people react in different ways to stress. Day trading takes an enormous amount of mental exertion, which requires physical energy. Successful trading is the by-product of a ruthless mentality that allows you to make quick decisions when there is a lot at stake. The best traders can make decisions objectively under stressful circumstances, without looking back.

Many traders fall into a middle ground wavering between subjective and objective interpretations. This happens because they are more attached to the outcome and what it represents than they should be. A trader who falls into a losing rut, for example, is more likely to perform poorly because of a negative state of mind. You tend to attract what you focus on. If you are in a losing streak, chances are that you are focusing on loss, thus attracting more loss. Detrimental mind games start to kick in when you refuse to accept the fact that you were not able to achieve your desired outcome. When you accept loss gracefully and refrain from beating yourself up, your mind-set will improve and you will be able to focus on where you want to go. This will improve your chances for success. What not to do "When you learn what not to do in order not to lose, only then can you begin to learn what to do in order to win." EDWIN LEFEVRE, REMINISCENCES OF A STOCK OPERATOR Successful trading involves two spheres of choice: action and inaction. The proactive course of offensive action is a step taken in order to win. It means that you have made a decision and are acting on it by putting yourself on the line. It should stem from a plan that provides contingencies for entering and exiting positions. It's an approach that requires doing something in order to benefit from it. It requires taking action now. Playing offense by taking action, however, is only half of the equation. The other half of the equation that leads to successful trading involves inaction, or negative selection. Inaction involves refraining from trading in order not to lose; it is a preventive posture used for insurance. Not taking action under certain circumstances can be harder than taking action. It is very hard to be patient when you are bored, looking for excitement, and eager to make some money. Many traders wrongly believe that they need to have a position in the market at all times. They ask themselves, "Should I be long or short here?" They rationalize that if they don't want to be long a stock anymore, then they have to be short it, or vice versa. Choosing not to trade, however, is also a decision. It's hard for some traders to admit that they may have no conviction on the current stock or market trend. There are times that having no position will statistically improve your chances of winning in the long run. If you consider being flat, along with being long or short, then you will begin to look at opportunities with more patience and less effort. An example of defensive inaction in day trading is refraining from chasing a stock too far past your ideal entry point. Not chasing a stock is, in many cases, a way to avoid unnecessary loss. In day trading, entry is a crucial part of the equation and should not be done impatiently. If an entry point is missed, so be it. Take non-action. Choose not to chase. Wait for the next opportunity. Traders should consider themselves to be on sentry duty throughout the trading day. Sentry duty is one of the hardest military assignments because most of the time nothing happens: It gets very boring. Even so, it requires careful attention to detail and concentration at all times, even though you may be bored. One little slip-up during a cigarette or coffee break could mean the difference between life and death, for the individual as well as the whole squad. The human mind will go to great lengths to avoid boredom. Yet in trading the natural human tendency to avoid boredom is a negative quality that must be recognized and controlled.

Avoiding certain actions preserves a trader's life and provides a shield from unforeseen difficulties. Defensive trading means not taking a course of action that might cause you harm or lost money. Inaction in trading is like defensive driving: It's a technique that involves knowing what not to do in order to get into an accident, such as not changing lanes before you look, or not gunning the gas when a light is about to turn. In order to win, a successful trader must first learn that how not to lose. Knowing what action not to take is just as important as knowing what action to take.

Bottom fishing No stock is ever cheap or expensive; it just is. A common rationalization is that because a stock was trading at 400 last week and now it's at 300, it's cheap! Stock price reflect the current supply and demand for an issue, regardless of past or future. A day trader's goal is to make money today, not to analyze long-term value. Each trading day must be approached with complete disregard for the past and future. Here and now is all there is. Today is when the money will be made, not yesterday and not tomorrow. As a day trader, do not believe for a minute that the way to make money trading is to buy low and sell high. This is false in day trading. Attempting to buy low or to short high is the way to lose money, not to make it. Buying low and selling high is a description of bottom and top fishing, which are the enemy of all traders. Bottom fishing is the by-product of a faulty egobased approach to trading. It involves a guessing game in which you are pitting yourself against the broader consensus. Let go of your desire to bottom fish. "In a bull market one should trade only from the long side. In a bear market one should trade only from the short side."WALL STREET PROVERB Although the above proverb sounds deceptively simple, experienced traders who attempt to pick bottoms and tops of trends lose fortunes. Bottoms and top fishing seem like the comfortable, rational thing to do. However, in the less than zero-sum game of trading, comfort and rationalization are costly goals that should be avoided whenever possible. The most successful traders make their profits from buying high and selling higher or from selling low and buying lower. The market does not take your opinion into consideration when it decides where it wants to go. When you buy high and sell higher, you eliminate a large part of the guessing game that so many traders get entangled in. Always allow the market to show you where it plans to go. Do not try to guess when it is going to stop. Allow yourself to do the uncomfortable thing, which is to buy strength and sell weakness.

The myth of averaging down A trader should never average down under any circumstances. Averaging down is buying more stock above the price where you originally shorted it. Averaging down means adding to a loser and hoping it will turn around. Whenever you hear the phase "average down," run for the hills. "I'll average down" is really a coined excuse that means, "I'll refuse to admit that I'm wrong."

Remember that you want to buy stocks that are moving in your direction, not against you. Your objective is to trade with the momentum. If you throw money into a losing position, you are fighting the momentum. Losses can easily become compounded in a snowfall effect when you average down. Adding to a loser is similar to rolling the dice out of frustration or desperation. If you maintain discipline in the first place, you will not be caught in the painful position of watching the size of your loss grow exponentially because you have thrown more money into a losing pit. When you add to a loss, you are throwing good money after bad. That money could much better serve you if it were put to work in a winning position. When you average down, a small manageable loss can easily be transformed into a large unmanageable one. As a simple rule, ever add to a losing position, under any circumstances.

Rolling the dice Great traders have proven time and again that they can consistently win by speculating when the odds are in their favor. They have the ability to correctly assess and integrate a risk-reward ratio that statistically favors a profitable outcome. The outcome is based on a statistical distribution, whereby the probabilities are measurable when the same strategy is employed consistently. Both novices and professional traders often confuse speculation with gambling. Speculation is derived from probabilities; pure gambling, on the other hand, is based on hope. Gambling is a less than zero-sum game in which the outcome is not based on any measurable probability. Traders sometimes gamble with positions, and gamblers sometimes count cards and play when the odds are stacked in their favor. When you become aware of the difference between speculation and gambling in trading, you'll be able to repeat profitable trading scenarios while cutting out blind gambling shots. In gambling, the house is the one that stands to collect, because the odds are in its favor. A gambler who wins will never really be able to explain why, except to say that "luck" was favorable. If you are trading for excitement, you are probably gambling. Gambling will force a trader's hand when no plan or discipline exists. Gambling is a sickness and an addiction in many people. Gambling is believed to increase dramatically during times of stress and pressure; many gamblers are unaware of or just don't care about their real probabilities of success. They rely on some untouchable or unexplainable gut feeling. There are between 2 million and 5 million compulsive gamblers in the India who bet on anything from cricket matches, election results, Miss World winners, horse races and even on Film success and a number of day traders may fall into this category. Gamblers in trading fall into the low end of the performance spectrum, if they last. They are usually influenced by some hyped-up sector that is receiving all the attention in the media. The impulsive gambling instinct causes them to trade from the hip, sometimes with an all-or-nothing destructive urge. It is hard for some gamblers not to trade if they fear they will miss the current craze. Successful traders are diametrically opposed to the gambling types. They do not look for excitement in the marketplace; they come thoroughly prepared with a clear plan and a search

routine that is methodical. Rational traders maintain superior discipline, which shields them from the human emotional biases, such as hope and boredom, that are prevalent in gamblers.

Swinging for the fences The desire to hit a home run in trading is the earmark of a beginner. The key to earning profits in day trading is consistency. Steadily hitting singles and doubles is how the pros fill the coffers with profits and produce dynamic results over the long run. Statistically speaking, a large swing occurring in a given stock at the precise time an order is entered is an anomaly. The stocks that make large and fast moves regularly are the ones that require a more diligent risk profile, translating into a smaller position with a wider stop-loss point. Focusing on hitting singles and doubles does not mean that you cannot maximize your gains. It simply means that you are focusing on technique. When a batter hits a home run in baseball, it happens naturally, usually without any effort. The same holds true with a home run trade. The home-run trade should not be the focal point. Successful traders pile on the profits take care of themselves. Successful traders tend to view trading as a business, like any other, in which wishful thinking is kept to a minimum. A Cricket batter who is attached to the idea of hitting a four is distracted by the thought and usually performs worse for it. Successful batters first visualize correct technique before getting up to the plate. They stay focused on the motions and technique that lead to consistency and greatness, such as stance, eye contact, grip, swinging motion, and other details. Proper technique leads to fours and sixers; boundaries do not lead to proper technique. Correct routine in trading revolves around visualizing and implementing proper methods, not around the big swing. Swinging for the fences in trading is destructive on several counts. The first reason it's destructive is that it's the product of unrealistic expectations. Having unrealistic expectations may set you up for a letdown in the future, because the odds can be slim that the hoped-for event will occur. When high expectations are not met, traders generally experience a sense of disappointment and frustration; emotions that interfere with optimal trading performance and could result in a downward confidence spiral. Another reason swinging for the fences is destructive is that it often fosters an-all-or nothing mentality, and traders risk far more than they should on a single position. The extra large position makes it harder for the trader to cut losses if the position turns the wrong way. A trader who is not willing to cut losses quickly will not last long. When traders focus on hitting home runs, their attention is diverted from other, profitable possibilities.

Position size envy Traders often take larger positions than they should because they are experiencing size envy. Position size envy occurs when your ego whispers to you, "The sky's the limit." You may be in an environment in which other traders are taking positions larger than yours. You decide that if they can do it, so can you: You jump in without sticking your toe in the water first. If the water is

ice cold, you could be in for the shock of your life. A trader's risk tolerance develops over time, given experience, confidence, and the emotional and financial ability to withstand losses. Someone who can trade large positions had arrived at that point through a long and painful learning process. Most people cannot walk into a gym and bench-press 100 kilos if they are used to putting up only 20. The only way to get to the 100 kilos mark is to slowly build up your strength and tolerance over time through a gradual increase in the weight lifted. The same holds true for increasing your position size. It should be a slow process based on your financial capacity and psychological and emotional development, discipline, and strength. Traders should judge themselves by their own goals and nothing else. One reason traders take positions that are too big is the almighty greed instinct. Greedy traders have an insatiable attachment to money. Remember, the most successful traders on Wall Street have a disregard for money. When you are glued to your Profit and Loss as a trader, your ability to act objectively is limited. Everyone experiences greed to some extent, but traders have to keep this human trait under control. Attachment in trading is detrimental because it represents emotionally charged subjectivity. The fewer associations and attachments a trader has, the better. Emotional attachment to money and what it represents is the main reason traders freeze and have a difficult time taking losses, especially large ones. They find themselves in situations they're unprepared for financially or mentally. One of the hardest things for a trader to do is to stick to a game plan when emotions blow things out of proportion. A trader who freezes is unable to act or think quickly. This hesitation usually makes the difference between a profit, a loss, or a huge loss. Another reason why a trader might have a position that is too large is because he adds to a loser, or averages down. Adding to a loser is probably the most deadly sin in trading, but the vast majority of traders do it at one time or another. Many do it out of sheer hope or desperation, refusing to acknowledge that they were wrong. Adding to a loser is the worst excuse for a trader to have a position that is too big. Wishful thinking and hoping to make back what was lost often result in huge losses. A snowfall effect is created, gaining size and momentum in the wrong direction. One way to avoid adding to a loser is to realize that you can always cut your losses now and get back in later. Successful day traders are constantly selling stocks for small losses and reentering the position when they think the momentum has begun to move in their favor. Successful traders add to winning positions, not losing ones. If losses set in that are above your risk tolerance, it becomes much harder to act quickly and to face the truth that you are wrong. As your account accumulates money, your position sizes should increase gradually. This will allow you to slowly build up your risk tolerance based on financial soundness. Position size in trading should be dictated by risk control, not high hopes. The anguish of being wrong in a trade grows exponentially when your positions get out of control. If the mind and wallet are not accustomed to taking large hits, it becomes very difficult to act swiftly and to cut your losses.

Vengeance trading Vengeance trading occurs after a trader takes a hit on a trade and wants to get even with the stock. The reason the trade went sour doesn't usually matter; the trader is angry, but not wanting to accept blame, will quickly place it elsewhere. This misdirected emotional firestorm usually translates into pure revenge. The only solution in this cloudy state of mind is for the trader to avenge honor and money lost by getting them back from the stock that took it. The stubbornness festers, and pretty soon it's an all-out battle. "The telecom stocks seemed likely to sell off hard this morning," thought Amar Damani, a market maker for a large firm. "They had a nice run yesterday, and with negative news out in Himachal and Global Tele, they should be down further." The Tech index was weak when Dhiren decided to short 5,000 shares of Himachal, which at the time was down 3 points. For some reason, Sterlite Optic started to bounce off its lows and Himachal and Global followed along with it. "I can't believe this stock! This thing should be down ten points and for some stupid reason it's now up five rupees! I'll prove that I'm right and that the market is wrong and I'll get my money back by shorting another two thousand shares here." Amar added to his losing position and shorted 2,000 more shares. Soon after, Himachal ran another three points. By this time, Amar was red in the face and could not think of anything else but getting back at Himachal. He was cursing at Himachal, at the market in general, and at the computer screen. Throughout the day, Himachal continued to rally along with all the other Tech stocks. Amar refused to cut his losses. As the day progressed, he became completely irrational and frozen with fear. His eyes were glued to the computer screen and he even punched the computer and the desk. He kept blaming Himachal and continued to short more stock so he could get even, until he was short 7,000 shares with Himachal up ten points. By the end of the day, Himachal was up 12 points touching the upper 8% filter and Amar was down Rs.100,000, and almost out of a job." The problem with vengeance trading is that the initial loss probably occurred because the original direction of the trade was incorrect. Vengeance trades rarely take place in the opposite direction of the original losing trade. It takes a seasoned pro to change directions on a position after initially being wrong. The vengeance trade goes in the same direction because vengeance traders need to prove that they were right in the first place, that it wasn't their fault they lost money. They need to get even so their egos can be restored to their original perches. The common misperception is that when you are trading, you are fighting the market, which is the enemy that must be defeated. Ameritrade recently ran an advertisement pitching on-line day traders and asking them if they were ready to take on the market with the following quote: "I don't want to just beat the market. I want to wrestle its scrawny little body to the ground and make it beg for mercy." This is faulty ego-based, unrealistic thinking that will lead toward losses, not profits. The market is never wrong and it cannot be defeated. It is selfless. It does not experience feelings of victory or defeat. The market is a cold battlefield and its participants are engaged in a life-or-death battle against themselves. "Every battle that takes place, whether within the body and mind or outside of it, is always a battle against oneself."ZEN SAYING

Vengeance trading can quickly turn into disaster, because revenge is one of the strongest and most stubborn of emotions. Vengeance trading is a futile exertion of time, energy, and money. Its grip only tightens, clogging clear thinking and profit; it drains the resources of a trader, sucking time away from other profitable opportunities by encouraging the trader to focus on where the losing trade did not go, rather than where another trade could go. Instead of fretting over lost money and trying to get even with a market that does not care, use your time and energy to focus on other situations that will be more profitable. You will immediately begin to improve as a trader when you stop wanting to control the outcome. The desire to control that which cannot be controlled creates a distorted reality, leading to stress and mind games that will thwart your success. It will be easier for you to acknowledge objective circumstance when you treat yourself kindly, and when you realize that each trade is just one step in the sphere of things to come. Acknowledging that you are not your results will help you to step outside of yourself and to trade with increased detachment and objectivity.

The trading mind All the great traders attest to the impact psychology has on trading. Many believe that psychology has the greatest impact on trading decisions. Crucial psychological elements, both conscious and unconscious, affect the decision-making process for traders. Many of these mental elements and psychological profiles are ingrained from childhood, and traders are unaware of them. Prices move with emotional extremes, triggered by psychological associations with gain and loss. The first step toward successful trading is developing an awareness of the influence of psychological and emotional factors on your actions.

No fear "There is only one thing that makes a dream impossible to achieve - the fear of failure."THE ALCHEMIST Fear is perhaps the most debilitating emotion a trader can experience. Painful memories produce fear, which warps a trader's focus. When you are afraid to lose for one reason or another, you will end up focusing on loss and, by doing so, will attract precisely the opposite of what you hope to avoid. When you operate out of the fear of being wrong, you are focusing your energies in a losing direction. Fear is the main reason traders cut their profits short and let their losses run. With winning positions, traders fear that they will lose what they have grained. Because of the fear of loss, they look for signs that indicate that the trade will reverse course, instead of looking for reason why it should work out. They eventually find a reason that confirms their fears, so they cut profits short instead of letting them run. The fear of loss is a double-edged sword that will convince a trader to do the wrong thing not only when you have a losing position. If you have a position that is going against you and is losing money, your fear of loss will cause you to look for signals that the trade will work,

because you do not want to accept the fact that you are experiencing loss. Because of this fear, you will let the loss run instead of accepting it and quickly cutting it short. According to scientific research, the Reticular Activating System (RAS) is a mechanism in your brain that determines what you observe and how you pay attention to it. The RAS attracts information to support what you are focusing on and alters your conscious experience. An example of the RAS in action is when you suddenly notice an item that you just purchased everywhere. If you believe that you will win at trading and you focus on where you want to go, then the RAS will attract information that supports your focus and belief. On the other hand, if you continually harbor fear in your heart about losing money on a position, your RAS will draw pieces of information that support your fear. If you enter into a trade that is working but you are afraid to lose what you have gained, the RAS will feed off the emotional intensity of fear, and will attract you to information on why the trade might not work, encouraging you to cut your profits short. Because your brain can only focus on a limited number of items at once, the RAS blocks out whatever it does not hold important. It filters out the noise it believes to be unimportant to your priorities. When you are trading stocks, innumerable tidbits of information about the market come streaming in, all of which require your interpretation. Because it is impossible for your brain to absorb all of the information coming at you at once, your RAS will determine what you will notice. When you focus on where you want to go, the RAS will block out information that is nonessential for you to achieve your objective. Doctors describes fear is "...the anticipation that something that's going to happen soon needs to be prepared for." Regardless of whether the event ever takes place, fearful anticipation is a reality. Preparing for the anticipated event beforehand is a crucial step toward managing fear. The worst thing a trader can do is deny that fear exists. Fear delivers a message that will not disappear until it is acted on. Action cures all fear. If you relinquish control to fear, then you allow it to increase its grip over your actions. If you ignore fear completely, then you are not respecting the potential value behind its message. The first step toward managing fear is to acknowledge that is exists. Be aware of its presence and determine what steps you need to take in order to diminish its power. Fearful emotions in trading range from small quantities of worry, unease, and apprehension to extreme levels of anxiety, panic, and horror. The associations a trader has developed about what a loss means to you on a personal, professional, or financial level will dictate your various levels of fear. The very best traders are comfortable with the notion that they can be lost it all. This acceptance of and detachment from loss eliminates a large part of their fear. Because their fear is managed, they have the mental freedom to focus their energies on winning. One of the best recipes for conquering the fear of loss is to prepare for the loss beforehand with proper risk control. Detachment from loss comes with the knowledge that you can financially withstand to lose everything you have riding on your current positions. If your liquid net worth is Rs.500,000, and you have a large percentage of that riding on a few positions without an

adequate stop-loss risk profile, the fear of loss will be magnified dramatically. This holds true especially if you are trading stocks that are volatile and less liquid, with a large slippage factor. When a day trader is trading with high levels of margin in volatile stocks, and the lion's share of his portfolio is riding on a few positions, his levels of fear will be magnified because a loss under these circumstances will mean a lot. If he loses under these circumstances, it will be easy for him to get caught up in a losing cycle. Desperation may set in and he will trade emotionally and subjectively to win back what he lost. The emotions he will experience at this point are not just fear of financial ruin, but also feelings of guilt, shame, and unworthiness. Under these circumstances, his confidence and conviction will be close to zero, which just happens to be the very worst time to be trading. When you invoke the financial discipline to trade with only a portion of your liquid net worth, and use a stop-loss risk profile of about 2 percent of your portfolio, then your fear of loss will be substantially reduced because you can afford to lose. This requires keeping expectations realistic about the amount you can expect to earn from trading, especially when you are just beginning. If you have Rs.500,000 in liquid assets and you earmark 20 percent or Rs.100,000 to trading, using a Rs.2,000 maximum stop-loss level per day, you have made a realistic pre-emptive strike against fear of loss. As you trade this money and if you are successful, you can reinvest your gains and use the profits to expand your base for larger trades. Managing and reducing the fear of loss also requires a willingness to understand and accept the fact that the money you have invested in day trading is money that you may never see again. When you come to this understanding beforehand and you are willing to lose the money, then you will not be attached to or afraid of loss. When you trade in this state of mind, your chances for success increase because you are free to act objectively, without hesitation or inhibition. When you reach this state, you are levels ahead of most of the other traders. Don't be afraid of the worst-case scenario when you are trading. If you understand that failure is a natural and necessary part of the trading process, you will have increased confidence to take risk and to cut losses quickly.

Listen to the market The current price of the market represents the belief and perception of all the traders who are participating in the market at the current time. The last price represents the emotional unanimity of the masses that are currently acting on their perceptions. The reason a stock or the market has reached a certain price level is irrelevant. Price action represents the interpretations of all the players, whether they are valid or not. If someone has inside information about a stock and acts on this information, the price action will be portrayed for all to see. Information that is acted upon cannot be hidden, because price and volume will always uncover it. Being right and making money when you are trading can be two separate issues. Your goal as a day trader is to make money, not to be right. Prices move in the direction of the strongest energy behind them. When you listen to the force behind the prices and jump on board for the ride, your actions will not conflict with the market's opinion. For example, suppose you have done research

on a company and you know that it is undervalued relative to its peers. Because of your conclusion, you buy 5,000 or 10,000 shares, only to watch it drop two points. Who was right you or the market? Waiting for the market to confirm your initial opinion is crucial. The market provides clear signals for the best course of action, regardless of your opinion. You must be go of any preconception about what the market is going to do, and instead remain focused on what the market is doing here and now. The clues and signals about what is happening are readily available to all who are willing to put aside their opinions and listen to the market instead. To increase your ability to listen to the signals of the market objectively, you should develop a mental state of mind that Deepak Chopra calls detached awareness. Detached awareness occurs when you observe what's going on with little at stake to your ego. Detached awareness occurs when you step outside of yourself and calmly observe your actions. For the trader, this detachment means abandoning your associations about what a stock's move will mean for you emotionally, financially, and personally.

Accept responsibility Taking responsibility for all your actions and all your trades at all times, regardless of the rhyme or reason, takes a great deal of maturity and can be a hard thing to do. Even if something happened that was outside your control, act as though you alone were responsible for the outcome. You alone are in control of your mind, and therefore your actions and your results. When you accept responsibility for all your actions, you will be empowered with the ability to choose how you want thing to be. You alone will be the cause and effect for your outcomes. Time and again, traders rationalize their actions by passing the buck for something that went awry onto someone or something outside of themselves. Rationalization has a corrupting influence on a trader, because it encourages you to dodge responsibility. There will always be excuses and reasons why a trade or anything in your life did not work out the way you planned or hoped for. The strongest traders are the ones who recognize that excuses and rationalizations are folly. As soon as you relinquish responsibility by rationalizing your actions, you lose the power to learn from your mistakes, which is the best way to learn. You can always think up reasons for holding on to a loser or adding to a losing position. Even when your reason for doing the wrong thing is sensible and learned, if you do not accept responsibility for the loss, you will not learn from it. Rationalization forms a barrier between what you know is the right thing to do and what you hope will ultimately happen. It indicates that you are having trouble admitting that you are wrong. When you catch yourself making excuses for things that went wrong, it is a sure sign that your ego is swelling up and getting in the way of your improved future performance.

You immediately empower yourself as a trader when you accept the consequences of all your actions, regardless of how painful it might be to do so. Trade with the belief that you are the cause in your universe of trading results. Do not believe for a second that there is such a thing as an accident in trading. When you accept principle of cause and effect, you will be empowered to take responsibility for everything that happens on your trading pad and in your life. There will be many times when you are faced with a situation you do not want to take responsibility for, one that may not be your fault. Some common excuses in trading include faulty trading systems, slow executions, backing away, an assistant who made a mistake, misinformation, false rumors, listening to others' opinions, and fuzzy thinking. Many of these could be valid, but resist the urge to fall back on them. When you do not accept responsibility, you relinquish the power to make things different in the future. This is a short-term fix used to alleviate discomfort, but a long-term blunder. When you accept responsibility for everything that happens in your life, you empower yourself to create the trading world you would like. By accepting responsibility for your trades, you empower yourself to consistently improve your performance in the future.

Greed is an obstacle Webster's dictionary defines greed as excessive or reprehensible acquisitiveness. The problem with greed is that it feed on itself and fosters a state of lack: the opposite of what you are trying to achieve by being greedy. When you are driven by greed, as you attain more you want more, so you have less instead. Wanting can actually be defined as a state of lacking. When you want something badly, your brain is sending you signals of destitution. If you live in a state of wanting something, then you will attract scarcity. Whatever you focus on and attach emotional significance to expands in your life. If you are driven by greed, then you are trading in a state in which you are constantly aware of what you do not have. This is called poverty consciousness, and it will work against your goals of creating abundance in your life. Greed indicates that your attachment to money is ironclad. It arises from the belief that you lack something because there is not enough to go around. This belief is destructive and false. The universe's natural state is one of abundance and wealth. Deep down, if you did not belief this was true, then you would not be trading with the objective of fulfilling your potential. Greed is unfulfilling because there will never be enough to satisfy what you believe you lack, so the more you get, the more you believe you need. Greedy traders are attached to what money represents to them on a personal level. Most people go through life with the belief that money and material objects that it secures represent the acknowledgement, approval, and validation of others. The thirst for approval is one of the strongest emotions human beings experience. These feelings are ingrained from early childhood and are dominant in the subconscious.

The quest for approval causes traders to act in all sorts of weird ways, disregarding their trading plans in the search for the stronger desire to attain approval in all forms - from their peers, their parents, their childhood teachers, themselves; the list goes on. Acknowledging the fact that you are seeking approval and recognition in a given situation is the first step toward releasing that emotion, which will provide you with freedom to trade objectively and without greed.

Conquer frustration Traders make some of the worst decisions when they are frustrated. Frustration clouds thought and destroys objectivity. Frustration is a state of insecurity or discontent stemming from unconcluded problems or needs that have not been fulfilled. This dissatisfaction can be commonplace among traders who are experiencing losses. It is very easy to become frustrated when you are trading. Hundreds of factors in trading can leave a door wide open to feelings of frustration. Trading is one of the most intense and physically demanding occupations. With so much dependent upon technology, and with so much at stake, little mishaps can pile up to create a state of agitation and frustration. Frustration is a common emotion in trading because so much effort is put into preparing for the moment when it's time to trade. Because loss in trading is natural and common, a trader can get frustrated quickly if you experience a string of losses without experiencing any reward. The perpetual motion of markets and prices causes discrepancies in price that will often test a trader's mettle and conviction. If you let yourself become frustrated due to a lack of immediate results, you are setting yourself up for a blurred subjective vision. When you experience frustration, realize that it is a sign for you to complement your approach to trading with increased flexibility and patience. Your success as a trader at times hinges on your ability to conquer frustration. Frustration will always appear on your path toward greatness. Some will triumph over it, while others succumb to its pettiness. When you encounter obstacles on your trail toward achievement, remind yourself that they were placed there in order for you to overcome them, so you can learn from them and become better than you were before. Remember, little things affect little mind.

Don't look back Regret is a poisonous emotion that traders experience all too often. It can be very painful to watch a stock move forcefully in your direction after you missed the chance to get on board for one reason or another. Because of the vast number of trading opportunities in the market, it is impossible not to miss many of them. Let go of regret and instead treat yourself kindly when trading. Do not beat yourself up for having missed an opportunity. Remember that there will be many, many more chances for winning trades. Regret is toxic because it encourages you to look back and to focus your energies on the past, when you should be using your valuable time and energy to focus on the here and now in order to uncover trading opportunities.

When you acknowledge that you are feeling regret, then you have taken the first step toward diminishing its power over you. Regret can serve a purpose when you admit that it exists, learn quickly from its message by accepting responsibility, and then pardon yourself and move on. Rather than living in the past by regretting what could have been, resolve to live here and now, in the present. Remind yourself that if you could have taken action, you would have. Excuses have no place in trading, because in the end they never make a difference anyway. Admit to yourself that for some reason, something within you prevented you from action. Only you know what it was, and only you can fix it. By accepting responsibility without blaming yourself, you will learn from the experience and develop into a stronger trader, without regret. Growth in trading is a continuous process. There is always room to become better, so give yourself the space to breathe and to learn unencumbered by feelings of regret.

Exude confidence The best traders are successful because they are able to maintain unshakable confidence in themselves and in their decisions. This serene self-confidence creates a positive state of mind and the will to act. There is an old saying: "If you would be powerful, pretend to be powerful." One technique for developing confidence when you are trading is to role-play. Think of a confident role model, preferably a successful trader whom you look up to, and pretend to be that trader. Imagine that you have the power to act decisively when trading, without hesitation, letting your winners run and cutting your losses short. This will transform the way you perceive yourself and how you make your decisions. We communicate more with our body language and tone of voice than with our words. When your body language and voice portray a confident person, then people will respond to you as if you were a confident person. Practice sitting, talking, and acting confidently in everyday life and watch your conviction and decision-making process on the trading desk improve. Exercise also substantially boosts your confidence. When you feel positive about yourself and how you look, you are more inclined to act confidently. Exercise also has a number of other positive side effects for traders, including alleviating stress and reducing anxiety. Because trading is such a physically demanding occupation, you owe it to yourself to exercise as often as possible. Consider exercise an investment in your trading career. Dress well when trading, because looking good will increase your self-esteem. High self-esteem will positively affect your everyday decisions and help you feel more optimistic in general. Developing confidence in yourself and in your actions is a continuous, lifelong process. This is an area that you should devote time to every single day. As your confidence increases, you will feel better about yourself and the world around you. As you practice using a confident tone of voice and body language on a regular basis, that confidence will be readily accessible when you need to use it in your decision-making process. When you look, sound, and act confident, you yourself will believe that you are. Others also react to you as a confident person, which in turn will empower you.

Maintain prosperity consciousness World renowned Spiritual guru Deepak Chopra says that "all relationship is a reflection of your relationship with yourself." If you feel guilty or insecure about having wealth or good things in your life, those feelings are a part of your character that you have to address. Profitable trades will not solve these issues. As a trader, an important question to ask yourself is whether you feel that you truly deserve to be wealthy. This question must be answered honestly. If you do not believe you deserve to be wealthy, sooner or later you will sabotage your chances for success. Many people carry around feelings of unworthiness ingrained from childhood. These feelings often stem from the association parents or a religion attaches to money. The first step toward changing these destructive and unrealistic feelings is awareness. Only when you allow these feelings to surface consciously can you address them, release them, and let them go. You are your own harshest critic. The feelings of guilt and shame that people carry around have no bearing on reality. People may have distorted memories of how they injured or hurt someone else, when in fact that was not the case. To achieve success in life, you have to learn to have compassion for yourself. Feelings of self-worth translate into positive outer manifestations in all areas of your life. Those who feel that they deserve only the best in life attract other people and circumstances to themselves that will confirm those beliefs. When you understand that abundance and wealth are the natural states of the universe, and you recognize that you deserve to be wealthy, your actions will begin to model your inner beliefs.

Security is an illusion Are you trading for security? If you are, you may be in the wrong business. If a trader is trading with the objective of being secure, you are juggling two opposing forces. You are attempting to derive stability and safety from market forces that are inherently unstable and insecure. Is there such a thing as security? Deepak Chopra said, "Life is either a daring adventure or nothing at all." If you are attached to the concept of security, it will have the effect of making you feel insecure. An attachment to something outside of yourself is unfulfilling, because you feel empty without it. There is no security in the markets. Time and again, some of the so-called smartest names in trading have gone bust practically overnight. When you are trading for security, you are attempting to keep what you have because you are afraid to lose. This fear will inhibit your actions and will make you a less effective trader. When you fear losing, you will actually create losses. You will be unable to cut your losses when they are small, and you will miss great trading opportunities because you are afraid to lose. The same fear of loss infects the actions of people in everyday life, holding them back from living the lives that they always dreamed of. Security is a very fleeting thing and can never come from money itself. Attachment to money or profits creates anxiety and a feeling of lack. This attachment means that your sense of well-being is dependent upon something outside of yourself, which there could never be enough of. If a person cannot afford to lose, fear and attachment will always reign.

A good question to ask yourself is what is the worst that could possibly happen to you, the worst outcome that you can imagine? You've managed to live up until now. You've always been provided for and cared for, or else you would not be reading this book. There has always been enough food on the table. Life will go on. You will be okay. The acceptance of loss puts into perspective the fact that each trade is only a single trade in the design of things to come. Ten years from now, when you look back at the loss, it will seem like an insignificant speck, a learning experience that happened for the best. The only thing that is sure in trading is that you'll win some and you'll lose some. The markets will always change. Nothing is permanent. Deepak Chopra said that "...to die having failed is not a shameful thing. It means that if you keep your spirit correct from morning to evening, accustomed to the idea of death, and resolved on death, and consider yourself as a dead body, thus becoming one with the Way of the Warrior, you can pass through life with no possibility of failure and perform your office properly." When the possibility of death or failure is accepted, which everyone will face eventually, then what is the worst that could happen to you? If you are trading with money that you can afford to lose, then you have accepted the worst-case possibility up front. Anticipation of failure or loss is worse than loss itself. Not being afraid to fail or to lose is true freedom. "To foster life all fear must be killed. Once all fear is killed you can dwell at ease. If you understand this meaning, an iron boat can float across water." ZEN SAYING

Write down what you want "You have to be specific with your goals because the universe will deliver what you want. The universe will give you what you dwell upon. If you Dwell upon ambiguity it will give thou just that."NOSTRADAMUS Write down your trading goals, and be as specific as possible. The goals need to be measurable, so when you achieve them you will know it. Remember to be very specific. Once your brain has the target, it can begin to figure out ways to best achieve it. Your profit and loss objectives should be broken down into yearly, monthly, weekly, and daily goals. Develop goals for all areas of your trading development. Focusing on the reward aspect of trading alone is a faulty approach. Certain areas of your trading approach will require more development than others. Only you know what you need to work on the most. This requires honest introspection and diligent analysis. You may be an expert at letting your profits run, but you may have trouble cutting your losses or taking profits. Perhaps you chase stocks past your ideal entry point too often, or it could be that you are not aggressive enough at executing trades. At the end of the day, record in a journal the correct and incorrect trades you made throughout the day, so you can learn from them. Keeping a daily journal is a potent way to zoom in on your strong and weak points as a trader. Once you are aware of shortcomings as a trader, you can convert them into positive written goals.

All your goals should be written down in the present, as if you have already achieved them. When working with goals, act and feel as if you already have that which you are seeking. When you act and feel and believe that you have achieved your goal, your confident state of mind will reject the obstacles that stand in your way. If your objective is to earn Rs.100,000 a month, write down the goal as follows: "I now earn Rs.100,000 a month trading." If your objective is to stick to your stop-loss criteria, then your written goal could be: "I always stick to my prearranged stop-loss points." Read these goals out loud in the evening before you go to sleep and in the morning when you wake up. When reading them, use as much emotion as possible so you can work yourself into a state of experiencing the outcome. Your trading goals should be as realistic as possible. If you do not believe inside that you can accomplish the result, then it will be hard for you to internalize it. A goal that is unrealistic is discouraging. The way to make your goals realistic is to start where you are today. Decide what specific action you can take and what sort of results you can expect to receive from that action. Begin with a more conservative goal for the near term. Use your past achievements as the immediate benchmark for what you can expect in the future. Your goals need to be timed toward your objectives. Setting specific dates is very important. Once you write down and commit to a deadline, your brain takes over, sometimes in mysterious ways. We use only a very small part of our brains consciously. Having a written goal accomplishes amazing things. Write out your goals as far as possible into the future, with as much detail as possible. Remember that you should always judge yourself by your goals only, not by anyone else's. What others are doing or have done should be of no concern to you. Financial goals in day trading can range from as little as Rs.500 a day to over Rs.5,00,000 for big time market makers. Just remember that it is important to maintain realistic expectations about your abilities and your resources. Psychology has a powerful impact on trading results. It is impossible to separate your psychological makeup from your results. Being aware of the way your mind works is the first step. You must know your own strengths and weaknesses before you can hope to grow stronger and to overcome the obstacles that will inevitably appear in your path toward trading greatness.

TIME TESTED TRADING RULES TO BE A MASTER TRADER This is a list of classic trading rules that was given to me while on the trading floor (called the trading ring of BSE then) in 1994 when I just begun a career in stock markets having passed out of HSC then. A senior trader collected these rules from classic trading literature throughout the twentieth century. They obviously withstand the age-old test of time. I'm sure most everybody knows these truisms in their hearts, but this list is nicely edited and makes a good read. • • • •

Plan your trades. Trade your plan. Keep records of your trading results. Keep a positive attitude, no matter how much you lose. Don't take the market home.

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Continually set higher trading goals. Successful traders buy into bad news and sell into good news. Successful traders are not afraid to buy high and sell low. Successful traders have a well-scheduled planned time for studying the markets. Successful traders isolate themselves from the opinions of others. Continually strive for patience, perseverance, determination, and rational action. Limit your losses - use stops! Never cancel a stop loss order after you have placed it! Place the stop at the time you make your trade. Never get into the market because you are anxious because of waiting. Avoid getting in or out of the market too often. Losses make the trader studious - not profits. Take advantage of every loss to improve your knowledge of market action. The most difficult task in speculation is not prediction but self-control. Successful trading is difficult and frustrating. You are the most important element in the equation for success. Always discipline yourself by following a pre-determined set of rules. Remember that a bear market will give back in one month what a bull market has taken three months to build. Don't ever allow a big winning trade to turn into a loser. Stop yourself out if the market moves against you 20% from your peak profit point. You must have a program, you must know your program, and you must follow your program. Expect and accept losses gracefully. Those who brood over losses always miss the next opportunity, which more than likely will be profitable. Split your profits right down the middle and never risk more than 50% of them again in the market. The key to successful trading is knowing yourself and your stress point. The difference between winners and losers isn't so much native ability as it is discipline exercised in avoiding mistakes. In trading as in fencing there are the quick and the dead. Speech may be silver but silence is golden. Traders with the golden touch do not talk about their success. Dream big dreams and think tall. Very few people set goals too high. A man becomes what he thinks about all day long. Accept failure as a step towards victory. Have you taken a loss? Forget it quickly. Have you taken a profit? Forget it even quicker! Don't let ego and greed inhibit clear thinking and hard work. One cannot do anything about yesterday. When one door closes, another door opens. The greater opportunity always lies through the open door. The deepest secret for the trader is to subordinate his will to the will of the market. The market is truth as it reflects all forces that bear upon it. As long as he recognizes this he is safe. When he ignores this, he is lost and doomed. It's much easier to put on a trade than to take it off. If a market doesn't do what you think it should do, get out.

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Beware of large positions that can control your emotions. Don't be overly aggressive with the market. Treat it gently by allowing your equity to grow steadily rather than in bursts. Never add to a losing position. Beware of trying to pick tops or bottoms. You must believe in yourself and your judgement if you expect to make a living at this game. In a narrow market there is no sense in trying to anticipate what the next big movement is going to be - up or down. A loss never bothers me after I take it. I forget it overnight. But being wrong and not taking the loss - that is what does the damage to the pocket book and to the soul. Never volunteer advice and never brag of your winnings. Of all speculative blunders, there are few greater than selling what shows a profit and keeping what shows a loss. Standing aside is a position. It is better to be more interested in the market's reaction to new information than in the piece of news itself. If you don't know who you are, the markets are an expensive place to find out. In the world of money, which is a world shaped by human behavior, nobody has the foggiest notion of what will happen in the future. Mark that word - Nobody! Thus the successful trader does not base moves on what supposedly will happen but reacts instead to what does happen. Except in unusual circumstances, get in the habit of taking your profit too soon. Don't torment yourself if a trade continues winning without you. Chances are it won't continue long. If it does, console yourself by thinking of all the times when liquidating early reserved gains that you would have otherwise lost. When the ship starts to sink, don't pray - jump! Lose your opinion - not your money.

Options Trading Strategy Guide: Glossary Have a question about an options trading or financial term? This is the place to look! Dive in... A ADJUSTED STRIKE PRICE Strike price of an option, created as the result of a special event such as stock split or a stock dividend. The adjusted strike price can differ from the regular intervals prescribed for strike prices. ADJUSTING A dynamic trading process by which a floor trader with a spread position buys or sells options or stock to maintain the delta neutrality of the position. See DELTA ALL OR NONE (AON) ORDER

A type of order that specifies that the order can only be activated if the full order will be filled. A term used more in securities markets than futures markets. AMERICAN STYLE OPTION A call or put option contract that can be exercised at any time before the expiration of the contract. ARBITRAGE A trading technique that involves the simultaneous purchase and sale of identical assets or of equivalent assets in two different markets with the intent of profiting by the price discrepancy. ASK, ASKED PRICE This is the price that the trader making the price is willing to sell an option or security. ASSIGNMENT Notification by Stock Exchange Clearing to a clearing member and the writer of an option that an owner of the option has exercised the option and that the terms of settlement must be met. Assignments are made on a random basis by the Stock Exchange Clearing. The writer of a call option is obligated to sell the underlying asset at the strike price of the call option; the writer of a put option is obligated to buy the underlying at the strike price of the put option. AT PRICE When you enter a prospective trade into a trade parameter, the "At Price" (At.Pr) is automatically computed and displayed. It is the price at which the program expects you can actually execute the trade, taking into account "slippage" and the current Bid/Ask, if available. AT-THE-MONEY (ATM) An at-the-money option is one whose strike price is equal to (or, in practice, very close to) the current price of the underlying. AVERAGING DOWN Buying more of a stock or an option at a lower price than the original purchase so as to reduce the average cost. B BACKSPREAD

A Delta-neutral spread composed of more long options than short options on the same underlying stock. This position generally profits from a large movement in either direction in the underlying stock. BACK MONTH A back month contract is any exchange-traded derivatives contract for a future period beyond the front month contract. Also called FAR MONTH. BEAR, BEARISH A bear is someone with a pessimistic view on a market or particular asset, e.g. believes that the price will fall. Such views are often described as bearish. BEAR CALL SPREAD A vertical credit spread using calls only. This is a net credit transaction established by selling a call and buying another call at a higher strike price, on the same underlying, in the same expiration. It is a directional trade where the maximum loss = the difference between the strike prices less the credit received, and the maximum profit = the credit received. Requires margin. BEAR PUT SPREAD A vertical debit spread using puts only. A net debit transaction established by selling a put and buying another put at a higher strike price, on the same underlying, in the same expiration. It is a directional trade where the maximum loss = the debit paid, and the maximum profit = the difference between the strike prices less the debit. No margin is required. BETA A prediction of what percentage a position will move in relation to an index. If a position has a BETA of 1, then the position will tend to move in line with the index. If the beta is 0.5 this suggests that a 1% move in the index will cause the position price to move by 0.5%. Beta should not be confused with volatility. Note: Beta can be misleading. It is based on past performance, which is not necessarily a guide to the future.

BELL CURVE See NORMAL DISTRIBUTION. BID This is the price that the trader making the price is willing to buy an option or security for.

BID-ASK SPREAD The difference between the Bid and Ask prices of a security. The wider (i.e. larger) the spread is, the less liquid the market and the greater the slippage. BINOMIAL PRICING MODEL Methodology employed in some option pricing models which assumes that the price of the underlying can either rise or fall by a certain amount at each pre-determined interval until expiration For more information, see COX-ROSS-RUBINSTEIN model. BLACK-SCHOLES PRICING MODEL A formula used to compute the theoretical value of European-style call and put options from the following inputs: stock price, strike price, interest rates, dividends, time of expiration, and volatiity. It was invented by Fischer Black and Myron Scholes. BOX SPREAD A four-sided option spread that involves a long call and short put at one strike price as well as a short call and long put at another strike price. In other words, this is a synthetic long stock position at one strike price and a synthetic short stock position at another strike price. BREAK-EVEN POINT A stock price at option expiration at which an option strategy results in neither a profit or a loss. BROKER A person acting as an agent/middleman for making securities transactions in stock exchanges. An "account executive" or a "broker" at a brokerage firm deals with customers. BULL, BULLISH A bull is someone with an optimistic view on a market or particular asset, e.g. believes that the price will rise. Such views are often described as bullish. BULL CALL SPREAD A vertical debit spread using calls only. This is a net debit transaction established by buying a call and selling another call at a higher strike price, on the same underlying, in the same expiration. It is a directional trade where the maximum loss = the debit paid, and the maximum profit = the difference between the strike prices, less the debit. No margin is required. BULL PUT SPREAD

A vertical credit spread using puts only. This is a net credit transaction established by buying a put and selling another put at a higher strike price, on the same underlying, in the same expiration. It is a directional trade where the maximum loss = the difference between the strike prices, less the credit, and the maximum profit = the credit received. Requires margin. BUTTERFLY SPREAD A strategy involving four contracts of the same type at three different strike prices. A long (short) butterfly involves buying (selling) the lowest strike price, selling (buying) double the quantity at the central strike price, and buying (selling) the highest strike price. All options are on the same underlying, in the same expiration. BUY WRITE See COVERED CALL. C CBOE The Chicago Board Options Exchange. CBOE opened in April 1973, and is the oldest and largest listed options exchange. CFTC The Commodity Futures Trading Commission. The CFTC is the agency of the federal government that regulates commodity futures trading. CALENDAR SPREAD The simultaneous purchase and sale of options of the same type, but with different expiration dates. This would include the strategies: horizontal debit spreads, horizontal credit spreads, diagonal debit spreads, and diagonal credit spreads. CALL This option contract conveys the right to buy a standard quantity of a specified asset at a fixed price per unit (the strike price) for a limited length of time (until expiration). CALL RATIO BACKSPREAD A long backspread using calls only. CANCELED ORDER A buy or sell order that is canceled before it has been executed. In most cases, a limit order can be canceled at any time as long as it has not been executed. (A market order may be canceled if

the order is placed after market hours and is then canceled before the market opens the following day). A request for cancel can be made at anytime before execution. CARRYING COST The interest expense on money borrowed to finance a stock or option position. CASH SETTLEMENT The process by which the terms of an option contract are fulfilled through the payment or receipt in Rupees of the amount by which the option is in-the-money as opposed to delivering or receiving the underlying stock. CHRISTMAS TREE SPREAD A strategy involving six options and four strike prices that has both limited risk and limited profit potential. For example, a long call Christmas tree spread is established by buying one call at the lowest strike, skipping the second strike, selling three calls are the third strike, and buying two calls at the fourth strike. CLOSING TRANSACTION To sell a previously purchased position or to buy back a previously purchased position, effectively canceling out the position. COLLAR A collar is a trade that establishes both a maximum profit (the ceiling) and minimum loss (the floor) when holding the underlying asset. The premium received from the sale of the ceiling reduces that due from the purchase of the floor. Strike prices are often chosen at the level at which the premiums net out. An example would be: owning 100 shares of a stock, while simultaneously selling a call, and buying a put. COLLATERAL This is the legally required amount of cash or securities deposited with a brokerage to insure that an investor can meet all potential obligations. Collateral (or margin) is required on investments with open-ended loss potential such as writing naked options. COMBINATION SPREAD An option technique involving a long call and a short put, or a short call and a long put. Such strategies do not fall into clearly defined categories, and the term combination is often used very loosely. This tactic is also called a fence strategy. SEE FENCE. COMMISSION

This is the charge paid to a broker for transacting the purchase or the sale of stock, options, or any other security. COMMODITY A raw material or primary product used in manufacturing or industrial processing or consumed in its natural form. CONDOR A strategy similar to the butterfly involving 4 contracts of the same type at four different strike prices. A long (short) condor involves buying (selling) the lowest strike price, selling (buying) 2 different central strike prices, and buying (selling) the highest strike price. All contracts are on the same underlying, in the same expiration. CONTRACT SIZE The number of units of an underlying specified in a contract. In stock options the standard contract size is 100 shares of stock. In futures options the contract size is one futures contract. In index options the contract size is an amount of cash equal to parity times the multiplier. In the case of currency options it varies. CONVERSION An investment strategy in which a long put and a short call with the same strike price and expiration are combined with long stock to lock in a nearly risk less profit. The process of executing these three-sided trades is sometimes called conversion arbitrage. See reverse conversion. COST OF CARRY This is the interest cost of holding an asset for a period of time. It is either the cost of funds to finance the purchase (real cost), or the loss of income because funds are diverted from one investment to another (opportunity cost). COVERED A covered option strategy is an investment in which all short options are completely offset with a position in the underlying or a long option in the same asset. The loss potential with such a strategy is therefore limited. COVERED CALL Both long the underlying and short a call. The sale of a call by investors who own the underlying is a common strategy and is used to enhance their return on investment. This strategy is short option (covered) using calls only.

COVERED PUT An option strategy in which a put option is written against a sufficient amount of cash to pay for the stock purchase if the short option is assigned. COVERED COMBO A strategy in which you are long the underlying, short a call, and short a put. Often used by those wishing to own the underlying at a price less than today's price. COVERED STRADDLE An option strategy in which one call and one put with the same strike price and expiration are written against 100 shares of the underlying stock. In actuality, this is not a "covered" strategy because assignment on the short put would require purchase of stock on margin. COVERED STRANGLE A strategy in which one call and one put with the same expiration - but different strike prices are written against 100 shares of the underlying stock. In actuality, this is not a "covered" strategy because assignment on the short put would require purchase of stock on margin. This method is also known as a covered combination. COX-ROSS-RUBINSTEIN A binomial option-pricing model invented by John Cox, Stephen Ross, and Mark Rubinstein. CREDIT The amount you receive for placing a trade. A net inflow of cash into your account as the result of a trade. CREDIT SPREAD A spread strategy that increases the amount's cash balance when it is established. A bull spread with puts and a bear spread with calls are examples of credit spreads. CYCLE See EXPIRATION CYCLE. D DAY ORDER An order to purchase or sell a security, usually at a specified price, that is good for just the trading session on which it is given. It is automatically cancelled on the close of the session if it is not executed.

DAY TRADE A position that is opened and closed on the same day. DEBIT The amount you pay for placing a trade. A net outflow of cash from your account as the result of a trade. DEBIT SPREAD A spread strategy that decreases the amount's cash balance when it is established. A bull spread with calls and a bear spread with puts are examples of debit spreads. DELTA Measures the rate of change in an option's theoretical value for a one-unit change in the underlying. Calls have positive Deltas and puts have negative Deltas. Delta for non-futures based options is the Rupee amount of gain/loss you should experience if the underlying goes up one point. For futures-based options, Delta represents an equivalent number of futures contracts times 100. DELTA NEUTRAL A strategy in which the Delta-adjusted values of the options (plus any position in the underlying) offset one another. To help an existing position become Delta neutral at the current price of the underlying. DIAGONAL CREDIT SPREAD A type of calendar spread. It is a debit transaction where options are purchased in a nearer expiration and options of the same type are sold in a farther expiration, on the same underlying. It is diagonal because the options have different strike prices. DIAGONAL DEBIT SPREAD Type of calendar spread. It is a credit transaction where options are sold in a nearer expiration and options of the same type are purchased in a farther expiration, on the same underlying. It is diagonal because the options have different strike prices. DIRECTIONAL TRADE A trade designed to take advantage of an expected movement in price. DISCOUNT

An adjective used to describe an option that is trading below its intrinsic value. DYNAMIC HEDGING A short-term trading strategy generally using futures contracts to replicate some of the characteristics of option contracts. The strategy takes into account the replicated option's delta and often requires adjusting. E EARLY EXERCISE A feature of American-style options that allows the owner to exercise an option at any time prior to its expiration date. EDGE (1) The spread between the bid and ask price. This is called the trader's edge. (2) The difference between the market price of an option and its theoretical value using an option-pricing model. This is called the theoretical edge. EQUITY OPTION An option on shares of an individual common stock. Also known as a stock option. EUROPEAN STYLE OPTION An option that can only be exercised on the expiration date of the contract. EX-DIVIDEND DATE The day before which an investor must have purchased the stock in order to receive the dividend. On the ex-dividend date, the previous day's closing price is reduced by the amount of the dividend because purchasers of the stock on the ex-dividend date will not receive the dividend payment. EXCHANGE TRADED The generic term used to describe futures, options and other derivative instruments that are traded on an organized exchange. EXERCISE The act by which the holder of an option takes up his rights to buy or sell the underlying at the strike price. The demand of the owner of a call option that the number of units of the underlying specified in the contract be delivered to him at the specified price. The demand by the owner of a

put option contract that the number of units of the underlying asset specified be bought from him at the specified price. EXERCISE PRICE The price at which the owner of a call option contract can buy an underlying asset. The price at which the owner of a put option contract can sell an underlying asset. See STRIKE PRICE. EXOTIC OPTIONS Various over-the-counter options whose terms are very specific, and sometimes unique. Examples include Bermuda options (somewhere between American and European type, this option can be exercised only on certain dates) and look-back options (whose strike price is set at the option's expiration date and varies depending on the level reached by the underlying security). EXPIRATION, EXPIRATION DATE, EXPIRATION MONTH This is the date by which an option contract must be exercised or it becomes void and the holder of the option ceases to have any rights under the contract. All stock and index option contracts expire on the Saturday following the third Friday of the month specified. EXPIRATION CYCLE Traditionally, there were three cycles of expiration dates used in options trading: JANUARY CYCLE (1): January / April / July / October FEBRUARY CYCLE (2): February / May / August / November MARCH CYCLE (3): March / June / September / December Today, equity options expire on a hybrid cycle which involves a total of four option series: the two nearest-term calendar months and the next two months from the traditional cycle to which it has been assigned. F FAIR VALUE See THEORETICAL PRICE, THEORETICAL VALUE. FAR MONTH, FAR TERM See BACK MONTH. FENCE A strategy involving a long call and a short put, or a short call and long put at different strike prices with the same expiration date. When this strategy is established in conjunction with the underlying stock, the three-sided tactic is called a risk conversion (long stock) or a risk reversal (short stock). This strategy is also called a combination. See conversion and reverse conversion.

FILL When an order has been completely executed, it is described as filled. FILL OR KILL (FOK) ORDER This means do it now if the option (or stock) is available in the crowd or from the specialist, otherwise kill the order altogether. Similar to an all-or-none (AON) order, except it is "killed" immediately if it cannot be completely executed as soon as it is announced. Unlike an AON order, the FOK order cannot be used as part of a GTC order. FLEXIBLE EXCHANGE OPTIONS (FLEX) Customized equity and equity index options. The user can specify, within certain limits, the terms of the options, such as exrcise price, expiration date, exercise type, and settlement calculation. Can only be traded in a minimum size, which makes FLEX an institutional product. FRONT MONTH The first month of those listed by an exchange - this is usually the most actively traded contract, but liquidity will move from this to the second month contract as the front month nears expiration. Also known as the NEAR MONTH. FRONTRUNNING An illegal securities transaction based on prior nonpublic knowledge of a forthcoming transaction that will affect the price of a stock. FOLLOW-UP ACTION Term used to describe the trades an investor makes subsequent to implementing a strategy. Through these adjustments, the investor transforms one strategy into a different one in response to price changes in the underlying. FUNDAMENTAL ANALYSIS A method of determining stock prices based on the study of earnings, sales, dividends, and accounting information. FUNGIBILITY Interchangeability resulting from standardization. Options listed on national exchanges are fungible, while over-the-counter options generally are not. FUTURE, FUTURES CONTRACT

A standardized, exchange-traded agreement specifying a quantity and price of a particular type of commodity (soybeans, gold, oil, etc.) to be purchased or sold at a pre-determined date in the future. On contract date, delivery and physical possession take place unless the contract has been closed out. Futures are also available on various financial products and indexes today. G GAMMA Gamma expresses how fast Delta changes with a one-point increase in the price of the underlying. Gamma is positive for all options. If an option has a Delta of 45 and a Gamma of 10, then the option's expected Delta will be 55 if the underlying goes up one point. If we consider Delta to be the velocity of an option, then Gamma is the acceleration. GOOD TILL CANCELED (GTC) ORDER A Good Till Canceled order is one that is effective until it is either filled by the broker or canceled by the investor. This order will automatically cancel at the option's expiration. GREEKS The Greek letters used to describe various measures of the sensitivity of the value of an option with respect to different factors. They include Delta, Gamma, Theta, Rho, and Vega. GUTS The purchase (or sale) of both an in-the-money call and in-the-money put. A box spread can be viewed as the combination of an in-the-money strangle and an out-of-the-money strangle. To differentiate between these two strangles, the term guts refer to the in-the-money strangle. See box spread and strangle. H HAIRCUT Similar to margin required of public customers this term refers to the equity required of floor traders on equity option exchanges. Generally, one of the advantages of being a floor trader is that the haircut is less than margin requirements for public customers. HEDGE A position established with the specific intent of protecting an existing position. Example: an owner of common stock buys a put option to hedge against a possible stock price decline. HISTORIC VOLATILITY

A measure of the actual price fluctuations of the underlying over a specific period of time. We use the term statistical volatility, reserving the word historic to refer to our past historical data for both Implied Volatility (IV) and Statistical Volatility (SV). HORIZONTAL CREDIT SPREAD A type of calendar spread. It is a credit transaction where you buy an option in a nearer expiration month and sell an option of the same type in a farther expiration month, with the same strike price, and in the same underlying asset. HORIZONTAL DEBIT SPREAD A type of calendar spread. It is a debit transaction where you sell an option in a nearer expiration month and buy an option of the same type in a farther expiration month, with the same strike price, and in the same underlying asset. I IMMEDIATE-OR-CANCEL (IOC) ORDER An option order that gives the trading floor an opportunity to partially or totally execute an order with any remaining balance immediately cancelled. ILLIQUID An illiquid market is one that cannot be easily traded without even relatively small orders tending to have a disproportionate impact on prices. This is usually due to a low volume of transactions and/or a small number of participants. IMPLIED VOLATILITY (IV) This is the volatility that the underlying would need to have for the pricing model to produce the same theoretical option price as the actual option price. The term implied volatility comes from the fact that options imply the volatility of their underlying, just by their price. A computer model starts with the actual market price of an option, and measures IV by working the option fair value model backward, solving for volatility (normally an input) as if it were the unknown. In actuality, the fair value model cannot be worked backward. By working forward repeatedly through a series of intelligent guesses until the volatility is found which makes the fair value equal to the actual market price of the option. INDEX The compilation of stocks and their prices into a single number. E.g. The BSE SENSEX / S&P CNX NSE NIFTY.

INDEX OPTION An option that has an index as the underlying. These are usually cash-settled. IN-THE-MONEY (ITM) Term used when the strike price of an option is less than the price of the underlying for a call option, or greater than the price of the underlying for a put option. In other words, the option has an intrinsic value greater than zero. INTRINSIC VALUE Amount of any favorable difference between the strike price of an option and the current price of the underlying (i.e., the amount by which it is in-the-money). The intrinsic value of an out-ofthe-money option is zero. IRON BUTTERFLY An option strategy with limited risk and limited profit potential that involves both a long (or short) straddle and a short (or long) strangle. L LAST TRADING DAY The last business day prior to the option's expiration during which purchases and sales of options can be made. For equity options, this is generally the third Friday of the expiration month. LEAPS Long-term Equity Anticipation Securities, also known as long-dated options. Calls and puts with expiration as long as 2-5 years. Only about 10% of equities have LEAPs. Currently, equity LEAPS have two series at any time, always with January expirations. Some indexes also have LEAPs. LEG Term describing one side of a spread position. LEGGING Term used to describe a risky method of implementing or closing out a spread strategy one side ("leg") at a time. Instead of utilizing a "spread order" to insure that both the written and the purchased options are filled simultaneously, an investor gambles a better deal can be obtained on the price of the spread by implementing it as two separate orders.

LEVERAGE A means of increasing return or worth without increasing investment. Using borrowed funds to increase one's investment return, for example buying stocks on margin. Option contracts are leveraged as they provide the prospect of a high return with little investment. LIMIT ORDER An order placed with a brokerage to buy or sell a predetermined number of contracts (or shares of stock) at a specified price, or better than the specified price. Limit orders also allow an investor to limit the length of time an order can be outstanding before canceled. It can be placed as a day or GTC order. Limit orders typically cost slightly more than market orders but are often better to use, especially with options, because you will always purchase or sell securities at that price or better. LIQUID A liquid market is one in which large deals can be easily traded without the price moving substantially. This is usually due to the involvement of many participants and/or a high volume of transactions. LONG You are long if you have bought more than you have sold in any particular market, commodity, instrument, or contract. Also known as having a long position, you are purchasing a financial asset with the intention of selling it at some time in the future. An asset is purchased long with the expectation of an increase in its price. LONG POSITION A term used to describe either (1) an open position that is expected to benefit from a rise in the price of the underlying stock such as long call, short put, or long stock; or (2) an open position resulting from an opening purchase transaction such as long call, long put, or long stock. LONG BACKSPREAD It involves selling one option nearer the money and buying two (or more) options of the same type farther out-of-the-money, using the same type, in the same expiration, on the same underlying. Requires margin. LONG OPTION Buying an option. See LONG. LONG STRADDLE See STRADDLE.

LONG STRANGLE See STRANGLE. LONG SYNTHETIC See SYNTHETIC. LONG UNDERLYING Buying the underlying (i.e. stock). See LONG. M MARGIN The minimum equity required to support an investment position. To buy on margin refers to borrowing part of the purchase price of a security from a brokerage firm. MARKET BASKET A group of common stocks whose price movement is expected to closely correlate with an index. MARK TO MARKET The revaluation of a position at its current market price. MARKET MAKER A trader or institution that plays a leading role in a market by being prepared to quote a two way price (Bid and Ask) on request - or constantly in the case of some screen based markets - during normal market hours. MARKET ORDER Sometimes referred to as an unrestricted order. It's an order to buy or sell a security immediately at the best available current price. A market order is the only order that guarantees execution. It should be used with caution in placing option trades, because you can end up paying a lot more than you anticipated. MARKET PRICE A combination of the Bid, Ask, and Last prices into a single representative price. When the Bid, Ask, and Last are all available, the default formula for MARKET PRICE is (10*Bid + 10*Ask + Last) / 21. MARKET-NOT-HELD ORDER A type of market order that allows the investor to give discretion regarding the price and/or time at which a trade is executed.

MARKET-ON-CLOSE (MOC) ORDER A type of order which requires that an order be executed at or near the close of a trading day on the day the order is entered. A MOC order, which can be considered a type of day order, cannot be used as part of a GTC order. MARRIED PUT STRATEGY The simultaneous purchase of stock and the corresponding number of put options. This is a limited risk strategy during the life of the puts because the stock can be sold at the strike price of the puts. MID IMPLIED VOLATILITY (MIV) Implied volatility computed based on the mid-point between the Bid and Ask prices. See IMPLIED VOLATILITY. N NAKED An investment in which options sold short are not matched with a long position in either the underlying or another option of the same type that expires at the same time or later than the options sold. The loss potential of naked strategies can be virtually unlimited. NEAR TERM See FRONT MONTH. NET MARGIN REQUIREMENT The equity required in a margin account to support an option position after deducting the premium received from sold options. NEUTRAL An adjective describing the belief that a stock or the market in general will neither rise nor decline significantly. NORMAL DISTRIBUTION A statistical distribution where observations are evenly distributed around the mean. Studies have shown that stock prices are very close to being log normally distributed over time. When you choose bell curve as a price target in the program, a lognormal distribution based on price, volatility, and time until valuation date is constructed. NOT-HELD ORDER

An order that gives a broker discretion as to the price and timing in executing the best possible trade. By placing this order, a customer agrees to not hold the broker responsible if the best deal is not obtained. O OFFER See ASK. ONE-CANCELS-THE-OTHER (OCO) ORDER Type of order which treats two or more option orders as a package, whereby the execution of any one of the orders causes all the orders to be reduced by the same amount. Can be placed as a day or GTC order. OPEN INTEREST The cumulative total of all option contracts of a particular series sold, but not yet repurchased or exercised. OPEN ORDER An order that has been placed with the broker, but not yet executed or canceled. OPENING TRANSACTION An addition to, or creation of, a trading position. OPTION A contract that gives the buyer the right, but not the obligation, to buy or sell a particular asset (the underlying security) at a fixed price for a specific period of time. The contract also obligates the seller to meet the terms of delivery if the contract right is exercised by the buyer. OPTION CHAIN A list of the options available for a given underlying. OPTIONS CLEARING CORPORATION (OCC) A corporation owned by the exchanges that trade listed stock options; OCC is an intermediary between option buyers and sellers. OCC issues and guarantees all option contracts. OPTION PERIOD The time from when an option contract is created to the expiration date. OPTION PRICING CURVE

A graphical representation of the estimated theoretical value of an option at one point of time, at various prices of the underlying asset. OPTION PRICING MODEL A mathematical formula used to calculate the theoretical value of an option. See BLACKSCHOLES MODEL and BINOMIAL MODEL. OPTION WRITER The seller of an option contract who is obligated to meet the terms of delivery if the option holder exercises his right. OUT-OF-THE-MONEY (OTM) An out-of-the-money option is one whose strike price is unfavorable in comparison to the current price of the underlying. This means when the strike price of a call is greater than the price of the underlying, or the strike price of a put is less than the price of the underlying. An out-of-themoney option has no intrinsic value, only time value. OVERVALUED An adjective used to describe an option that is trading at a price higher that its theoretical value. It must be remembered that this is a subjective evaluation, because theoretical value depends on one subjective input - the volatility estimate. OVERWRITE An option strategy involving the sale of a call option against an existing long stock position. This is different from the covered - write strategy, which involves the simultaneous purchase of stock and sale of a call. P PARITY An adjective used to describe the difference between the stock price and the strike price of an inthe-money option. When an option is trading at its intrinsic value, it is said to be trading at parity. POSITION The combined total of an investor's open option contracts and long or short stock. POSITION LIMITS

The maximum number of open option contracts that an investor can hold in one account or a group of related accounts. Some exchange express the limit in terms of option contracts on the same side of the market, and others express it in terms of total long or short delta. POSITION TRADING An investing strategy in which open positions are held for an extended period of time. PREMIUM (1) Total price of an option: intrinsic value plus time value. (2) Often this word is used to mean the same as time value. PROFIT GRAPH A graphical presentation of the profit-and-loss possibilities of an investment strategy at one point in time (usually option expiration), at various stock prices. PUT This option contract conveys the right to sell a standard quantity of a specified asset at a fixed price per unit (the strike price) for a limited length of time (until expiration). PUT/CALL RATIO This ratio is used by many as a leading indicator. It is computed by dividing the 4-day average of total put VOLUME by the 4-day average of total call VOLUME. PUT RATIO BACKSPREAD In the Trade Finder, a long backspread using puts only. R RATIO CALENDAR COMBINATION A term used loosely to describe any variation on an investment strategy that involves both puts and calls in unequal quantities and at least two different strike prices and two different expirations. RATIO CALENDAR SPREAD An investment strategy in which more short-term options are sold than longer-term options are purchased. RATIO SPREAD

(1) Most commonly used to describe the purchase of near-the-money options and the sale of a greater number of farther out-of-the-money options, with all options having the same expiration date. (2) Generally used to describe any investment strategy in which options are bought and sold in unequal numbers or on a greater than one-for-one basis with the underlying stock. REALIZED GAINS AND LOSSES The profit or losses received or paid when a closing transaction is made and matched together with an opening transaction. RESISTANCE A term used in technical analysis to describe a price area at which rising price action is expected to stop or meet increased selling activity. This analysis is based on historic price behavior of the stock. REVERSAL A short position in the underlying protected by a synthetic long. REVERSE CONVERSION An investment strategy used by professional option traders in which a short put and long call with the same strike price and expiration are combined with short stock to lock in a nearly risk less profit. The process of executing these three-sided trades is sometimes called reversal arbitrage. RHO The change in the value of an option with respect to a unit change in the risk-free rate. RISK-FREE RATE The term used to describe the prevailing rate of interest for securities issued by the government of the country of the currency concerned. It is used in the pricing models. ROLLOVER Moving a position from one expiration date to another further into the future. As the front month approaches expiration, traders wishing to maintain their positions will often move them to the next contract month. This is accomplished by a simultaneous sale of one and purchase of the other. ROUND TURN

When an option contract is bought and then sold (or sold and then bought). The second trade cancels the first, leaving only a profit or loss. This process is referred to as a round turn. Brokerage charges are usually quoted on this basis. S SCALPER A trader on the floor of an exchange who hopes to buy on the bid price, sell on the ask price, and profit from moment to moment price movements. Risk is limited by the very short time duration (usually 10 seconds to 3 minutes) of maintaining any one position. SEC The Securities and Exchange Commission. The SEC is the United States federal government agency that regulates the securities industry. SECTOR INDICES Indices that measure the performance of a narrow market segment, such as biotechnology or small capitalization stocks. SETTLEMENT PRICE The official price at the end of a trading session. This price is established by The Options Clearing Corporation and is used to determine changes in account equity, margin requirements, and for other purposes. See mark-to-market. SHORT An obligation to purchase an asset at some time in the future. You are short if you have sold more than you have bought in any particular market, commodity, instrument, or contract. Also known as having a short position. An asset is sold short with the expectation of a decline in its price. Can have almost unlimited risk. Short option (covered), short option (naked), and short underlying are strategies available in the Trade Finder. Uncovered short positions require margin. SHORT BACKSPREAD It involves buying one option nearer the money and selling two (or more) options of the same type farther out-of-the-money, with the same expiration, on the same underlying. Requires margin. SHORT OPTION (COVERED) See COVERED CALL. SHORT OPTION (NAKED)

Selling an option you don't own. See SHORT. SHORT STRADDLE See STRADDLE. SHORT STRANGLE See STRANGLE. SHORT SYNTHETIC See SYNTHETIC. SHORT UNDERLYING Selling an asset you don't own. See SHORT. SLIPPAGE Thinly traded options have a wider Bid-Ask spread than heavily traded options. Therefore, you have to "give" more in order to execute a trade in thinly traded options; less in heavily traded ones. This "give" is what we refer to as slippage. The slippage model is a sophisticated formula that takes into account the volume of your prospective trade in relation to the average daily volume in the option. You can choose four different degrees of slippage; large, moderate, small or none. Adjustments should be made base on your trading experience. SPREAD A trading strategy involving two or more legs, the incorporation of one or more of which is designed to reduce the risk involved in the others. SPREAD ORDER This is an order for the simultaneous purchase and sale of two (or more) options of the same type on the same underlying. If placed with a limit, the two options must be filled for a specified price difference, or better. It can be critical in this type of order to specify whether it is an opening transaction or a closing transaction. STANDARD DEVIATION The square root of the mean of the squares of the deviations of each member of a population (in simple terms, a group of prices) from their mean. In a normal distribution (or bell curve), one standard deviation encompasses 68% of all possible outcomes. STATISTICAL VOLATILITY (SV) Measures the magnitude of the asset's recent price swings on a percentage basis. It can be measured using any recent sample period. The default is 20 days. Regardless of the length of the sample period, SV is always normalized to represent a one-year, single Standard Deviation price move of the underlying.

Note: It is important to remember that what is needed for accurate options pricing is near-term future volatility, which is something that nobody knows for sure. STRAP A strategy involving two calls and one put. All options have the same strike price, expiration, and underlying stock. STOCK INDEX FUTURES A futures contract that has as its underlying entity a stock market index. Such futures contracts are generally subject to cash settlement. STOP ORDER "Stop-Loss" and "Stop-Limit" orders placed on options are activated when there is a trade at that price only on the specific exchange on which the order is located. They are orders to trade when its price falls to a particular point, often used to limit an investor's losses. It's an especially good idea to use a stop order if you will be unable to watch your positions for an extended period. STRADDLE A strategy involving the purchase (or sale) of both call and put options with the same strike price, same expiration, and on the same underlying. A short straddle means that both the call and put are sold short, for a credit. A long straddle means that both the call and put are bought long, for a debit. STRANGLE A strategy involving the purchase or sale of both call and put options with different strike prices - normally of equal, but opposite, Deltas. The options share the same expiration and the same underlying. A strangle is usually a position in out-of-the-money options. A short strangle means that both the calls and puts are sold short, for a credit. A long strangle means both the calls and puts are bought long, for a debit. STRATEGY, STRATEGIES An option strategy is any one of a variety of option investments. It involves the combination of the underlying and/or options at the same time to create the desired investment portfolio and risk. STRIKE PRICE The price at which the holder of an option has the right to buy or sell the underlying. This is a fixed price per unit and is specified in the option contract. Also known as striking price or exercise price.

SUPPORT A term used in technical analysis to describe a price area at which falling price action is expected to stop or meet increased buying activity. This analysis is based on previous price behavior of the stock. SYNTHETIC A strategy that uses options to mimic the underlying asset. Both long and short synthetics are strategies in the Trade Finder. The long synthetic combines a long call and a short put to mimic a long position in the underlying. The short synthetic combines a short call and a long put to mimic a short position in the underlying. In both cases, both the call and put have the same strike price, the same expiration, and are on the same underlying. T TECHNICAL ANALYSIS Method of predicting future price movements based on historical market data such as (among others) the prices themselves, trading volume, open interest, the relation of advancing issues to declining issues, and short selling volume. THEORETICAL VALUE, THEORETICAL PRICE This is the mathematically calculated value of an option. It is determined by (1) the strike price of the option, (2) the current price of the underlying, (3) the amount of time until expiration, (4) the volatility of the underlying, and (5) the current interest rate. THETA The sensitivity of the value of an option with respect to the time remaining to expiration. It is the daily drop in Rupee value of an option due to the effect of time alone. Theta is Rupees lost per day, per contract. Negative Theta signifies a long option position (or a debit spread); positive Theta signifies a short option position (or a credit spread). TICK The smallest unit price change allowed in trading a specific security. This varies by security, and can also be dependent on the current price of the security. TIME DECAY Term used to describe how the theoretical value of an option "erodes" or reduces with the passage of time. Time decay is quantified by Theta. TIME SPREAD See CALENDAR SPREAD.

TIME PREMIUM Also known as "Time Value", this is the amount that the value of an option exceeds its intrinsic value. It reflects the statistical possibility that an option will reach expiration with intrinsic value rather than finishing at zero Rupees. If an option is out-of-the-money then its entire value consists of time premium. TRADER (1) Any investor who makes frequent purchases and sales. (2) A member of an exchange who conducts his buying and selling on the trading floor of the exchange. TRADE HALT A temporary suspension of trading in a particular issue due to an order imbalance, or in anticipation of a major news announcement. An industry-wide trading halt can occur if the BSE SENSEX falls below parameters set by the BSE. TRADING PIT A specific location on the trading floor of an exchange designated for the trading of a specific option class or stock. TRADING ROTATION A trading procedure on exchange floor in which bids and offers are made on specific options in a sequential order. Opening trading rotations are conducted to guarantee all entitled public orders an execution. At times of extreme market activity, a closing trading rotation can also be conducted. TRANSACTION COSTS All charges associated with executing a trade and maintaining a position, including brokerage commissions, fees for exercise and/or assignment, and margin interest. TRUE DELTA, TRUE GAMMA More accurate than standard Delta and Gamma. Projects a change in volatility when projecting a change in price. Taking this volatility shift into account gives a more accurate representation of the true behavior of the option. TYPE The type of option. The classification of an option contract as either a call or put. U

UNCOVERED A short option position that is not fully collateralized if notification of assignment is received. See also NAKED. UNDERLYING This is the asset specified in an option contract that is transferred when the option contract is exercised, unless cash-settled. With cash-settled options, only cash changes hands, based on the current price of the underlying. UNREALIZED GAIN OR LOSS The difference between the original cost of an open position and its current market price. Once the position is closed, it becomes a realized gain or loss. UNDERVALUED An adjective used to describe an option that is trading at a price lower than its theoretical value. It must be remembered that this is a subjective evaluation because theoretical value depends on one subjective input - the volatility estimate. V VEGA A measure of the sensitivity of the value of an option at a particular point in time to changes in volatility. Also known as "Kappa" and "Lambda". Vega is the Rupee amount of gain or loss you should theoretically experience if implied volatility goes up one percentage point. VERTICAL CREDIT SPREAD The purchase and sale for a net credit of two options of the same type but different strike prices. They must have the same expiration, and be on the same underlying. See also BULL PUT SPREAD and BEAR CALL SPREAD. VERTICAL DEBIT SPREAD The purchase and sale for a net debit of two options of the same type but different strike prices. They must have the same expiration, and be on the same underlying. See also BULL CALL SPREAD and BEAR PUT SPREAD. VOLATILITY

Volatility is a measure of the amount by which an asset has fluctuated, or is expected to fluctuate, in a given period of time. Assets with greater volatility exhibit wider price swings and their options are higher in price than less volatile assets. Volatility is not equivalent to BETA. VOLATILITY TRADE A trade designed to take advantage of an expected change in volatility. VOLUME The quantity of trading in a market or security. It can be measured by Rupees or units traded (i.e. number of contracts for options, or number of shares for stocks). W WASH SALE When an investor repurchases an asset within 30 days of the sale date and reports the original sale as a tax loss. The Internal Revenue Service prohibits wash sales since no change in ownership takes place. WASTING ASSET An investment with a finite life, the value of which decreases over time if there is no price fluctuation in the underlying asset. WRITE, WRITER To sell an option that is not owned through an opening sale transaction. While this position remains open, the writer is obligated to fulfill the terms of that option contract if the option is assigned. An investor who sells an option is called the writer, regardless of whether the option is covered or uncovered. Y YATES MODEL The Yates pricing model is a refined version of the Black-Scholes pricing model that takes into account dividends and the possibility of early exercise.