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OptionsPhysics Basics covers all of those questions you want answered but are too afraid to ask. The modules are designed to walk you through the very beginning of why you should consider an option, through the basics of brokers and even an introduction to volatility. Each module contains several lessons, learning objectives and recommended exercises.

Below are the 7 OptionsPhysics Basic modules:

Module 1: Why should you consider options (6 lessons)
Module 2: Options basics (7 lessons)
Module 3: How not to be a sucker (4 lessons)
Module 4: Brokerage basics (6 lessons)
Module 5: Puts & Calls (6 lessons)
Module 6: Basic put-call parity (6 lessons)
Module 7: Volatility (9 lessons)

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Introduction / Learning Outcomes:

“We can accept what the economy and stocks hand us, but we don’t have to be entirely satisfied with those returns – not when we have options.” Join us in the first module for options basics. This module covers some of the differences between a stock and an option, how options have the potential to generate returns in any economy as well as how to choose an option. Specifically, in this module you shall learn:

1. The differences between a stock and an option.
2. The meaning of stagflation.
3. Where to find Warren Buffet’s current thoughts on the market and the overall economy.
4. How an option can be profitable while the underlying stock rises in value.
5. Expected return.
6. Risk versus return for an option.
7. How to choose a strike price.
8. The good and bad of leveraged options.
9. How to choose an expiration date.

Recommended Exercises:

1. Find Warren Buffett’s quarterly and annual reports.
2. Read Warren Buffett’s most recent report.
3. Describe how options alter your risk-reward profile.
4. Identify an out-of-the-money option, an in-the-money option and an at-the-money option on the ETF, SPY.
5. Calculate the potential profitability of an at-the-money call option on the ETF, SPY if the SPY increases by 50%.
6. Describe the leverage of an in-the-money call option.

Describe why a longer-dated option is more expensive than a shorter-dated option.

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Does it look like It’s Deja Vu, All Over Again?

 Do you own any stocks or mutual funds today that you also owned in the year 2000?

If so, you might be experiencing deja vu because just when we got to new all-time highs in the broad stock averages (coincidentally, not far from the highs of 2000), we have sharply reversed course and are now entering a period of much lower expectations for the economy and for investment returns–just like when the tech bubble burst at the birth of the new millennium and stocks tumbled for 3 years, sending the NASDAQ from 5,000 to 1,500 (down over 70%) and the Dow from 11,700 to 8,000 (down nearly 32%).

The investing landscape might be different in some ways–the NASDAQ is still less than half the value it was in 2000, and we are not feeling the immediate fright of terrorist attacks every day like we did after 9/11 and into 2002–but what both periods seem to have in common is a slowdown in the country’s economic activity and growth, aka, a recession. And as any experienced investor or student of economics will tell you, stocks typically don’t do very well when the economy enters a recession.

Some people might think It Just Isn’t Fair!

So you mean to tell me that 8 years ago the stock market made new highs close to 12,000 on the Dow and over 1,500 on the broader S&P 500 index, and now we slightly exceeded those levels 8 years later only to start heading back down again? Yes, the bad news is that we are right back where we started. If you owned GE or PFE or MSFT in 2000 you watched your investments get cut in half by the time 2003 began. And in 2007 you felt a little better as they recovered, not nearly back to where you were in terms of gains 7 years ago, but hopeful that these were still “blue chip” stocks you could own for another 7 years and do well with.

Many professional money managers, responsible for the investment decisions involving hundreds of billions in retirement accounts, mutual funds, and institutional portfolios, will tell you that this is just a normal market cycle “correction” and that the long-term, “fundamental” trend of American capital growth, productivity, and technological dominance will continue after the current market turmoil caused merely by bad mortgage lending practices is washed out. Other market watchers, possibly with less money on the line, are less sanguine. These doubters think that the systemic crisis in the banking system, combined with $100 oil prices and the falling dollar, spell doom for stock prices as the economy enters what could be a much deeper recession, like the ones we saw in 1989-91 and 1973-74.

Is it really that bad? I’ll share the recent views of the world’s greatest investor in Part 2 of our discussion Why Should I Consider Options?

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Part 2 of “Why Should I Consider Options?”

My earlier comparison of today’s economic situation to the 1970’s slowdown is especially worrisome. That’s because today looks in some ways a lot like that period and conjures a phrase that would scare even the most veteran of investors—stagflation! This is an unusually nasty confluence of factors: receding growth (thus, recession) plus higher prices that fuel inflation while at the same time a drop in the dollar on world foreign exchange markets, lowering the purchasing of our currency. It’s a vicious cycle and, some would say, a market bear’s perfect storm.

A Voice of Experience in the Wilderness

Is there a middle point of view in this mess? It sure would be nice to hear from an experienced and successful investor who tells it like it is and who has nothing to promote or hide. Maybe we should call Warren Buffett and see what he thinks. As a matter of fact, that isn’t so hard to do after all. Mr. Buffett is always sharing his folksy–and successful–opinions with the investment community. His quarterly and annual reports to his shareholders are required reading for some smart investors. And journalists are always trying to get him to either reveal his secrets or share his views on the latest business news and trends. Whether he likes to or not isn’t clear. He doesn’t seem like the celebrity investor the media makes him out to be. But maybe he can’t help responding to a few of the hundreds of requests he must get every month to opine.

So, what does the Oracle of Omaha have to say this month? You don’t want to know. Warren is telling us that we should get used to lower stock market returns for a few more years. He says that the annualized double-digit returns we had gotten used to in the 80’s and 90’s are gone for a while now–maybe for the next 10 years. Single-digit returns, therefore, are part of the new investing landscape we should grow accustomed to. What he is referring to of course is the overall annualized returns of the broad stock market averages, the Dow and the S&P. That means that many individual stocks will probably do much better, and much worse, than those average single-digit gains.

What’s an Investor To Do?

Faced with an economy and a stock market that won’t naturally elevate your portfolio leaves you wondering what your options for investment success are. How will you save for a new home, or that business you want to start, while also planning for your kids’ college funds and building a secure retirement? Something’s gotta give. Or does it? Speaking of options for investment success, there is in fact a way to supplement your regular investing returns of single-digits from your mutual funds, which strive to track or beat the stock market with underwhelming success (most mutual funds don’t). That way is with an investment vehicle that is specially built for double-digit, and sometimes triple-digit, returns, with very reasonable and controllable risk. Of course, we are talking about equity options.

Join me in Part 3 of this discussion and we’ll profile what options can do for us and why we should consider their use.

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Why Should I Consider Options? Part 3

Equity options are some of the most versatile investment vehicles you can have regular access to. Few other alternatives match their terrific combination of benefits: low cost and low risk with high leverage and high flexibility. What follows is an example of the choices that options can give you.

Say that you want to invest in Apple stock because you believe it could go to $200 by the next holiday season on sales of its new products. But, you also realize that this is a volatile and risk time in the markets and you don’t want to shell out $12,500 on an equally volatile and risky stock to purchase 100 shares at its current price of $125. So you look at some option quotes and find that you can buy a 9-month call option on the $135 strike for a $10.00 premium (the price of the option).

A call option provides the buyer with the right, but not the obligation, to buy the underlying stock at the strike price before the option expires. This costs you $1,000 ($10.00 premium times the 100 shares that each option contract represents) and allows you to buy 100 shares of Apple at the price of $135 any time up until the option expires in 9 months. If Apple goes to $175, you will profit by the difference between your strike price of $135 and the current price of $175, minus your initial cost of $1,000. You can either sell the option before it expires, or you can exercise your option and then deposit the necessary funds to buy 100 shares at $135.

In this case, your profit would be $3,000 ($175 minus $135 = $40 times 100 shares, and then subtracting your investment of $1,000 leaves you with a $3,000 profit). This profit represents a 300% return on your money in only 9 months! That sure beats a single-digit return. And it even beats the 40% return you would have realized had you bought 100 shares of Apple at $125 and sold them at $175 ($12,500 investment appreciates to $17,500). You should know that you could also lose your entire $1,000 investment if Apple shares do not rise above $135 before expiration of your option.

But, you also have other possible ways to profit. Anytime between now and expiration, you will be able to sell your option back at whatever price it is trading in the options marketplace. One scenario that may develop is that in 6 months time, Apple shares are trading at $150 and your option is trading at $20 with 3 months left to expiration. Here, your $135 strike call option has an intrinsic value of $15.00 (current stock price of $150 minus the strike price of $135 = $15.00 of actual, or intrinsic, value in this option). The remaining $5.00 of extrinsic value is also called time value. You could sell your option that you paid a $10.00 premium on for $20.00 now. That equals a 100% return in only 6 months. Again, not too bad.

These are common examples of what can be achieved with options. As always, options are not appropriate for every investor and there is a risk of loss of your entire investment. You should consult with your broker for all the details about options use and risks.

Considering the risks of options against their incredible benefits, a smart investor would do well to learn more about them—especially in the current economic environment where we might expect the stock market to give us mediocre, single-digit returns for the next few years. We can accept what the economy and stocks hand us, but we don’t have to be entirely satisfied with those returns—not when we have options.

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Introduction / Learning Outcomes:

“Options equal limited control, for a limited price.” Join us for our second series of options basics videos. This series dives much more deeply into what an option is, who uses options and whether or not you can benefit from learning more about them. Specifically, you shall learn:

1. Understand how stocks are the basis for options.
2. Describe what options are.
3. Describe who uses options.
4. Understand what the strike price is.
5. Understand why options are some much more inexpensive than equities.
6. Why sellers of options have more risk than buyers of options.
7. Break-even points.
8. How to calculate real profit from an option.
9. Explain the difference between in-the-money, at-the-money and out-of-the-money.
10. Describe what intrinsic value is.

Recommended Exercises:

1. Look at an option chain.
2. Determine what the strike price and expiration of an option is on an options chain.
3. Go to the Options Clearing Corporation website.
4. Read through the Characteristics and Risks of Standardized Options.
5. Explain how an option has a limited life.
6. Calculate the break-even of a long call option on the ETF SPY.
7. Describe why longer-dated options are more expensive than shorter-dated options.
8. Find a broker’s policy on exercising options.
9. Demonstrate how to profit from exercising a long call.
10. Find an option which is in-the-money, out-of-the-money and at-the-money.
11. Demonstrate how to profit from the increase in value of an option.
12. Discuss what intrinsic value of an option is.

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Options Basics 101: Introducing Financial Power Tools Every Investor Should Know About

Lesson 1—Am I an Investor Who’s Ready to Learn about Options?

What exactly are options? Aren’t they complicated and risky investments, just for use by traders and Wall St. pros?
In this series of basic option terms and uses, we are going to answer those two questions and a whole lot more. If you’ve never used an option, or never even learned what options are, don’t worry. By the end of this series on Options Basics, you will have a good grasp of what options are for, who uses them, and whether or not you can benefit from learning more about them. Eventually, you may feel comfortable enough in your knowledge to start using options yourself.

First, before you can successfully learn about options, you should have a basic understanding of what a stock is as an investment. When you learn about investing, you have to deal with concepts like rates of return, liquidity, and risk tolerance. I remember when I first started down this road; I came across a handy acronym to remember those ideas. SLY, stands for safety, liquidity, yield—three of the most important criteria for evaluating any investment. You may not consider yourself a “sly as a fox” investor, but even when you begin to compare safety vs. yield, you enter the realm of cunning investing because you are learning to balance risk and reward. We recommend that you learn as much about investing as you can before trading options. There are so many terrific resources available in print and online for you to do this; I almost don’t know where to send you first. Reading a financial newspaper like the Wall St. Journal whenever you can is an invaluable way to educate yourself on the language and practices of professional investors. And here’s a handy book that you might find a useful introduction—What You Need to Know Before You Invest published by Barron’s in this 3rd edition, 2003.

If you already have a good idea of what a stock is as an investment, then you are ready to understand options. Options are another way of investing in stocks, but with a lot more flexibility. You can do things with an option that you can’t do with a stock. An option is a legally binding contract which grants the buyer of the option the right, but not the obligation, to purchase or sell stock at some future date, at a specific price. That specific price is known as the strike price. Every option has a strike price that determines at what price the option grants the right to buy or sell the underlying stock. If you don’t understand how the strike price works, fear not. We’ll go over plenty of examples in coming lessons.

Before I tell you more about how options work, I need to tell you that options involve risk and may not be suitable for every investor. I should also direct your attention to a very important document provided by the Options Clearing Corporation, the institution charged with the regulation and efficient, fair handling of option transactions. Characteristics and Risks of Standardized Options is necessary reading for any options investor, and can be found on the OCC website or through your broker. This is not just a legal disclaimer—I really believe you can benefit from reviewing this publication and referring to it often.

Options can be thought of as an insurance product. Investors use options to protect their current holdings of stock, often called equity. The investing universe is full of risks, and options used intelligently, are tools that help minimize and control some of those risks. There are two primary types of options—calls and puts. A call option gives you the right to buy stock, and a put option gives you the right to sell stock. Sounds good so far, right? An option sounds like it gives you exactly what it should—a choice, in the form of a right to do something you may want to do in the future. Let’s dive a little deeper into this right.

Every option contract represents 100 shares of the underlying stock. For instance, 1 call option contract for Boeing stock, symbol BA, is equal to the right to buy 100 shares of BA stock. Options contracts are standardized like this in set amounts of 100 shares to make it easy for investors and traders to use options. If options contracts were customized for varying amounts, then it would be difficult to trade them back and forth. Standardization makes options fungible. That’s a fancy word for easily transferable.

If you ask me, I think options are just plain fun. In dozens of free lessons on our site here at OptionsNews.com, through our premier education channel OptionsPhysics, you can learn everything you ever wanted to know about options. We try and take you from “never-touched-an-option” before to being ready to make your first trades—and all the way to professional-level training if that’s an ultimate goal for you. Whatever your investing goals, options can be a simple—and some would say, necessary—tool.

At this point, you might be wondering why someone would invest in an option instead of simply buying the stock itself. The primary reasons are that options are generally a cheaper and less risky way to invest in stocks. You can often buy a call option for less than $5 on a $100 stock and once you own the option, it gives you the right, but not the obligation, to buy the stock for a certain price at a later date. And your total risk can be limited to that $5 you paid. That means, in the case of a $5 option on a $100 stock, you are able to control 100 shares of stock for 1/20th of their full value.

So why are options so affordable and why do they let you have so much control for so little investment? We’ll answer that question and look at a specific example of a call option investment in Options Basics, Lesson 2.

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Options Basics 101: Financial Power Tools Every Investor Should Know About

Lesson 2—Why Are Options So Inexpensive?

Before we jump into why options are so affordable compared to their underlying stocks, I want to tell you that option contracts exist for all kinds of financial products—bonds, commodities, foreign currencies, and stock indexes like the Dow and the S&P 500. These are all just different kinds of underlying products, or financial instruments that can have option contracts investors use to buy or sell the instruments.

And options on all these instruments work basically the same, with only some minor differences. So, what you are learning here about options will help you understand a whole universe of investing vehicles. We’ll stick to talking about stock options, aka equity options, in the next few lessons.

Remember our definition of an option? We said that an option is a legally binding contract which grants the buyer of the option the right, but not the obligation, to purchase or sell stock at some future date, at a specific price. Both the specific price, the strike price, and the future date are pre-determined in the options contract. That future date is called the option expiration, and it helps us answer our next question—why are options so inexpensive compared to the underlying stock?

The main reason that options are so affordable compared to their underlying stocks is that options have limited life. When you buy a stock, you could conceivably own that stock forever. But, every option contract is only good for a set period of time. So, you will often hear options talked about with specific expiration months. For example, the January 2009 calls expire on a certain day in that month—the third Friday—and can no longer be traded afterwards because they will no longer exist.

When the option contract expires, you no longer have the right to buy the underlying stock. So, options give you control over the right to buy or sell stock at a specific price, until a specific date, and that control in effect “buys you time” to make the bigger investment decision of buying or selling the actual stock. But, because of the time limit on the life of the option, there is a limit on its value. Options equal limited control, for a limited price.

There are a few other factors besides time that affect the prices of options. And some of them make options really fascinating—I can’t wait to show you! We’ll be exploring those cool factors in coming lessons.

Now, the best way to learn about investing in options is to run through some specific examples of how they work for investors. In our next 2 lessons in this series, we’ll look at our first example of an option investment by using a call option to invest in Apple. We’ll also introduce the very important idea of option exercise, which is how you turn your option contract rights into real stock.

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Options Basics 101: Financial Power Tools Every Investor Should Know About

Lesson 3—The Call Option as an Investment

Let’s look at a call option investment in Apple stock. Pretend you love this company for a moment—I mean you don’t have to be a Mac Fanatic, but say you believe enough in their products and business strategy to become an investor in Apple. You notice the stock, symbol AAPL, is trading around $150 per share in mid-April and you really believe that it will rise back up to the $200 level it saw last year as sales of its new products begin to ramp up before the 2008 Holidays. Even if everybody you know already has an I-pod, my kids are always finding new ways to break theirs or crash the computer and make me buy all those songs again. So, I think it’s a safe bet that they sell a few more this year.

Anyway, you want to buy 100 shares of AAPL, but you don’t have the $15,000 it would require. You only have $10,000 available for an investment in stocks. You could just buy $10,000 worth of AAPL shares and be done, which would get you about 66 shares—but a friend who trades options told you about a way you can invest less than $2,000 right now and control the right to buy 100 AAPL shares for up to 9 months. Even better, you only have to put up the rest of the money to buy the 100 shares of stock if the stock price goes higher, as you predict, and then only if you want to. Sounds like your friend is talking about one of the most perfect investments on the planet—the call option. We’ll look at all your choices as we breakdown an actual trade.

First, your friend shows you how to look up option prices on your broker’s website. You can do this through an option chain, which is a display of all the listed options for a particular stock, organized according to contract expiration month and strike price for both calls and puts.

Remember, the strike price is the pre-determined part of the option contract that tells you at what price you can buy or sell the stock. Since we are talking now about a call option investment, we are just concerned with where we can buy the stock. Puts will be a topic we cover after we fully understand the call. But, here’s a great way to think about strike prices. For stocks trading above $50, the options exchanges will list option contracts available to trade at every $5 interval in the stock’s recent range. So, from $50 to $75 there’s going to be an option contracts “struck” at 55, 60, 65, 70, and 75. Once again you can see that options are full of choices.

Okay, now what does the option chain show us. With AAPL trading around $150, there are call option strikes listed for trading at every $5 interval from $100 to $200. Let’s say the $175 strike is trading at $8 for the October 2008 expiration, which means for just $800—100 shares in the option contract x $8—we can own the right, but not the obligation, to buy 100 shares of AAPL at $175 any time before the October expiration. We also look at the January 2009 175 call option, and see it’s trading for around $15, which means it will cost us $1,500 but give us rights until January.

Hey, our time’s up for this lesson. Join me in lesson 4 where we’ll look at different ways these investments can play out and why the October and January options have different prices.

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Options Basics 101: Financial Power Tools Every Investor Should Know About
Lesson 4—Profit and Loss Potential on Our Call Option Investment

Before we continue our breakdown of a call option investment in AAPL, I want to double-back on an important theme we talked about in Lesson 2, namely why options are so affordable compared to their underlying stocks. I should emphasize another reason for this, that may seem obvious, but it’s definitely worth repeating. Options are cheaper than their underlying stocks because they don’t grant ownership of stock. They only grant the right to buy or sell stock. To invest in stock using options, you don’t have to pay the full cost of the stock when you buy an option. Only if and when you decide to turn your option into the actual stock, will you then have to provide the full funds necessary to take ownership of the stock.

Okay, back to Apple. We found that an October 2008 $175 call on AAPL was trading for $8 per share, while the Jan 2009 $175 call was trading for $15 per share. It would be nice to invest only $800 instead of $1,500, but then our option wouldn’t last as long and we might miss the Holiday push we expect in Apple shares. Why does the option with more time until expiration cost more money?

Recall our discussion about an option’s main trade-off—limited price for limited life. And if it helps, you can think of any investment as having a time value component. Generally, the longer that investors part with their money, or their obligation to take on risk, the more they want to be compensated. The person who sold you the option contract has risk that extends forward in time to the option expiration. Thus, options with more time left will cost more because the investors who sell the options have risk for a longer period of time. In our example, the option that expires in October of 2008 will be cheaper than the same type of option that expires in January of 2009. As the buyer of the option, your risk is only what you paid for it. But, the option seller, often called the writer of the option, has much more risk that we’ll explain soon. All you need to keep in mind now is that the more time you want to buy for your option investment, the more you will have to pay upfront for that option.

So, let’s see what could happen if we buy the AAPL January 2009 175 call option. We place an order with our broker to buy the option by paying the amount of the option’s premium, which is the term commonly used for an option’s price. We’ll say that the current bid/ask on this option is $14.80 bid and $15.00 ask. If we place a market order, we may likely get our order filled at the ask price of $15.00, but we may also pay higher if the market moves between now and the matching of our order. With AAPL shares still at $150, our call option to buy at $175 is worth only the time value that the market gives it. We don’t want to buy AAPL stock at $175 when it is trading $150—we made this investment for the chance to buy it there if it goes to $200 like we think it might. Why didn’t we buy the $150 call option? Well it was trading for $25 and would have cost us $2,500 to own that option.

Assuming we are now owner’s of this option contract at $15.00, we will begin to realize a profit as soon as AAPL stock goes above the strike price by the premium amount, while our option is still alive. We are ignoring other costs right now like commissions. So, if AAPL shares rise to $190, we will be at our break-even point for this investment because the strike price of $175 plus the premium of $15 we paid = $190. Every dollar per share above $190, becomes potential profit for us because we own the right to buy 100 AAPL shares at $175 and we only paid $15.

Let’s pretend for a moment that AAPL shares do extremely well between now and our option’s expiration and they rise to $220. How much will our potential profit be? $220 – $190 = $30 potential profit per share. So, how do we turn this potential profit into a real profit? We’ll get to that in our next lesson, and we’ll also consider what happens if the stock doesn’t rise.

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Options Basics 101: Financial Power Tools Every Investor Should Know About
Lesson 5—Profit and Loss Potential on Our Call Option Investment, part 2

In lesson 4 we talked about how we can profit from the AAPL call option we bought. Just to review our investment position, we own one 175 strike call with a January 2009 expiration. We bought this option for a $15 premium… premium is just another term for the price of the option, sort of like an insurance premium. And remember, options can be thought of as an insurance product, because investors use them as a low-risk, low-cost way to control their investment risks. This will become especially clear when we talk about how to use put options to protect your investments from occasional drops in their value.

Another term we need to become familiar with is exercise. It describes one of the actions we can take to realize our profit on our AAPL call. Last time we looked at what our profit might be if AAPL stock rose to $220. Our 175 strike call gives us the right to buy AAPL at $175 per share, so right away we can see that this was a profitable investment. Exercise is the formal process of turning our call option rights into real stock. We do that by notifying our broker anytime before the option expires on the third Friday in January 2009. We tell our broker we want to exercise our option, and he or she begins the process in conjunction with The Options Clearing Corporation (OCC) that randomly notifies any seller of any Jan 175 AAPL call that they and their broker have to provide you with what you want—100 shares of AAPL stock at the purchase price of $175!

In this process, you are exercising your right. But to do so, and take delivery of your 100 shares of AAPL stock, you also have to provide the funds necessary, in this case $17,500. Your broker will require you to have at least half of that money in your account to complete the exercise process. The other half could come from a margin loan if your broker approves you for that type of transaction. In any case, once you exercise your call option and take ownership of the stock, you now own the stock just like any regular stock investment. The option no longer exists for you and the transaction cannot be reversed. BTW, strike price is often called exercise price too because it’s the price where we exercise our right!

So how much profit have you made? Well, with AAPL at $220 and your cost of $175 plus the $15 premium you paid to buy the option, your unrealized profit is $30. I say unrealized because you still haven’t liquidated your investment in the stock and made the profit realized. All you did was turn your option into the underlying stock. To realize the profit you would have to sell the stock. If you sell the 100 shares you bought for $17,500 and receive $22,000, you get back the $1,500 you paid for the option and you pocket $3,000 in profits. But, if you want to keep your investment in AAPL, you won’t sell your shares and you will be subject to the same risks and opportunities as every other shareholder. If the stock goes back to $175 or lower, your unrealized profit will turn into an unrealized loss. Obviously, if the stock goes above $220, your $30 in unrealized profit will continue to increase. Next time, I’ll show you another way to profit from your call option—with even less cash and less risk, because you never hold stock!

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Options Basics 101: Financial Power Tools Every Investor Should Know About, Lesson 6 

In lesson 5, we looked at how we could realize the profit on our call option investment by exercising the option before expiration. Now, I want to show you another way to realize a profit, or recoup some of the loss, from an option investment. Let’s look at the same scenario as our exercise example where we own the 175 call and the stock has appreciated to $220. Our 175 call is considered “in-the-money” (ITM) because the strike price is below the stock price and the option has real or intrinsic value.Let’s take a moment and explore this concept of “moneyness.” We use the phrase “at-the-money” (ATM) to describe an option contract whose strike price is closest to the underlying stock’s price. In this case, the 220 strike call would be called ATM. “Out-of-the-money” (OTM) is how we refer to a call option contract where the strike price is above the stock price. The 230 call would be considered OTM. We can buy or sell any options we want to, but generally we only want to exercise ITM options because they have real, or intrinsic value, where we can turn our option position into a profitable position in the underlying stock.For our ITM 175 call, instead of exercising the option and turning it into real stock, we can simply sell the option contract back to the marketplace. The price we get for the option will be affected primarily by two components, the intrinsic value (if any) of the option and the time left until expiration. In this case our 175 call has $45 of intrinsic value, because the stock price of $220 minus the strike price = 45. This means this option will be selling for at least that much in the options marketplace. Then depending on the time left until options expiration, the option premium will have a time value component.With 2 months left, the time value might add another $1 to $5. With only 2 weeks left, all options will have very little time value. The key idea here is that since this option is “deeply” ITM—meaning its strike is a good percentage below the stock price—it will trade for a value nearly identical to its intrinsic value. Since option investors and traders can readily exercise ITM calls to realize their value, these options tend to trade just like the underlying stock, moving up and down dollar for dollar with it.When we bought this 175 call option, it was OTM with the stock at $150, and it cost us $15. That $15 was all time value since the option had 9 months to live. Now if we sell our option for $46 (which is $45 of intrinsic value and $1 of time value, our profit would be $46 minus the $15 premium we initially paid, or $31. I’ll be back in our final lesson to show you how a put option investment works.

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Options Basics 101: Financial Power Tools Every Investor Should Know About, Lesson 7

Welcome to the final lesson in this series on some of the basics of options! We’ve spent the majority of our time so far talking about a call option investment. Now it’s time to talk about the other type of option available to us—the put. A put option gives the holder the right, but not the obligation to sell underlying stock. Put contracts are structured the same way as calls, with each contract equivalent to 100 shares of the underlying instrument, be it stock, futures contract, or ETF. If I buy a 150 strike put option on AAPL shares, I have bought the right, but not the obligation to sell 100 shares of AAPL stock at $150 anytime during the life of that option.

Why might an investor choose to do this? Well, consider the investor who already owns shares of AAPL. Buying a put is like buying insurance to protect gains and to limit losses on that stock investment. If an investor bought AAPL at any price, from $100 to $200, buying a put contract is a way of insuring that investment against a drop in the share price. The great thing about puts, just like calls, is that you can choose among numerous different strike prices and expirations. This variety of possible positions allows investors to customize their risk and reward.

Let’s look at an example to see how the put works and what kind of choices we have. Assume an investor owns AAPL from $125 per share and now the stock has appreciated to $175. The investor wants to keep this stock for at least a few more years because he or she is fairly certain of the fundamental growth story of this techno-gadget powerhouse. But, she also wants to insure her stock risk in the short-term by buying a put. If you want 3 months of insurance, you look at a put with about 3 months until expiration; 6 months of protection can be had as well. Put contracts for anywhere from 1 month to over 2 years can be purchased to insure just about any time frame you want. The next consideration is how big do you want your deductible to be? What do I mean by deductible. Well, just like when you insure your car, you choose a deductible that determines the minimum you must pay for any claim. And the higher your deductible, the lower your premium. Option work in a very similar way. The more of your own loss you are willing to cover, the less premium you have to pay for that coverage.

Here are some examples. If you decided to start your AAPL insurance coverage at $150, you would buy the 150 strike put. If AAPL shares fall below $150, you would own the right to sell them at $150. With AAPL shares at $175, a 6-month 150 strike put might cost $12. This 150 strike put is called “out-of-the-money” because it has no real, or intrinsic value. The “moneyness” of put options is the opposite of calls. Remember, call premiums increase in value, and thus move closer to “in-the-money,” as the underlying rises. Why? Because they confer the right to buy the underlying. Put premiums increase in value, and move closer to ITM, as the underlying falls because they confer the right to sell the underlying. An ITM put, say the 190 strike put, would be worth at least $15 with the underlying at $175. It would have $15 of intrinsic value and with 6 months until expiration, it might have time value of another 3-5 dollars, bringing its total premium to nearly $20. So, the 190 put costs considerably more than the 150 put because it has a much lower deductible—being able to sell AAPL at $190 vs. $150 should cost more in premium, right?

Well, that wraps up our introduction to Options Basics. We covered a lot of new concepts and terminology, but I hope you recognized that many option mechanics are readily familiar to you—like insurance and deductibles and the time value of money. Please visit some of the other excellent knowledge series on the OptionsPhysics Basic Channel, such as “Why Should I Consider Options?” or “Put-Call Parity” or our series on Spreads. And please turn to ONN.tv every week to further your options education. Now, when you watch our Mad About Options show or the SideWinder Report, you will start to have some fun with how much you already know about options! See you there!

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Introduction / Learning Outcomes:

Kevin Cook takes you through the foundation of options trading – probabilities. Understanding probabilities and volatilities gives options traders an edge. This series takes a look at generating expected returns from known probabilities. Kevin further demonstrates how this knowledge is useful in trading options. He also points out why an option trader needs to be aware of the improbable happening in the markets. “If you take away the 10 biggest returns of the S&P500 for the last 50 years, the index would be 1,000 points higher.” Specifically, you shall learn:

1. The importance of understanding how to analyze volatility.
2. Where expectations, particularly in returns, is generated.
3. Probabilities using a single die.
4. The difference between gambling and investing.
5. Why Taleb disagrees with using probabilities for investing.

Recommended Exercises:

1. Conduct die rolling exercise with bet at $3.00 a roll.
2. Conduct die rolling exercise with bet at $4.00 a roll.
3. Conduct die rolling exercise with bet at $3.50 a roll.
4. Review returns of the S&P500 for the last 10 years.
5. Identify the 10 biggest daily returns.

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When you hang around pro trader’s enough, you’ll often get to hear them say “you have to have an edge.” What they mean is that you have to have some sort of advantage to overcome the imposing odds that are standing between you and successful short-term trading. Many are called, few chosen… so you had better know something or do something different than the crowd. For discretionary traders, this might translate into excellent fundamental research skills, or superior technical analysis, or maybe just having good and fast informational contacts in the markets. For options traders, it means having a good grasp of volatility analysis and moving quickly to exploit relative mispricing of options.

In the end, “edge” seems like it means a lot of different things to a lot of different traders. But, you “have to have one,” so I’m going to give you one that won’t fail you. It’s the one edge that all the others depend on. And it also starts with the letter “E.” It’s Expectation. It comes from a mythical land known commonly as probability and statistics. But, to traders, a solid grasp of probability—whether the intuitive grasp of the independent trader or the quantified grasp of the fund manager—is essential to long-term success in the markets. And mathematical expectation is the core tool of probability. When we train traders, our primary goal is to take them through a learning process from unrealistic and financially-dangerous expectations to well-grounded, mathematical expectations.

I first learned about probability and the expected value of any bet from smart option traders in the Chicago pits. I also took classes from one of the best instructors of option traders in Chicago, Sheldon Natenberg. Shelly used to introduce the topic of expected value with a simple dice example. Actually, it was so simple, it was just one die. Say that I offer to pay you a dollar for the face value of every roll. So, if you roll a 2, I pay you $2… you roll a 6, I pay you $6. How much would you pay for this bet? You might guess that if you paid $3 for it, things would work out fair for both of us, in the long run. And if you understand “the long run,” that’s a big step toward making use of mathematical expectation. But, if we put that guess to the test and we played at least 100 rolls, we’d find that you’d actually come out ahead by around $50! Hmm…

How do we find out precisely what bet amount makes this a fair gamble, where neither of us has a mathematical advantage? We have to calculate the expected value. You do that by multiplying the probability for each outcome times the payoff. So, you’d have 1/6 x 6, and 1/6 x 5, and so on. The result is $3.50. If I charged you $3.5 for every roll, and we played this game with only ten rolls, either one of us might come out ahead by some unpredictable amount. But, if we did 100 rolls, chances are—since this is an extremely fair bet based on precise mathematical expectation—there would be no clear winner. On the other hand, if I charged you $4.00 for every roll, I could be expected to come out ahead by close to $50 for 100 rolls, since I am making, on average, 50 cents above the fair EV on each roll. In this simple dice bet, you can begin to see how more complicated games build in the advantage for the owner of the dice. Whether you are a casino operator or a trader, the way to win is to know expected value. In coming videos, we’ll look at a few other games where the house has a built in edge. And I’ll also show you one of the best probability brain busters ever—The Monty Hall Problem.

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I’m teaching you about probability because it is one of the first lines of offense for pro traders. To prepare for a trading career, or even just a trading day, requires detailed knowledge and detailed planning. And one of the most important areas of knowledge you can have is that of probability, and its workhorse, expected value. Remember our dice game? If you had any trouble at all understanding how I described the mathematical outcomes of that game, then you are in luck, so to speak. Because all you have to do is play the game and it will become perfectly clear to you. And it’s a lot of fun too, I promise. Here’s what you do: grab a friend, a relative, or co-worker and one little die. Play with pretend money if you want, or even pennies. Just agree that each spot or pip on the die is equal to one unit of whatever currency amount you decide on so the math is simple. Then, choose one person to be the “house” and the other to be the gambler. Play 10 rolls with the gambler betting $3 per roll, and 10 rolls betting $4. With only ten rolls, the results of each game of 10 will seem unpredictable.

Let’s say you’re playing the game with your co-worker Sue. She’s the gambler and you’re the house. In only ten rolls, you will see results that don’t always seem to match what the averaging predicts. Sue may come out ahead of the house betting $4—even though we figured out that $4 is overpaying for this game. How? If she hits a nice run of high numbers. If she hits 5 “sixes” and 5 “threes,” you have to pay her out a total of $45 and she just made $5 off of you since she only bet a total of $40. And in the second game, if you as the house take $3 bets, which have no built-in edge for you, you could still end up the net winner after 10 rolls. How is that possible? Because it’s certainly possible, in such a small sample of rolls, for the die to land on small numbers enough times that you end up keeping a few bucks of the bet money. In ten rolls, with a $3 bet, a total of $30 in bets will come your way as the house. But if Sue gets 5 “ones” and 5 “fours,” you only have to pay her back $25 and you get to keep $5. In the simple randomness of this 10-roll game, the gambler could get streaks of high numbers or low numbers that make bets which are close or even equal to the expected value end up benefiting either you or the gambler.

This is how things work out in the short-run. Even though each side of the die has an equal 1 in 6 chance of surfacing, you don’t get to see the equality of those probabilities unless you run enough trials. You have to play with at least 30 bets, and 50 would be better to see how the math of expected value rules the universe in the long-run. BTW, that’s a universe with fair dice, not the kind they play with in alley ways. Anyway, you have to try this simple game to see what I’m talking about—believe me, you’ll have a blast! I taught this to my kids when they were in grade school and it really seemed to surprise them and open their eyes to the power of a probability-weighted bet as it unfolds over the long-run. I hope it will help me teach them more advanced stuff with probability, like “how not to be a sucker” when politicians, pundits, and newspapers misuse statistics. The long-run is about the law of large numbers, first named by one of the Bernoulli clan of mathematicians 300 years ago. Knowing how randomness unfolds in the short-run and in the long-run is key to never being surprised or manipulated by others’ large numbers, shocking statistics, or strange, newsworthy anecdotes like the story of the guy who caught a rare disease in a hospital or the new epidemic of home foreclosures.

Now, a wise trading philosopher I know thinks it’s ludicrous to teach people about investing and trading with games of chance. I’ll tell you about his very interesting, and wise, point of view when you join me in Part 3 of “How Not to Be a Sucker.” See you there!

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How Not to Be a Sucker, or Probability 101 – Part 3

We left off in Part 2 talking about the opinion of a trader-philosopher who thinks that teaching people about markets with games of chance is ludicrous. Actually, he calls it The Ludic Fallacy. Our opinionated thinker is the author of this book, The Black Swan. I wrote a review of it that will appear in the August issue of Stocks, Futures, and Options Magazine. Nassim Nicholas Taleb is, in his own words, a “derivatives trader-turned-philosopher” and he doesn’t disappoint. Both an experienced institutional options trader and risk manager, and a literate essayist and original thinker, NNT has a lot to say about our problems with probability and risk. And this book is an extension of his 2001 Fooled By Randomness. So what is his point in saying it’s a mistake to teach people about probability and risk in markets using casino games? He doesn’t think this because investing and trading aren’t like gambling in the general sense of betting money on things like the uncertain rolls of dice or company fortunes or currency fluctuations, but because they are different in a very specific sense concerning their domains, or types, of randomness.

Investing and trading vs. most gambling games (except poker, which we’ll talk about later) are so qualitatively and quantitatively different with regard to randomness that most people, even professionals, don’t notice and their ignorance gets blown up wildly when they go from casino math to the markets. I agree with the wise man on this point—just look at LTCM or the current subprime debacles for evidence. But I still think we can use a basic knowledge of probability to develop a foundation of practical understanding and street smarts that guide us in our investing and trading. If we don’t start with some probability smarts, we may fall victim to traps much simpler than Wall St. can dish out.

Don’t get me wrong, I am not a fan of betting on rolls of the dice as a way of making money—unless I have a great edge, like paying $3 for a bet with an EV of $3.50. And when I invest in a company or trade options, I like to think I have put some research into the matter. But before I tell you how investing and gambling are different, let me tell you how they are similar. Modern finance is actually built on the probability structures inherent in games of chance. From MPT to the CAPM and the Black-Scholes model, it’s all about the mechanics of probability discovered by smart gamblers and math geniuses in the last 350 years. For that story, I can’t recommend enough this book by market chronicler Peter Bernstein, Against the Gods: The Remarkable Story of Risk. The title is a brilliant play on words. “Gods” not only rhymes with odds—it symbolizes how civilization crawled out from under centuries of superstition and uncertainty about the future by learning to quantify randomness. It’s a great read, and reveals how investment theory has grown from some surprising roots to put Wall St. at the center of the economic universe.

When we come back in Part 4, I’ll tell you where The Sultan of Swan thinks standard risk models breakdown in markets, and where they mis-judge randomness.

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How Not to Be a Sucker, or Probability 101 – Part 4

So, why is probability so important for us and where does The Black Swan author disagree about its usefulness? Probability helps you understand what can happen to your capital in the short-run and in the long-run when you either focus on, or ignore, the expected value and risk of your investing and trading decisions. The Black Swan author points out limits of standard risk analysis. But, our wise trader-philosopher is simply concerned with the severe limitations of the standard risk analysis that accompany these probability-based models. From Bear Stearns to UBS, he wants Wall St. to be aware, and then honest, about the models and methods that keep losing people and institutions so much money when they claimed to have measured, weighed, and understood all the risks beforehand.

Here’s an example to help you think about why standard models of probability and risk like standard deviation might have some severe limitations. If you take away the 10 biggest returns of the S&P 500 for the last 50 years, the index would be 1,000 points higher. That’s right. When I say returns, obviously I am not just talking about positive returns, but all returns. 10 biggest one-day moves = 60% of S&P returns! The S&P would be over 60% higher if you took away the 10 biggest one-day moves, which may not be surprising to you. But, what this also means is that the market has risk that the conventional models don’t seem to measure. The big down days are sucked into the averaging of standard volatility measures and get washed out so that the market looks much tamer than it really is.

Where this shows up and hurts the most is on successive days and weeks when the market drops by over 10%. According to the conventional models, the odds of this happening are so remote that we shouldn’t ever consider them happening. If daily volatility for the S&P 500 is 1%, then a 10% or 10-standard deviation move shouldn’t happen even 1day in a million billion days— Odds of 10% move in the stock market tomorrow? A quadrillion to one! in a that’s a number with 15 zeros after it, and more days than we talk about being important in human evolution. But 10% moves in the stock market in a matter of a few days or weeks happen every few years. That’s why Taleb says there’s something wrong with our reliance on conventional risk models. I highly recommend his book to get the full argument, but if you want a quick summary, be sure to check out my review in the August edition of Stocks, Futures, and Options Magazine… SFOmag.com.

So, where does probability and statistical analysis work well? Options trading, of course! Probability and its derivative tools work great for options traders who can dynamically evaluate and hedge their risks. Check out the OptionsPhysics Advanced and Pro instruction from Ben Reid and Joe Troccolo to learn how pro traders use volatility and the Greeks to navigate the options markets and capitalize on short-term probabilities.

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Introduction / Learning Outcomes:

Kevin Cook and Jared Levy lead you through the basics of option brokers. During this series of videos Kevin and Jared will describe what to look for in a broker, the different types of market orders, how to interpret a bid-ask spread and what type of order is appropriate and finally a checklist of questions to ask your broker. Specifically, you shall learn:

1. What to look for in an options broker.
2. The brokers’ duties.
3. The different features of an options broker.
4. What a broker is.
5. The different types of accounts.
6. Why there are so many different options exchanges.
7. How to use the National Best-Bid or Offer.
8. The regulating bodies of options brokers.
9. How to open an account.
10. What minimum account size means to a broker.
11. How a commissions rate impacts your decision.
12. How to get educated on options.
13. Understand the different options trading levels.
14. Understand how clearance level impacts what you are allowed to trade.
15. Understand the different types of order types.
16. Understand when options traders will use a market order and why it’s the cheapest.
17. Understand when an options trader will use a limit order and how it may never get filled.
18. Understand how a stop loss is a trigger order.
19. Differentiate between a stop loss and a stop limit.
20. Why a trailing stop is like a ratchet.
21. Why an OCO order is like a bracket order.
22. Additional order qualifiers.
23. Tricks and tips of the bid-ask spread.
24. A checklist of questions for your broker.

Recommended Exercises:

1. Contact two different options brokers.
2. Create records of each options broker.
3. Ask each broker if they have a dedicated options desk.
4. Ask each broker what their commission rates are.
5. Ask each broker what the minimum account size is.
6. Ask each broker starting options clearance.
7. Ask each broker how experienced they are with options.
8. Watch ONN.tv for education.
9. Determine your appropriate options trading level for each broker.
10. Differentiate between a market order, a limit order, a stop ‘loss’, stop ‘limit’, a trailing stop or orders cancel orders.
11. Describe how a limit order would give you a partial fill.
12. Describe a trigger which would generate a trigger order.
13. Find an option with a high bid-ask spread.
14. Determine which type of order is best for a high bid-ask spread.
15. Find an option with a low bid-ask spread.
16. Determine which type of order is best for a low bid-ask spread.

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Kevin Cook and Jared Levy discuss Brokerage Basics.

Open a virtual trading account to practice what you pick up in each module

Kevin Cook and Jared Levy discuss Brokerage Basics.

Open a virtual trading account to practice what you pick up in each module

Kevin Cook and Jared Levy discuus Brokerage Basics.

Open a virtual trading account to practice what you pick up in each module

Kevin Cook and Jared Levy discuss Brokerage Basics.

Open a virtual trading account to practice what you pick up in each module

Kevin Cook and Jared Levy discuss Brokerage Basics.

Kevin Cook and Jared Levy discuss Brokerage Basics.

Open a virtual trading account to practice what you pick up in each module

Joe Troccolo and Jared Levy lead you through Puts and Calls. This series of videos will describe what a put is, when to invest in a put, what to look for and how to execute. Very similarly, the series also provides definitions on what a call is and how to properly invest in a call – as opposed to following the chatter of the markets. “Getting stock ideas and making trades solely by word of mouth is an extremely general and often risk proposition.” Furthermore, the series takes a good hard look at how delta impacts call options. Specifically, you shall learn:

1. How to sell a stock short.
2. Why margin calls have additional risks.
3. The definition of a put option.
4. How to profit from purchasing a put option.
5. What the maximum loss for a put option is.
6. How to hedge a long position.
7. What the risks of an out-of-the-money put option are.
8. How a put is similar to a short stock.
9. How to perform due diligence in purchasing a call option.
10. How trading patterns impact the stock’s price.
11. How to determine the time frame for purchasing a call option.
12. What some different technical factors are.
13. Why technical analysis confirms fundamental analysis.
14. Why reviewing an options’ delta is appropriate.
15. The difference between a low and high delta option.
16. Understand what Average True Range is and how to use it when evaluating an option.
17. How to calculate an appropriate stop loss gauge for an option.
18. How to calculate the average length of trades.
19. How time erosion negatively impacts an option.
20. Why longer-dated options are better.
21. How a bid-ask spread goes to market makers.
22. What the reasons are for a large bid-ask spread.
23. What open interest represents.
24. Why open interest increases as an option’s life progresses.
25. Why understanding liquidity is so important to an options trader.
26. Why having a checklist for purchasing options is important.
27. Why a call is like a coupon.
28. What the two values of a call are.

Recommended Exercises:

1. Describe the rules of selling a stock short.
2. Find a put option on the S&P500 ETF, the SPY.
3. Calculate the maximum profit from this put option.
4. Calculate the maximum loss for this put option.
5. Calculate the maximum profit from a hedged long position.
6. Calculate the maximum loss from a hedged long position.
7. Find an out-of-the-money put option.
8. Find an equity position and perform basic due diligence on the equity.
9. Using this same equity, determine the appropriate time frame for a call option.
10. Look at the technical analysis for this same equity.
11. Determine the delta of the chosen option.
12. Find a call option with a high delta.
13. Find a call option with a low delta.
14. Determine a call options Average True Range.
15. Calculate an appropriate stop loss gauge for the option.
16. Calculate the average length of your trades.
17. Find an option with a large bid-ask spread due to low volume.
18. Find an option with a large bid-ask spread due to high volatility.
19. Find an option with a high open interest.
20. Create an options purchasing checklist.
21. Find an option and calculate the intrinsic and extrinsic value of the option.

Find an option and determine why it is similar to a coupon.

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Basic checklist for buying a call:

Locate a potential candidate: Finding potential stocks to trade can actually be quite easy; you can consult websites, TV, friends, workmates, family, etc – you can even look around your home for ideas. The hard part may be finding success in the stocks you uncover. Stocks are on the minds and lips of most Americans; getting stock ideas and making trades solely by word of mouth is an extremely general and often risky proposition, if you don’t do your homework. There are many tools available which enable you to search for a certain stock based on its price, sector, fundamentals, analyst recommendations, chart patterns, options strategies, etc.

Be sure that once you have located a stock you perform your due diligence. This process may include, reading the analysts reports, checking the news, checking past earnings dates and results, and noting upcoming earnings. Surfing the web is actually a great place to start, just make sure the sources you use are reputable.

When forming your trading plan, be sure to specify how you will go about locating potential trades. Many traders tend to focus on a group of stocks, this is acceptable – just be sure that you don’t pigeonhole yourself into just one group that may not be performing well.

I’ll be using actual companies as illustrative examples during today’s presentation instead of the infamous “XYZ Company”. None of the discussions should be construed as recommendations to buy, sell or trade a specific stock or use a certain strategy. The opinions I express throughout this presentation are my own…you will need to form your own educated opinions. Remember, only you can determine if the option strategies discussed are suitable for your investment portfolio.

Practical Application: I typically trade the same group of 15 stocks over and over. As a market maker, I became accustomed to trading the same issue all the time; therefore, I got extremely familiar with its earnings reports, trading patterns, volatility, etc. One of the stocks I have traded over the years is Google (GOOG), which has seen its stock price cut by 60% in less than six-months’ time as of today. (It took 2.5 years to get from its current price level to its all time high. Fundamentally, I like the stock – I mean, aside from the financials, statistically Google is the world’s largest search engine, on the cutting edge when it comes to technology and innovation, and they are always exploring new ways to make money. So now let’s begin to examine the rest of the parameters.

Fundamental Analysis: Some traders look for certain characteristics in the companies in which they invest. Fundamental analysis, (which means analyzing a company’s financial statements, management, and competitors), becomes much more important with regards to longer-term investing, as you obviously want to invest in a company that will not only be around in a couple years, but will thrive. For day traders, fundamental analysis becomes less of an issue; in fact, there are some active traders who may trade a stock they know nothing about. Personally, I feel having knowledge and some level of familiarity with a company and its sector can only benefit you and increase your confidence in your trading decisions.

Practical Application: GOOG has a market cap of $92.5 billion and are one of the top performers in their sector. The company’s after-tax profit margins are good compared to the rest of the sector, checking in at roughly 20% (as of the end of 2008) GOOG has been running at roughly a 25% profit margin over the past four years, on the average. This is only one indicator to consider, there are many other factors that can be used to evaluate a company’s financial health and standing within its sector. Certainly GOOG is feeling some pain with the world in an economic downturn. I have noticed its ability to adapt in a changing marketplace. You may choose to go deeper into fundamentals, but I know that I am more of a shorter-term statistical trader and am satisfied with the small amount of research that I have done thus far. Please remember that my trading patterns and habits may not define your habits or pattern Also remember that I have traded GOOG many times in the past and feel comfortable with the behavior of the stock and its volatility. One last thing I like to glance at, not that this is going to insure success in a trade, is analyst recommendations. Out of the 21 major analysts that follow the stock 16 rate it a “strong buy,” 3 a “buy,” and 2 a “hold.” The mean 52-week price target for the stock is $475.00. Realize that analysts can NOT predict a stocks direction, nor is it feasible for anyone to pick the exact price a stock is going to be at in a given period of time. All they can do is give a best guess at the stock’s direction based on certain factors that they deem important. Even though I understand this risk, mentally, knowing that analysts are bullish makes me feel better about my trade.

Strategy Selection: Since we are discussing the long call, this is obviously the strategy we are going to discuss. Options provide a vast arsenal of strategies that traders can employ in the marketplace. As you broaden your strategic knowledge, you will be able to find the most appropriate strategy for the situation the marketpresents you. The market is forever changing, and no two days are exactly the same; therefore, having a strategy to fit just about every situation will leave you better prepared to face the markets.

Practical Application: In this example, we are looking at a simple long call. I am typically an active-to-swing type trader, meaning I usually stay in my positions anywhere from a couple of minutes to about three days, max. This is important to determine BEFORE you place your trade. It not only helps determine what strategy you employ, but also how much time you buy. GOOG hit $340.00 on 1/6/09 and has since been hammered down to $295.00 as of January, 20th 2009. The market has really been struggling here; horrible employment numbers, foreclosures, and Bank of America is asking for more TARP funds to help buffer the acquisition of Merrill Lynch. The situation seems very bleak, but as a professional (and experiencing these types of situations before), I am deciding to take a calculated risk.

Technical Analysis: Many investors use some form of technical analysis, and there are a multitude of charting packages, indicators, etc. Obviously some indicators are better than others, and many would agree that (for the most part) technicals work better as you target shorter-term trends and reversals. Basically, find an indicator that is easy for you to understand, one that offers you some edge and a potential advantage in your entries and exits, not to mention gives you some guidelines when monitoring your trades. Some of the indicators that traders use are MACD, Stochastics, Elliot wave, and Moving Averages. The more indicators that you follow the more difficult it may be to execute your trades efficiently and effectively. There are no guarantees of success with any analytical tool, and the more you add the more muddled your results may be. What I can say is you must try to use as much consistency in your analysis and quality in your execution and money management.

Practical Application: I use technicals to confirm my bullish thinking and trigger my entry, the key to any market trading system is simplicity. You should have your stock, strategy, and money management plan in place before making any trade! The reason for the plan is to try and mitigate any surprises. However, even with the best planning, you can still be wrong in a trade at follow-up. Planning is also important in the mental preparation for your trade and to establish realistic expectations.

ALL TRADING SYSTEMS ARE FLAWED, none will offer you perfect results. In fact, some don’t offer any results at all. Look for a system or method that can offer you an edge, just a slight advantage when it comes to timing your entries and exits into and out of positions. The more complicated and longer trades take to analyze, the more difficult it will be for you to execute and be successful. I use a proprietary system that is easy for me to read and understand. I also take a look at standard 20, two standard deviation Bollinger bands and look for oversold or overbought conditions. (This is an advanced technique that will require study, it is not intended for every trader) Frankly, I believe the only reason that any technical analysis works (besides measuring deviation from an average price or mean) is that enough people follow and execute the parameters so perception becomes reality. Again, this is just my personal view. Be sure to paper trade and test your methods and systems before applying real money to the trade.

Delta: Before clicking the buy button, be sure that the call you are selecting meets your trade-style objectives. Each and every trader will have a different pattern, different financial needs, and different goals and time frames to their trading. First and foremost, most traders have a hard enough time picking a stock that is going to move in the direction that they desire. In fact, it may be harder still to find an option with the best balance of leverage, probability of success, and enough time to expiry. Luckily there are some simple guidelines beginning traders can use to find the best potential call candidates.

If you want to trade an option that behaves the closest to the stock, look for a delta 0.70 to 0.90. This is MY method and does not mean that every option with a 0.70 to 0.90 delta will behave exactly like the stock, nor does it mean that you will be successful trading this type of an option, it is purely a guideline. . Trading a call with a high delta may solidify the relationship between stock and option (generally speaking, an option with a higher delta has a tendency to behave more like the stock), it will also help ensure a high intrinsic-to-time ratio and will increase the chance that the option will move when the stock moves. Buying a lower delta is not necessarily a bad thing; just understand that the relationship between stock and option will be more dependent on other factors, meaning the stock may have to move further, faster for you to potentially profit. When placing a directional trade, in other words, if you are just buying a call because you feel the stock will increase in value, the delta that may NOT be desirable to purchase would be the 0.40 – 0.60 range, as the at-the-money options have the most amount of time value, relative to the other options. Remember, time value is the decaying part of the option (more time value means you must lose more per day to get to zero by expiration). Having the most amount of time value means the option is also the most sensitive to volatility changes.

Practical Application: For my GOOG example, I am staying in the money. I am executing this strategy for several reasons. As a rule, I like to buy a 0.70-0.90 delta. Here is my logic (usually it falls into line): First, let’s take a look at the average true range (ATR) of GOOG.- the average deviation of GOOG over a recent month’s time is 45.00. The ATR is a rolling 14-period average of a stock’s greatest movement in that given time frame and can be used to measure minutes, days, weeks, months, etc. I use ATR as a gauge to place my stop losses, I usually multiply the ATR times 1.2 to find a stop loss for my intended period I do this to stay outside of the stock’s ‘normal’ variations, this is a personal preference. To simplify the math : 45 (ATR) x 1.2(my risk factor)= $54. This means that $54 would be my acceptable stop loss in the stock. This means that if the stock is trading at $300.00, I would subtract 54.00 from the current trading price to find where to place my stop order. In this case, $300 – $54 = $246.00. A friend of mine also showed me a neat little trick, you can subtract your stop-loss amount from the stock price and that’s the strike that you buy (Again this is just a formula that he uses and does not guarantee success in the trade. Using this formula, if GOOG is $300.00 and I subtract $54.00 from it, I may purchase the 250 or 260 call, as long as it falls within the 0.70-0.90 delta range. The call I chose was the March 260 Call for $51.00. If your wondering why I chose March expiration, that is the next part in my checklist.

I have found that if you are using the monthly ATR as your stop-loss gauge, it tends to put you in range of using the above method to find your delta. So the question is, now that I have chosen my option, do I set a stop loss or do I have to lose everything? Here is my method, I take the ATR of the time frame that I want to be in the trade (MONTHLY MAX) then I multiply it by 1.2 then multiply by the delta.

So if my ATR is 45 and my option has a 0.70 delta the math looks like this:

Entry Price [51.00] – ((45[ATR]*1.2)*0.70 DELTA) = stop loss of $37.80.

My stop-loss order would be placed at my (entry price [$51.00] – loss amount) or $16.20 in this case This loss may seem steep, but remember that you were willing to originally tolerate a $54.00 loss in the stock, all the while having $300.00 per share tied up in the trade

Expiration: Having enough time for your trade to work is a risk many options traders have to contend with. One of the ways to determine how much time to buy is to look back on your past trading history. If you have a history of being in trades for an average of a month, then maybe you should buy a minimum of 60 days to expiration (DTE). If you have never traded live before, you should practice trading your methods. Take a look at your practice trades in your virtual account and use those as a guide to how long you tend to be in trades. Before you begin to trade real money, be sure you understand all risks involved, as a general rule, you should place at least 25 or more trades in your virtual account and have a written trade plan before using real money.

Here is an easy formula: Look back at your past two years of trading (or your total history if less than two years), then take all the trades you made and take the time you were in them and average them all. Then take your longest trade and average those two numbers (the average and the longest trade) – whatever number you come up with, add 30. The result is a good minimum DTE to purchase when you are making trades. This is a formula that I have developed myself, it does not guarantee that you will always buy the right option, but it is a guideline to start with. I use this guideline because many traders that I have taught over the years have experienced a trade where they felt they needed to hold an option longer than expected. This situation is why I choose to add 30 (or more) days to my average trade length.

Obviously, purchasing more time for what you deem to be a more long-term investment is generally not a bad thing, although I would be careful buying less time, as we all know that sometimes things don’t go exactly as planned in the market,. Having more time in your trade may open some other “options” that you may not have had available to you if you were out of time. Most traders do not want to be long an option with 30 DTE or less, as time value begins to erode more exponentially the closer you get to expiry, Experienced traders who understand the more advanced behaviors of options may chose to trade front month options.

Open a virtual trading account to practice what you pick up in each module

Practical Application: As noted, we are trading a long call on GOOG. Even though I am only planning on being in the trade for no more than three days, the market is quite turbulent and I know that I am human and make mistakes. This is where you need to be honest with yourself and assess your trading personality. If you are the type of person that has held on to trades for longer than you intended in the past, or if you know that you have a problem exiting trades in general: a good suggestion is to buy a longer-dated option. While it may cost you a bit more, I feel that nothing is worse than owning an option in the last couple weeks of its life and the stock still has not done what I need it to do. This of course is my opinion, but limited time is a factor that many new option traders have to learn to deal with. What’s worse is holding an option to expiration and having the stock move in the direction you had picked the following Monday. For this trade, I chose March expiration, roughly 54 days out from the date this was written. This may seem like excess, but it gives me some piece of mind and the ability to turn this trade into a spread if need be.

Bid-Ask Spreads: I like to think of the spread as another commission, this one goes to the market makers. Typically you buy on the ask and sell on the bid. You can always enter a limit order and get filled in-between the market, but this is not a guarantee. Think about it like this, if you are trading a call with a bid-ask spread of $1.00 (yes there are many of those out there) and you buy just 10 contracts, you are immediately marked at a $1,000 loss. WOW! Psychologically, the loss may be a blow for some traders. Now imagine you bought a 0.70 delta call and the stock rises $1.00, you may still be at a loss in your trade, which can certainly be disheartening. Granted, spreads are usually wide for a reason, either the stock is thinly traded or it may have a high relative volatility. I would prefer the latter if I were to trade an option with a large spread. Usually trading stocks with poor volume isn’t the soundest strategy. (although some more advanced traders are successful at trading low volume stocks) . Try to find options with spreads less than $0.20, if possible. You can find these lower spreads in the bigger stock names that trade heavy volume (1mm plus ), stocks like AAPL, QQQQ, IBM, etc. Sometimes higher spreads will be inevitable, just be aware of them and be sure to look up and down the option chain to get an idea of the average spread size. Remember, the lower the spread, the less your immediate loss will be in a trade, I chose .20, however you can chose a number that you feel comfortable with.

Practical Application: Bid-Ask Spreads are rather wide in GOOG. Even though it is a popular and heavily traded issue, it’s a volatile one. This fact places most spreads between $0.70 and $2.00. The March 260 Call that I chose to trade had a Bid of $50.60 and an Ask of $51.30 at about 2pm today. I entered a limit-day order for $51.00, and got filled in roughly two minutes. Remember, placing a limit order will allow you to set the purchase or sale price, but not a fill. Also remember with spreads typically there is a better chance of shaving the spread (paying less than the asking price or selling for more than the bid price) on the entry and exit.

Open Interest: Open interest can tell us a great deal about a particular option. Open interest is the number of contracts held in an open position and it can be long OR short. Some traders tend to forget that, you can buy to open OR sell to open a position. Traders should not always assume that because one contract has sizeable open interest, every holder is long or short that option. For the retail options trader, open interest can give an indication of how interested people are in trading that option. Typically higher open interest may lead to tighter bid-ask spreads, although this is not always the case. Open interest may increase as an option’s life progresses, and it may decrease as the option gets closer to expiration. Again, none of these are guarantees. As a general rule, it is good to see open interest of 100 or more, and utilize caution when placing a trade that makes you more than 25% of the total open interest. Remember, when months are added the Monday after expiration day, you may see zero open interest in that strike,while there may be a great deal of open interest in that same strike in the prior or next expiration month. If that is the case, take the lower of the two months and cut it in half, that may be a good estimate of where the additional(??) month’s open interest may end up. This again is one of my quick formulas, it is NOT a assurance of open interest, just a best guess.

Practical Application: My option choice had 225 open interest, plenty for the one lot that I traded.

Average Stock Volume: Volume is important. Remember that without volume, there would be no stock trading and potentially no change in prices. Think about it this way: you are trying to sell a vintage lamp with a “real” value of the lamp of $10.00. You can tell everyone that you are selling it for $100, $90, $80, $60, etc. But until someone steps in and PAYS you something (most likely $10.00) a trade is not made, nor would that trade be recorded. Stocks work the same way, a stock finds its “market value” by people showing their best bid price and their best offer price. When these prices meet, that is a trade and that is the current price of the stock. The more “players,” ”investors,” and “traders” participating, the more opinions on the stock, and the more liquidity that stock will have. This basically means that it will be easier to transact large amounts of shares (and options) at a single price. Volume is the cause and price is the effect, not vise-versa.

This may seem like a lot to digest, but the truth of the matter is that, with practice, this process will take less and less time. When it comes to your money, make sure that you understand your risk and put the probability on your side.

Once you’ve found the issue you want to trade, found a suitable entry point, and located the call option you want to trade, you must determine a profit target as well as a stop-loss point for yourself. Remember, earlier we discussed several techniques such as using a stocks ATR as a means of finding a ‘normal’ or average movement for the stock over a given period of time. The goal here is to set realistic expectations in your stock and options trades.

Before executing the trade, note the ATR or volatility of the stock that you are trading so you can get an idea of its “normal” range. This range can be used to set goals and help manage a trade once you are in. With the long call you are buying to open to enter the trade and when you are ready to exit, you must sell to close.

While you are in the trade, remember that the long call is also shorttheta, which means you are paying every day to be in that call. Also remember that it is best if volatility rises because you are long vega, basically you want that stock to move higher as fast as it can and if it does not move in your desired direction, be sure that you control your risk and have an acceptable stop loss set. Don’t forget, you do NOT have to lose all of your option’s value if the trade does not move in your favor.

Once you are in a profitable situation, a professional trader would look at protecting that edge or taking the trade off potentially. A great way for a retail trader to protect a profit and mechanize the trade is to use a trailing stop. Trailing stops allow a trade to move in a profitable direction, but will take the trader out if the position moves against him or her.

In this trade, I bought the option at $51.00 and also put a good to cancel (GTC) order to sell the option at $54.00, as I would be happy with 6% return on my trade. I ended up getting filled as the market rallied intraday.

Remember, there is no guarantee that you will make money using these methods and guidelines. Be sure to paper trade before applying ANY new strategies in real time with real funds. Please remember that all of the complex strategies in this piece don’t fit every investor’s strategy, make sure you do your homework

Open a virtual trading account to practice what you pick up in each module

Basic checklist for buying a Put – Practical:

Locate a potential candidate: Similar to finding a call candidate, finding potential stocks to trade puts on can be straightforward, but does require a shift in your thought process. Calls get more expensive as stocks rise, enabling you to take advantage of a stock’s rise in value. Puts get more expensive as stocks fall in value, which is where investors can sometimes get confused.

Most investors tend to be bullish on stocks; that is, they tend to place trades in anticipation of a stock rising in value. When you think about it, investing in a company that you believe in with hopes that it will become more and more profitable is not only intuitive; it’s a core social belief that many of us have. On the other hand, the stock could theoretically fall to zero, and the investor could lose their entire investment in the stock.

Alternatively, shorting stock outright can be extremely risky. In fact, short stock has unlimited risk because a stock can theoretically rise to infinity. Conversely, the reward in shorting a stock is if the stock price in theory, continues to fall to zero. Shorting stock has a limited reward. Some traders think that by shorting stock or buying puts you are betting on the demise of a company and – for some reason – “doing something wrong.” It is my firm belief that without buyers AND sellers together, a stock’s true value in the marketplace would be hard to determine. Stocks can sometimes get relatively overpriced. If you disagree, take a look back at some of the dot-com companies of the mid and late 1990’s; some of these companies had little or no cash, no revenue and maybe were in business for a couple months and yet were trading publicly at astronomic values. In my opinion, a company that is worth 0 (or less) on paper with no history of revenue and no proven business model probably shouldn’t have a market cap of 500 million dollars. This is just an example; that is not to say there were not many great companies that emerged during that time. My point is that the market needs the buyer and the seller together to discover the best price, and it is not necessarily a bad thing if you think a stock is overpriced.

How to determine whether or not you want to buy a put on a stock is obviously a decision you must make for yourself. As you search for potential put candidates, keep in mind that you may be targeting companies that do not have the strongest balance sheets, or may not be the “best” in their sector.

The same tools that are used to find long call candidates may also be used to search for a put.

Once you have located a stock you need to perform your due diligence. This process may include reading the analysts reports, checking the news, indicators, past earnings dates and results, and noting upcoming earnings. Remember, you are looking for potential company weakness here. Surfing the web is actually a great place to start, just make sure the sources you use are reputable.

When forming your trading plan, be sure to specify how you will go about locating potential trades, in order to remain consistent. Many traders tend to focus on a group of stocks, this strategy is acceptable as well.

As with the call, I’ll be using actual companies as illustrative examples during today’s presentation instead of the infamous “XYZ Company.” None of the discussions should be construed as recommendations to buy, sell, or hold a specific stock, or to implement a certain strategy. The opinions I express throughout this presentation are my own…you will need to form your own educated opinions. Remember, only you can determine if the complex option strategies discussed are suitable for your investment portfolio.

Practical Application: I typically trade the same group of 15 stocks over and over, both long and short. I must also note that I am typically a shorter-term trader, usually in and out of trades in a day or less, although I may hold a position for a couple weeks. As a market maker, I became accustomed to trading the same issue all the time; therefore, I got extremely familiar with its earnings reports, trading patterns, volatility, etc.

I have found in my trading that in many cases stocks tend to fall faster than they rise. If you look at broad-market indices, such as the DOW, NASDAQ and S&P 500, you will notice that just about all three were at relative lows in early 2003, it took them all about four years to reach their five-year-high points which came mid 2007 and less than a year and a half to return to their 2002/2003 levels.

The point I am making here is that greed can be a dominant factor in the market place. However, when fear takes hold, the corrections can come quickly and sharply.

Before I make any trade, I personally want to take note of how my stock has performed recently. For instance, each day a stock closes higher I have found that it becomes statistically less probable that the stock will continue to rise another day. Again, this is just my technique, it does not mean that this will work for everyone; certainly a stock can drop after a single bullish day.

Fundamental Analysis: Some traders look for certain characteristics in the companies in which they choose to take a short position. As with trading to the long side, fundamental analysis (which means analyzing a company’s financial statements, management, and competitors) becomes much more important with regards to longer-term investing. When I buy a put, I look for potential future weakness in a company. For instance, maybe the company is dominated by another in its sector and is losing market share, possibly the company’s products are not sustainable in the long term because of changes in technology. Eastman Kodak (EK) comes to mind here. For example, obviously Kodak was known for its film and when I was young everyone needed film for all cameras, personal and professional. With the advent of digital image technology and the costs of said technology plunging, Eastman Kodak has tried to reinvent itself because mass demand for their film is now more of a niche demand. What was once an $80-dollar-per-share DOW component, bellwether of corporate America has become a company with a $1 billion market cap trading around $4, as of today, February 13, 2009. This is only an example and I am by no means saying that Eastman Kodak is a short candidate or a bad company, this example was meant to illustrate how fundamentals of a company can play a role. In Eastman Kodak’s case, it was the potential of failing to adjust to a changing marketplace.

For day traders, short or long fundamental analysis generally becomes less of a concern. In fact, there are some active traders who may trade a stock they know nothing about. Personally, I feel having knowledge and level of familiarity with a company and its sector can only benefit you and increase your confidence in your trading decisions.

Practical Application: For this example, I am going to use financial concern, JP Morgan Chase (JPM). As many of you know, banks have been under extreme pressure and most have seen their stock prices cut substantially. JPM is the largest in its sector in terms of market capitalization, which is something that I tend to read as bullish – but given the current circumstances I am bearish, here is why. The potential creation of a “bad bank” that will aggregate all the toxic assets in our current banking system may help banks get back on their feet and enable them to resume lending. The issue with this “bad bank,” in my mind, is that the banks selling the debt will have to assign a value. This value will probably be deeply discounted, even from current valuations. Remember, this bank is being formed along with private funds, which will most likely not want to pony up for these assets. In addition, In my opinion and based on many expert analysts opinions, JPM’s peers have been priced for nationalization. There is certainly no guarantee of this, and JPM, like Goldman Sachs (GS) is a brokerage firm as well. The difference between the two is that JPM is also Chase Bank, which gives it added exposure. Goldman Sachs does not have the ‘banking exposure’ being that is has only recently become a bank holding company as of September, 2008. I say this, because it is important when you are comparing companies to be sure your looking at apples to apples, not apples to oranges.Today, (February 12, 2009) the market is down substantially, dragging JPM down as well. I will most likely wait until the market is rallying before placing my trade.

This may be a trade that I will have on for some time as my goal will be to make 10%-20% in less than a month’s time, with a stop loss of 40%. I will discuss these numbers later. Setting goals as well as stop losses in your account is key to good money management and potential success.

Strategy Selection: I have chosen to keep this strategy straightforward;, I am looking at a long put.

Practical Application: In this example,(a long put), I am typically an active-to-swing type trader, meaning I usually stay in my positions anywhere from a couple of minutes to about three days -max. But for this trade, I have chosen to commit myself up to a month because I feel that it may be some time before the trade works out as the market is in a period of high volatility. It is important to determine your intended time frame BEFORE you place your trade, because this will influence the type of options strategy you employ as well as the expiry date you choose. The market has really been struggling here; horrible employment numbers, foreclosures, many companies swinging to losses this quarter. Even with all this, I want to enter on a rally. I prefer to enter when the market is rallying because volatility typically comes in when the market is moving higher. When a trader buys a put, they are long VEGA. In other words, they will benefit from a rise in volatility. Conversly if implied volatility drops, long puts may lose some of their value.

Technical Analysis: Many investors use some form of technical analysis, and there are a multitude of charting packages, indicators, etc. Obviously some indicators are better than others, and many would agree that (for the most part) technicals work better as you target shorter-term trends and reversals. Basically, find an indicator that is easy for you to understand, one that offers you some edge and a potential advantage in your entries and exits, not to mention gives you some guidelines when monitoring your trades. Some of the indicators that traders use are MACD, Stochastics, Elliot Wave, and Moving Averages. The more indicators that you follow, the more difficult it may be to execute your trades efficiently and effectively. There are no guarantees of success with any analytical tool, and the more you add, the more muddled your results may be. You must try to use as much consistency in your analysis and quality in your execution and money management. Most indicators will alert you for a potential entry and exit point for both bullish and bearish actions.

Open a virtual trading account to practice what you pick up in each module

Practical Application: I use technicals to confirm my bearish thinking and trigger my entry, the key to any market trading system is simplicity. Based on experience, you should have your stock, strategy, and money-management plan in place before making any trade! The reason for the plan is to try and mitigate any surprises. However, even with the best planning, you can still be wrong in a trade at follow-up. Planning is also important in the mental preparation for your trade, and to establish realistic expectations. My indictor is showing strong bearish trends over the long term, but suggesting a potential bounce from the 24.55 level (where JPM is currently trading). I am going to wait until my indictors show me a more advantageous entry. Again, this is only software, it cannot assure me a profitable trade, nor does it know exactly what a stock will do, I am only using it to interpret patterns.

ALL TRADING SYSTEMS ARE FLAWED, none will offer you perfect results. In fact, some don’t offer any results. Look for a system or method that can offer you an edge, just a slight advantage when it comes to timing determining your entries and exits into and out of positions. The more complicated and longer trades take to analyze, the more difficult it will be for you to execute and be successful. I use a proprietary system that is easy for me to read and understand. I also take a look at standard 20, two standard deviation Bollinger Bands, and look for oversold or overbought conditions. (This is an advanced technique that will require study, it is not intended for every trader.) Frankly, I believe the only reason that any technical analysis works (besides measuring deviation from an average price or mean) is that enough people follow and execute the parameters so perception becomes reality. Again, this is just my personal view. Be sure to paper trade and test your methods and systems before applying real money to the trade.

Delta: So I have already decided to trade a put. Before clicking the buy button, be sure that the trade you are selecting meets your trade-style objectives. Each and every trader will have a different pattern, different financial needs, and different goals and time frames to their trading. First and foremost, most traders have a hard enough time picking a stock that is going to move in the direction that they desire. In fact, it may be harder still to find an option with the best balance of leverage, probability of success, and enough time to expiry. Luckily there are some simple guidelines beginning traders can use to find the best potential put candidates.

As a guideline that I use, if you want to trade a put that behaves the closest to the stock, look for a delta -0.70 to -0.90. This is MY method and does not mean that every option with a -0.70 to -0.90 delta will behave exactly like the stock, nor does it mean that you will be successful trading this type of an option. Trading a put with a higher delta may solidify the relationship between stock and option (generally speaking, an option with a higher delta +0.75 for calls and -0.75 for puts) has a tendency to behave more like the stock,) could help ensure a higher intrinsic-to-time ratio and may increase the chance that the option will move when the stock moves. Buying a lower delta is not necessarily a bad thing; just understand that the relationship between stock and option will be more dependent on other factors, meaning the stock may have to move further, faster for you to potentially profit. In other words, when placing a directional trade – if you are just buying a put because you feel the stock will decrease in value in my opinion,-the undesirable delta to purchase would be the -0.40 to -0.60 range, as the at-the-money options have the most amount of time value relative to other options. Remember, time value is the decaying part of the option (more time value means you must lose more per day to get to zero by expiration). Having the most amount of time value means the option is also the most sensitive to volatility changes.

Practical Application: For my JPM example, I am staying in the money. I am executing this strategy for several reasons. As a rule, I like to buy a put with a -0.70 to -0.90 delta. Here is my logic (usually it falls into line): First, let’s take a look at the monthly average true range (ATR) of JPM- the average deviation of JPM over a recent month’s time is about $10.00. The ATR is a rolling 14-period average of a stock’s greatest movement in that given time frame and can be used to measure minutes, days, weeks, months, etc. I use ATR as a gauge to place my stop losses, I usually multiply the ATR by 1.2 to find a stop loss for my intended period. I use this formula to stay outside of the stock’s ‘normal’ variations, this is a personal preference. To simplify the math: 10 (ATR) x 1.2(my risk factor)= $12 This means that $12 would be my acceptable stop loss in the stock. This means that if the stock is currently trading at $26.00, I would add (because we are going short) $12.00 from the current trading price to find where to place my stop order. In this case, $26+$12 = $38.00. A friend of mine also showed me a neat little trick, you can add your stop-loss amount from the stock price and that’s the put strike that you buy (Again this is just a formula that he uses and does not guarantee success in the trade.) Using this formula, if JPM is $26 and I add $12.00 from to it, I may purchase the 37.50 or 40 Put, as long as it falls within the -0.70 to -0.90 delta range. The put I chose was the June 37.50 Put for $13.50. If you’re wondering why I chose June expiration, that is the next section in my checklist.

I have found that if you are using the monthly ATR as your stop-loss gauge, it tends to put you in range of using the above method to find your delta.

So the question is, now that I have chosen my option, do I set a stop loss for my option or do I potentially lose my entire investment if the stock stays out of the money? Here is my method, I take the ATR of the time frame that I want to be in the trade (MONTHLY MAX) then I multiply it by 1.2, then multiply by the delta.

So, for example, if my monthly ATR is 10 and my option has a -0.71 delta the math looks like this:

Entry Price [13.50 - (10[ATR]*1.2)*0.71[DELTA]) = stop loss at $5.00, or an $8.50 loss

My stop-loss order would be placed at the (entry price [$13.50] + loss amount [$8.50]) or $5.00 $22 in this case. Remember that puts go up in value as the underlying stock drops.

This loss may seem steep, but remember that you were willing to originally tolerate a $12.00 loss in the stock, all the while having $26.00 per share tied up in the trade.

Expiration: Having enough time for your trade to work is a risk many options traders have to contend with. This is important whether you are trading puts or calls. One of the ways to determine how much time to buy is to look back on your past trading history. If you have a history of being in trades for an average of a month, then maybe you should buy a minimum of 60 days to expiration (DTE). If you have never traded live before, you should practice trading your methods before going live. Take a look at your practice trades in your virtual account and use those as a guide to how long you tend to be in trades. Before you begin to trade real money, be sure you understand all risks involved. As a general rule, you should place at least 25 or more trades in your virtual account and have a written trade plan before using real money.

Here is a straightforward formula that I have found useful: Look back at your past two years of trading (or your total history if less than two years), then take all the trades you made and take the time you were in them and average them all out. Next, take your longest trade and average trade time and average those two numbers out (the average and the longest trade) – whatever number you come up with, add 30. The result is a good minimum DTE to purchase when you are making trades. This is a formula that I have developed myself, it does not guarantee that you will always buy the right option, but it is a guideline to start with. I use this guideline because many traders I have taught over the years have experienced a trade where they felt they needed to hold an option longer than expected. This situation is why I choose to add 30 (or more) days to my average trade length.

Obviously, purchasing more time for what you deem to be a more long-term investment is generally not a bad thing, although I would be careful buying less time, as we all know that sometimes things don’t go exactly as planned in the market,. Having more time in your trade may open some other “alternatives” that you may not have had available to you if you were out of time. In my opinion, most traders do not want to be long an option with 30 DTE or less, as time value begins to erode more exponentially the closer you get to expiry, experienced traders who understand the more advanced behaviors of options may chose to trade front month options.

Practical Application: As noted, we are implementing a long put on JPM. Even though I plan on being in the trade no more than a month, the market is quite turbulent and I know that I am human and make mistakes. This is where you need to be honest with yourself and assess your trading personality. If you are the type of person that has held on to trades for longer than you intended in the past, or if you know that you have a problem exiting trades in general: a good suggestion is to buy a longer-dated option. While it may cost you a bit more, I feel that nothing is worse than owning an option in the last couple weeks of its life and the stock still has not done what I need it to do. Of course,this is my opinion, but limited time is a factor that many new option traders have to learn to deal with. What’s worse is holding an option to expiration and having the stock move in the direction you had picked the following Monday. For this trade, I chose June expiration, roughly 125 days out from the date this was written. This may seem like excess, but it gives me some piece of mind and the ability to turn this trade into a spread if need be.

Bid-Ask Spreads: I like to think of the spread as another commission, this one goes to the market makers. Typically you buy on the ask and sell on the bid, this goes for puts as well. You can always enter a limit order and get filled in between the market, but this is not a guarantee. Think about it like this, if you are trading a put with a bid-ask spread of $1.00 (yes there are many of those out there) and you buy just 10 contracts, you are immediately marked at a $1,000 loss (excluding commission). WOW! Psychologically, the loss may be a blow for some traders. Now imagine you bought a -0.70 delta put and the stock falls $1.00, you may still be at a loss in your trade, which can certainly be disheartening.

Granted, spreads are usually wide for a reason, either the stock is thinly traded or it may have a high relative volatility. I would prefer the latter if I were to trade an option with a large spread. Usually trading stocks with poor volume isn’t the soundest strategy (although some more advanced traders are successful at trading low volume stocks). In my opinion, try to find options with spreads less than $0.20, if possible. You can find these lower spreads in the bigger stock names that trade heavy volume (1mm plus), stocks like AAPL, QQQQ, IBM, etc. Sometimes higher spreads will be inevitable, just be aware of them and be sure to look up and down the option chain to get an idea of the average spread size. Remember, the lower the spread, the less your immediate loss will be in a trade, I prefer to trade options with spreads less than $0.20; however, you can chose a number that you feel comfortable with.

Practical Application: Bid-ask spreads are fairly tight in JPM. It is a popular and heavily traded issue, the stock, in my opinion, is also not that expensive. Most bid-ask spreads fall between $0.05 and $.10. The June 37.50 Put that I chose to trade had a bid of $13.40 and an ask of $13.50 at about 2pm today, February 13th, 2009. As I said earlier I am waiting for the stock to rally a bit for the perfect entry, but for demonstration’s sake, I placed a limit order “buy to open” 10 contracts at $13.50. Remember, placing a limit order will allow you to set the purchase or sale price, but not a fill. Also, remember with spreads there is typically a better chance of shaving the spread (paying less than the asking price or selling for more than the bid price) on the entry and exit.

Open Interest: Open interest can tell us a great deal about a particular option. Open interest is the number of contracts held in an open position and it can be long OR short. Some traders tend to forget that you can buy to open OR sell to open a position. Traders should not always assume that because one contract has sizeable open interest, every holder is long or short that option. For the retail options trader, open interest can give an indication of how interested people are in trading that option. Typically, higher open interest may lead to tighter bid-ask spreads, although this is not always the case. Open interest may increase as an option’s life progresses, and it may decrease as the option gets closer to expiration. Again, none of these are guarantees. As a general rule, it is good to see open interest of 100 or more, and to utilize caution when placing a trade that makes you more than 25% of the total open interest. Remember, when months are added the Monday after expiration day, you may see zero open interest in that strike, while there may be a great deal of open interest in that same strike in the prior (or next) expiration month. If that is the case, take the lower of the two months and cut it in half, which may be a good estimate of where the additional month’s open interest may end up. This again is one of my quick formulas, it is NOT a assurance of open interest, just a best guess.

Practical Application: My option choice had 1,079 open interest, plenty for the 10 lot I traded.

Average Stock Volume: Volume is important. Remember that without volume, there would be no stock trading and potentially no change in prices. Think about it this way: you are trying to sell a vintage lamp with a “real” value of the lamp of $10.00. You can tell everyone that you are selling it for $100, $90, $80, $60, etc. But until someone steps in and PAYS you something (most likely $10.00) a trade is not made, nor would that trade be recorded. Stocks work the same way, a stock finds its “market value” by people showing their best bid price and their best offer price. When these prices meet, that is a trade and that is the current price of the stock. The more “players,” ”investors,” and “traders” participating, the more opinions on the stock, the more liquidity that stock will have. This basically means that it will be easier to transact large amounts of shares (and options) at a single price. Volume is the cause and price is the effect, not vise-versa.

This may seem like a lot to digest, but the truth of the matter is that, with practice, this process will take less and less time. When it comes to your money, make sure that you understand your risk and put the probability on your side.

Once you’ve found the issue you want to trade, determined a suitable entry point, and located the put option you want to trade, you should determine a profit target as well as a stop-loss point for yourself. Remember, earlier we discussed several techniques such as using a stock’s ATR as a means of finding a ”normal” or average movement for the stock over a given period of time. The goal here is to set realistic expectations in your stock and option trades.

Before executing the trade, note the ATR or historical volatility of the stock that you are trading so you can get an idea of its “normal” range. This range can be used to set goals and help manage an active trade. With the long put you are buying to open to enter the trade and, when you are ready to exit, you must sell to close.

The Probability calculator that OptionsHouse offers is extremely powerful in predicting statistical probability of your stocks movement within a given period of time.

While you are in the trade, remember that the long put has negative theta, which means you are paying every day to be in that put or in other words, time is working against you. Also remember that it is best if volatility rises because you are long vega, basically you want that stock to move lower as fast as it can and – if it does not move in your desired direction – be sure that you control your risk and in my opinion, have an acceptable stop loss set. Don’t forget, you do NOT have to lose all of your option’s value if the trade does not move in your favor.

Once you are in a profitable situation, a professional trader would look at protecting that edge, or potentially taking the trade off. A great way for a retail trader to protect a profit and mechanize the trade is to use a trailing stop. Trailing stops allow a trade to move in a profitable direction, but will take the trader out if the position moves against him or her.

In this trade, I bought the put option at $13.50 and also put a good-to-cancel (GTC) order to sell the option at $14.80, as I would be happy with a 10% return on my trade. I will continue to monitor the trade as it progresses.  – is this a correct statement? Thanks.

Remember, there is no guarantee that you will make money using these methods and guidelines. Be sure to paper trade before applying ANY new strategies in real time with real funds. Please remember that all of the complex strategies in this piece don’t fit every investor’s strategy, make sure you do your homework.

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Option Strategies – Buying Puts

Have you noticed that stock prices don’t always go up? I thought so. But if you think the price of a share is going to drop, is there any way for you to profit from this?

Some brave souls might consider selling the stock short. In a short sale, the investor borrows the shares, sells them on the exchange, and delivers the borrowed shares to complete the transaction. At some point in the future, the investor will buy the shares in the market and return them to the party that loaned them. How hard is this to do? For shares that are fairly liquid, selling short can be accomplished through most brokers so long as you have a margin account. There will be requirements from your broker concerning how much cash you maintain in your account to be sure you can buy the shares back, particularly if the share price moves against you. There may be additional fees charged for borrowing the shares in addition to possible commissions. Still, an investor who is determined to sell short will often be able to do so.

However, from a risk point of view, the investor is exposed to any increase in the share price. Increases can result in margin “calls”, these are demands for additional margin to cover potential losses. Many investors are, rightly, reluctant to take on this form of risk.

An alternative to selling short is to buy a put option. A long put, that is a put that you own, is similar to a short position in the underlying. Let’s suppose the shares of ABC are trading for $50. An investor who thinks ABC shares are overvalued and will decrease in price, could consider buying a put on ABC. Suppose there are puts with strike prices of 45, 50 and 55 trading on ABC.  How would we decide which of these to buy?  Although we might either sell or exercise the option prior to expiry, for now let’s think about possible outcomes if we hold the option all the way to expiry.

To start with, suppose we buy the 50 Put. At the expiry of the option, if the shares of ABC are trading for less than $50, the put will be worth 50 –share price. So, for example, if ABC is trading for $40, the 50 Put will be worth $10 at expiry but this would not be pure profit since you will have paid both premium and commission.  And if ABC is trading at $35 at expiry, the 50 Put will be worth $15, again before considering costs. On the upside though, if ABC is trading for $50 or $55 or $60, or in fact any price above $50, the 50 Put will be worth zero.

This means that if ABC is less than $50 at expiry, the value of the 50 Put will be the same as the profit on a short sale of ABC at a price of $50.  Of course, prior to expiry, the option has additional value due to the volatility of the stock price and the other variables that affect option prices such as dividends and interest rates. On the downside the Put  looks like a short sale. But on the upside, the value of the Put is zero, while the short sale at $50 has a loss, which is potentially unlimited. For prices of ABC at $55, $60, $65, the loss on a short sale at $50 would be $5, or $10 or $15.

Of course if you had bought the put you also would have lost all the premium you paid for it. But that premium is the maximum possible loss on the trade. So buying the 50 Put is similar to selling the shares for $50 with a hedge against higher prices.

What about the 55 Put? It too looks like a short sale. This time we can compare buying  the 55 Put to selling the shares short at $55. Since the shares are currently  trading at $50, you would have to pay more for the 55 Put than for the 50 Put.  But probably not $5 more.

This is because the 55 Put hedges you less against price increases than the 50 Put. If the share price of ABC is at $55 at expiry, your option will be worthless. You will have lost whatever additional amount you paid for the 55 Put compared to the 50 Put because of the rise in the share price from 50 to 55. But once the price exceeds $55, your hedge “kicks in.” 

This hedge– against the share price going above 55 – is not worth as much as the hedge against the share price going above 50. That is the volatility value of the 55 Put is less than the volatility value of the 50 Put. Overall the 55 Put costs more than the 50 Put, but a good part of the additional price is simply that the 55 Put gives you the right to sell the shares for 55 when they were originally trading for $50. The volatility value – this is also referred to as time value –  of the 55 Put, which is the hedge it gives, is less than that of the 50 Put. 

Another way to see this is that if you buy the 55 Put and the share price is less than $50 at expiry you get the $5 difference in strike price compared to buying the 50 Put (again, based solely on intrinsic value). So an investor who buys the 55 Put rather than the 50 Put is saying – I’m willing to take the chance that the share price might rise to $55 and therefore I’ll have a $5 loss due to that increase, but I’m not willing to accept any additional exposure. I’ll pay for the 55 Put because I am, in a sense, less exposed above 55, compared to having sold the shares short. I know that I can lose the entire premium I paid for the Put, but the risk is less than the risk of an outright short sale.

And what about the 45 Put? We can’t talk about this in terms of hedging. Since the shares are trading at $50, the right to sell them for $45 will only have value at expiry if the shares are below $45 at that time.  The 45 Put will have the lowest price of the three options, but the investor needs the shares to decrease at least $5 from their current price for that option to have a positive value at expiry. Once again, prior to expiry the option has value because of the volatility of the share price and the time remaining before expiry. An investor buying the 45 Put is buying the potential profit if the share price decreases sufficiently by or possibly before expiry.

This put option is called Out-Of-The-Money (OTM) because the exercise price is lower than the current share price. OTM options are simultaneously lower in price than At-The-Money (ATM) and In-The-Money (ITM) options and more highly leveraged.  If you buy an OTM option you will need the shares to move more from their current price in order to make a profit, compared with buying an ATM or ITM option. To make this explicit, suppose the option prices were  $2 for the 45 Put, $4 for the 50 Put and $7 for the 55Put (these are just sample prices, not including commissions – actual prices could be different depending on market conditions).  Then the share price would have to decline at least $7 for an investor to profit from buying the 45 Put. The price moves needed for the 50 Put and 55 Put to be profitable are $4 for the 50 Put and $2 for the 55 Put, measured from the current $50 share price. Notice though that for every $1 the share price ends below 45, the rate of return on the 45 Put increases by 50%. For example, if the share price ends at 44, the return on the 45 Put (not including commissions) would be 50% and at 43 the return would be 100%. This shows how highly leveraged this OTM option is.

The risk of such an OTM option is that the investor loses the entire premium they paid and the probability of this is clearly greater than losing all the premium the investor might have paid for the 50 Put or the 55 Put. That said, the premium paid is the least of the three, but keep in mind how much the share price has to move for this put to prove to be a profitable investment.

Which of these three options, if any, an investor might choose depends on the view the investor has of the share price, how strong that view is, the investor’s timeframe and how much tolerance the investor has for risk. To summarize, buying a put is similar to selling the shares short and paying a fee – the option premium – to avoid the potentially unlimited loss of a short position.

Perhaps more than most other option trades, buying a Put is a specialized form of investment that may not be suitable for many investors.  We hope we have made clear that buying a Put expresses a negative view on the equity and risks the total loss of the investment if the equity prospers.

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Options as Investments

You have some money to invest – In order to have a value to discuss let’s say its $10,000 just to have a number to talk about. Now what does it mean to say you are investing it? It means that instead of using it to buy something you want right now – like DVDs or movie tickets or a flight to visit your family i.e. (things you really want) – you’re going to devote it to something you hope will be worth more than $10,000 at some point in the future. No doubt you think we’re being cagey about the way we said “devote it” instead of saying you’re going to buy something or lend the money out. We say this just to be as open minded as possible as to how you might try to grow your assets.

Whenever you invest you hope the value of what you invest in will increase. To focus our attention it’s good to think about a time frame for our investment.  Often people don’t do that this – if they buy shares of stock they don’t necessarily think about how long they plan on holding them and then when they would sell them. It’s pretty hard to discuss objectives without some sense of time. Let’s suppose we’re thinking about a relatively short term investment – maybe three months. We’ll call that our investment horizon. We’ll start our investment today and we’ll re-evaluate it in three months time. Now what is a realistic goal or expectation for a three- month investment? Most advisers would say it depends on how much risk you are willing to accept. The greater the risk you take, the greater the potential return – this seems to be a commonly accepted idea in the markets. However, risk is a slightly fuzzy concept, and in reality risk comes not just in quantity but also in type.

Investments

Let’s suppose we had an investment where we knew there were only two possibilities: in three months the investment would be worth no more than it is worth today or it would be worth 20% more than it is worth today. We’d say the possible returns are 0% and 20%. Let’s go a little further and suppose we knew that the two possible returns were equally likely, that is a 50-50 chance that we earn 0% and a 50-50 chance we earn 20%. Let’s call this investment A.

Here’s another possibility. Let’s suppose investment B also only has two outcomes. Either it will be worth 100% more in three months, or it will be worth 60% less.   Once again the two possibilities are equally likely. Now some people would prefer investment A and some would prefer investment B.

Just sit back and let me do the math for you: investment A has an expected return of 10%, which is half of 0 plus half of 20. Investment B has an expected return of 20%, which is half of 100 minus half of 60. So investment B has a higher expected return, but if you implement this strategy you stand to lose 60% of your money.

What does this all have to do with options? Let’s suppose we could buy shares of company ABC – for $100 per share. Let’s also suppose we could buy three-month options on ABC for $10 per share, or $1,000 for options on 100 shares. It really doesn’t matter for our discussion here what kind of an option it is – either a call or a put, or what the exercise price is whether its $100 or,$ 90 or $110.

Three Investments

Let’s consider three investments – I know it’s hard to think of three things at once but try!

Our first investment is 100 shares of ABC stock: 100 shares times $100 per share is $10,000. Three months from now this investment could be worth the same as today, or much more, or much less. In fact, your potential gain is unlimited, although it’s not very likely that the share price will double or triple in three months.  Your potential loss is limited to the $10,000 you invested but again it’s not too likely that the shares will be worthless in three months, although that can happen.

Now for investment number two: buy 10 options. Remember, that since the standard contract is on 100 shares, one option costs $10 times 100 which is $1,000. So you could buy 10 of these options. Now it is possible that the value of the option at expiry will be much more than $10 or it could be $0, but this time the likelihood is different than it was with the stock. If the share price is still $100 at expiry, then – if you had invested in the shares -you would have earned 0% return. But with the option you will have undoubtedly lost a significant percentage of your investment. Certainly if the exercise price of the option was 100, you have lost all your money a -100% return. If the option was a call option and the strike price was higher than 100 you have also lost all your money, or if it was a put with a strike price lower than 100 you have lost it all. Even if the option you bought was a call with a strike lower than 100, you have still lost the original price of the call minus the difference between the strike price and 100 (excluding commissions). So the probability of getting a negative return is much greater with the option than with the stock. But on the bright side, the return on the option investment could be much greater than the return on the shares.

For our last investment possibility, suppose we buy just one option instead of 10. We spend $1,000 on options. We hold onto the other $9,000. Three months from now, even If the option is worthless we still have $9,000. We don’t have the same exciting upside as did with our all option investment, but we don’t have the same depressing downside as we did with our all stock investment. We could make a return as good as the return on the shares, but it is less likely than with the all-option investment (the second investment),but we simply cannot lose more than 10% of our original investment.

The point of all this is, investing using options is still an investment, but the amount and type of risk you take on is up to you.   Options may not be appropriate for every person or every portfolio but if you understand the characteristics and risks of options, you may find that them to be a useful investment alternative.

virtual trading account

Introduction / Learning Outcomes:

Kevin Cook takes you through the foundation of options trading – put-call parity. Kevin answers the question, “Where does the arb opportunity end and logical, fair pricing begin again?” Kevin discusses how puts and calls make up a whole and how puts and calls trade in lock-step. Specifically, you shall learn:

1. What arbitrage means.
2. How arbitrage helps determine fair option prices.
3. Characteristics of an arbitrage trader.
4. How a put and a call make up a whole.
5. How multi-purpose combinations are different from pointless combinations.
6. How multi-purpose combinations allow an options investor to go in both directions for the underling equity.
7. How to replicate a long-stock.
8. How to replicate a short-stock.
9. How puts and calls are locked-in step with regards to their prices.
10. What happens to options when they trade out of line with their fundamental relationships.
11. When it is arbitrage trades become unprofitable.
12. Why options have a built-in interest rate component.

Recommended Exercises:

1. Compare the profit/loss graph of a long stock to the profit/loss graph of selling a stock short.
2. Replicate a long stock’s profit/loss graph.
3. Replicate a short stock’s profit/loss graph.

Calculate the built-in interest rate component for an option.

Open a virtual trading account to practice what you pick up in each module

Lesson 1: introducing the structure of options magic–and profits!

This series–option physics 101–is like nothing you’ve ever seen before! We are going to launch your understanding of fundamental option relationships over the top! And this new knowledge will easily allow you to do what you really want to do with options–have some serious fun and make some serious money!

Do you know what put-call parity is and how to build synthetic positions using options? Of course, most investors and traders don’t, even if they trade options regularly in their own accounts. Nobody wants options trading to be too complicated. That would defeat the purpose of what we are trying to achieve–namely, greater returns with less capital, less risk, and less time and effort.

We only want it to be more complicated if the challenge suits us. Like learning to use complex spread and volatility strategies. These can be a blast once we know how to tailor them to our goals and views of the market. So, to fully enjoy both the fun and the money of trading options, you need to learn what various options spread strategies can do for you. Does that mean you need to memorize all those strategy graphs, and exactly how many calls and puts to buy or sell at which strikes in the butterfly, condor, or ratios?

No–you don’t need to study or memorize anything! Because we have just come up with a way for you to master the fundamental structure of options that will allow you to build the strategies in your head, just from recalling a few basic relationships! By understanding the most basic relationships between calls, puts, and their underlying stocks, you can amaze people with your options knowledge!

Are you ready to master the options universe? Alright then, let’s set the table for putting more money in your trading pockets… We all know that options are an efficient, low-cost way to buy insurance for our investment portfolios. Or, they can be a great, low-risk way to speculate on a market move with leverage.

But they can also be a powerful and dynamic tool for safely generating cash income to boost our overall returns–if we know how to evaluate option prices and probability. So, one of the first challenges we have to deal with is this: “how do we know what is a fair price at which to buy or sell a given option without some fancy trading software to run the numbers?”

We can obviously learn to analyze historic and implied volatility, and then use programs that help us scan and rank the implieds of various option premiums against their historic averages. But there is more tangible and intuitive way to understand option premiums that will give us insight into “what’s a fair price?” And this method will also fuel and ignite your mastery of option spread and volatility strategies–which ultimately are the meat and potatoes of our approach to making money! Heck, the rules and tools you are about to learn will even give you more confidence in your grasp of the option Greeks, too!

You have probably already heard of these tools and rules before, and I hope that if were ever intimidated or confused by them in the past, that after “option physics 101″ you will find them to be your best friends in options trading! So, what are these magic tools and rules? You guessed it! Put-call parity and synthetic option relationships.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Lesson 2: Of Arbitrage and Apples

Put-call parity and synthetics… Sound scary? Fughedaboutit! Once we’re done, you’ll feel like a “made man” in an “organization” where they answer to you.

These are the same rules and tools of the pro option trader. And pro option traders live and die by them! In fact, the pros help keep all option prices fair because they use put-call parity and synthetics to find profitable arbitrage trades. You may remember that arbitrage is simply buying and selling identical, or very similar, instruments simultaneously in two different markets to capture a price difference.

If you recall this fundamental aspect of liquid markets, then you can already imagine that arbitrage is what drives option premiums back to their fair values, as option traders sell overpriced options and buy underpriced ones. So, it sounds like the mechanics of put-call parity and synthetics must be pretty important if they drive something as vital as arbitrage in options markets. Even though you may never do an option arbitrage trade yourself, your knowledge and use of these mechanics will be invaluable in your tackling of option spreads and volatility strategies.

Plus, once you see how easy the rules and tools of put-call parity and synthetics are, you will amaze your friends with your ability to diagram and explain the risk/reward of dozens of strategies! They’ll think you just got your PhD in quantitative finance from the University of Chicago! Okay, let’s dive into these simple “quant” toys!

You know what the profit and loss graph for buying a stock looks like. And you know what the profit/loss graph for selling short looks like. Both have unlimited profit and loss profiles. Would you ever do them both at the same time, at the same price? Of course not—that’s what I call “a pointless combination.” And it’s definitely not arbitrage either!

And only a floor trader or electronic scalper has the skill, resources, and low transaction costs to quickly buy and sell stocks back and forth to capture a profit. But, that is a tough hyper-speed way to make a living. I’ve done it for a large interbank currency desk and it wasn’t easy—and when it was fun, it didn’t last long. So, what does this have to do with options?

Well, think of our stock that we can buy, or we can sell, as an apple. Not a bad analogy for a stock, since God knows (or Jobs knows) you have to own it just for the billions of people who still don’t have an I-pod. Anyway, we can only buy or sell the whole apple. As we learned a moment ago, we can’t buy and sell the stock at the same time. Pointless. One or the other—not both. Now, chop the apple in half. These two halves are our call and our put.

We have just created some more choices by splitting the stock into some components that are merely “easier-to-bite” pieces that can do some different things—things the whole apple can’t do by itself. These 2 pieces are still part of the whole, and share many of its characteristics. They can be put back together and act exactly like the whole again, even though they will never be perfectly like it. By splitting the apple in two, we have gained lots of flexibility, with a minor trade-off.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Lesson 3: The Artificial Intelligence of Options

Last time, we split an apple in half and called the pieces our put and call. But, we said there was a trade-off. The trade-off is limited life. To get all the benefits of options, we settle for a shorter life-span for your strategy to work.

So, we simply made a trade by turning the whole into its smaller, component alternatives. And, that’s exactly what options are—more choices. Our first obvious choices? The call and the put can each be used alone. Here we can replicate the stock with lower risk and lower cost, which increases our leverage and thus our rate of return. And they can be used together in what I will call “multi-purpose” combinations to distinguish them from our prior “pointless” combo.

What are some of those multi-purpose combos? I’d bet you have either traded or heard of many of them. You can buy both a put and call at the same at-the-money strike, and there you have your straddle. You can buy both a put and call at different out-of-the-money strikes, and there’s your strangle. Both of these allow us to do what we couldn’t do with the whole apple of stock—we can now “go in both directions” simultaneously with our apple split in two!

That alone makes us lovers of options!

But, what if we now chop our apple into quarters… Representing the ability to also sell calls and sell puts. Now we have four choices. The multi-purpose universe of option versatility is growing fast! What can we do with these four components? We can create stock artificially!

Or, more accurately, we can create combination positions of options that are equivalent to stock and exactly mirror its profit and loss characteristics. That’s right—we don’t ever have to touch the underlying apple stock, and yet we can create a position that works precisely like it with our 4 apple puzzle pieces.

How do we do it?

For an option combination that replicates a long stock position, we simply buy a call and sell a put of the same strike. For an option combo that replicates short stock, we buy the put and sell the call. These are called “synthetic” stock positions, created only with option combinations!

In this most basic relationship between the call and the put of the same strike, we can begin to see that certain things must be true for these apple pieces to truly be derived from the whole apple, and to truly be capable of fitting back together again to re-create the whole, albeit artificial, apple.

These “certain things which must be true” involve the premiums of the calls and puts.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

OPTION PHYSICS 101: The Powerful Symmetry of Put-Call Parity and Synthetics

Lesson 4: Split Apart, But Forever Locked in Symmetry

We left off in Lesson 3 talking about “certain things which must be true” about call and put premiums. Let me start off here by letting you know that this section is going to be a little more detailed as we dive deeper into the powerful symmetry of option physics.

So hang with me, and don’t hesitate to watch this lesson over again a few times to help it fully sink in. It will be well worth your time to walk away confident in your knowledge of these rules and tools of put-call parity and option synthetics.

So what are we talking about when we say “certain things must be true” about option prices?

Can’t calls and puts just trade at any price traders agree on in the market? Yes they can. And they often do, when markets are moving fast—too fast for arbitrageurs to catch every mis-pricing opportunity. But, we are heading towards an understanding of why they usually trade, under normal conditions, at closely-related, interlocking prices because of fundamental physical relationships. You could say that the call and the put “owe” it to each other to remain in this fundamental pricing symmetry.

And an option that is mispriced relative to its “other physical half,” will provide a prime arbitrage opportunity for professional traders to keep it from trading at just “any price.”

Locked in symmetry on behalf of the underlying stock they represent, the same strike/same expiration call and put must have a consistently logical relationship in terms of their value, even though they have been “broken out” into separate pieces from “the mother stock,” so to speak.

Let’s look at a few examples to highlight why this is true and what laws of option physics this relationship must follow…

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Assume a stock is trading at $30.

The 30-strike, 3-month call and put have the following premiums: the call is trading around $4, and the put is trading at about $5.

You probably notice right away that since both of these options are at-the-money, both of their premiums consist largely of time value.

But, do you notice any trading opportunities?

There is a great arbitrage trade here that pro option traders would snatch up immediately!

You could create a synthetic long stock combination that pays you $1 for being long the stock at $30—which is essentially like buying the stock at $29 when it is trading $30!

Let me break this trade down for you, so you can see the money flow:

First, we go into the market to buy the call and sell the put, either as a spread order often called a combination, or as separately legged trades. We receive a net credit of approximately $1, depending on our actual execution prices ($4 out, $5 in = $1 credit).

Believe me, since these options are sorely mispriced relative to each other, there will be a lot of traders piling into this one and driving their prices closer their current $1 difference. But, even if we get it done at say, a 50 cent credit, we will profit from the arbitrage.

Here’s how: we now own the stock “synthetically” at $30—and we got paid to do it, so whatever credit we received instantly reduces our cost for this position. It seems that now we just have this synthetic long stock position… so, where’s the arbitrage profit?

Remember, the idea of arbitrage is to quickly buy and sell in two different markets to capture a price difference, a profitable discrepancy. Once we trade both sides, our risk is eliminated, or at least controlled, and our profit—hopefully—is in the bag.

So, we need to offset this synthetic long stock trade with a corresponding short stock trade in another market. That way our risk is limited or “hedged,” and our profit realized.

Where do we go to offset or hedge this trade? The one other market we know of that is closely related to this one is the actual stock itself. What do we do? Well, the smart pro traders have probably already done it while I was standing here talking about it.

After they initiated the synthetic long stock position, they immediately went and sold the equivalent number of shares in the underlying stock to “lock in” their profit. If they put on the synthetic long 30-strike combo for a dollar credit and sold the cash stock for $30, they pocketed a risk-free $1 profit—ignoring transaction or financing costs.

Would you like to do this trade? ALL DAY, right?

And so would every professional in the market!

That means the arb opportunity won’t last very long. In reality, it probably would never exist, as long as enough traders are paying attention. The prices of ATM calls and puts will be much closer, and in fact, if any price difference exists, it would probably favor the call being more expensive than the put. This logic will all be explained in a coming lesson.

We’ll see what happens to this trade, and where the call and put would normally be priced–when enough traders are paying attention—in Lesson 5. Take a break now—I know this was a lot of material to think about. I’ll be there when you’re ready to learn more about The Powerful Symmetry of Put-Call Parity and Option Synthetics!

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Lesson 5: What’s a Fair Price Relationship for Puts and Calls of the Same Strike and Expiration?

In our last discussion, we found out that calls and puts of the same underlying stock, with the same strike and expiration, don’t just trade at any price traders agree on in the market. There are consistently logical relationships that tie their prices together, and if these prices trade “out of line” with those fundamental relationships, then option arbitrageurs will quickly notice and step into the market to take advantage of the price discrepancy. Their arb activity will drive prices back to “fair value” and eliminate the mis-pricing opportunity.

So, using our last example from Lesson 4, we might want to know, “Where does the arb opportunity end and logical, fair pricing begin again?” To understand that, we need to go a little deeper into put-call parity and synthetics. First let’s review how the arb opportunity worked in our earlier example.

Remember that the put was “overpriced” relative to the call (or you could say that the call was “underpriced” relative to the put) and we were able to create synthetic long stock at an effective price that was below where the actual stock was trading. This gave us the chance to buy the stock synthetically at $29 while it was trading at $30. I say “chance” as in opportunity because there are no guarantees, even in arbitrage where you must move quickly and secure both sides of a trade to lock-in the “risk-free” profit. In other words, it’s not risk-free until both of the trades are done and consequently hedge one another.

Where would the arbitrage cease to be advantageous? Depending on your capital and transactions costs (and possible other considerations like dividends, corporate events, and the ramifications of early exercise potential), we’ll say that the arb in this situation ends somewhere around a difference between the call and put prices of $0.25, with the call priced higher than the put. That could be achieved with a call price of $4 and a put price of $3.75, or a call price of $2.25 and a put price of $2. And we’ll soon see that it doesn’t matter what the actual price levels are of the options because it is their value relative to each other that counts.

How did we come up with this $0.25 call premium over put premium? I’ll be honest with you—there’s a little bit of math and investment theory involved. But, it’s also based on a lot of common sense. It has to do with how anyone would have to approach this trade, or any investment for that matter–by considering the cost of money to finance the positions. In our arbitrage example, we had to be able to sell short the actual stock to lock in a profit against our long synthetic stock position. That short selling ability is not a free service from your broker. We have to deposit margin funds in our brokerage account equivalent to at least half the amount of the stock, in this case $1,500, and then you have to pay margin interest to your broker on the rest for their ability to borrow or secure stock they may not own, but will be responsible for if the stock goes higher.

In the simplest scenario, if you already had sufficient cash to fund a margin account that would allow you to short a $30 stock, you would still have an opportunity cost for that money. In other words, like any investor with choices for asset allocation, you can decide to keep your cash in an interest bearing account, or buy Treasury securities or some other low-risk investment like a CD. You should therefore expect to include that opportunity cost of money in your calculation of the cost of any stock position, long or short. The costs associated with buying or selling stock are described formally by investment theory as the cost of carry.

On the other hand, if you had no money, you would have to borrow it and pay interest on the entire $3,000, or more, to be able to deposit it in your account and cover the margin requirements of your broker. In either case, the cost of money is always a factor in calculating the fair price relationships of puts and calls because of the fact that they can ultimately be combined to create synthetic stock positions, and those “future” positions must have cost of carry implications in their pricing.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Kevin Cook takes you through the foundation of options trading – volatility. “Volatility is your best friend in options trading…” Kevin walks you through the general definition of volatility, how to calculate volatility, how to compare volatility against different stocks and time periods to get a better read on the stock, future volatility and the mythical implied volatility. Specifically, you shall learn:

1. A general definition of volatility.
2. How volatility is used in options pricing.
3. How standard deviation is used as volatility.
4. How probability can put profits in your pockets.
5. How to interpret a volatility reading.
6. Why the options market uses volatility to determine the future.
7. How volatility is the speed in which an option reaches a price.
8. The definition of historical volatility.
9. How traders use future volatility.
10. How option market makers use forecast volatility.
11. Where implied volatility is generated.
12. How each volatility generates a unique price in the Black-Scholes option-model.
13. Why implied volatility describes an options risk.
14. How to trade options using implied volatility.

Recommended Exercises:

1. Calculate the standard deviation of a stock’s monthly returns for the past year.
2. Calculate the standard deviation of another stock’s monthly returns for the past year.
3. Compare the standard deviations of both and determine which stock is more volatile.
4. Using the first stock, calculate the standard deviation of the stock’s monthly returns for two years.
5. Compare the standard deviations between the stocks using one year and two years. Compare if the stock has increased volatility, decreased volatility or remained the same.
6. Look at three stocks priced similarly. Calculate the standard deviation of each. Add each of the stock prices with their standard deviation respectively. Compared which stock is predicted to move the most and the least.

Find the implied volatility for an option.

Open a virtual trading account to practice what you pick up in each module

Lesson 1: what is volatility and why is it so important? (Part I)

Volatility is your best friend in options trading…

Not only is it an extremely powerful, must-know tool for analyzing and trading options, it has the greatest overall impact on the day-to-day, week-to-week changes in option premiums—and thus on your profit and loss!

More specifically, it is the single biggest factor in the gains and losses of time value in those premiums. If you can learn to use volatility tools and rules to your advantage, you can launch your options trading profits to a level that is consistently above average, if not to a level that even a pro would envy.

Pro option traders don’t care whether a given stock or the market goes up, down, or sideways, because they have mastered the art of trading volatility. They buy options when their real value is priced too low and they sell options when their real value is priced too high. And volatility is the powerful tool that tells them what they need to know about option prices and their real relative value.

You may not have the time to devote to options analysis the way the pros do, but you can still replicate their strategies once you become friends with volatility.

There are 4 types of volatility you need understand.

In this series of lessons, we will introduce and clearly define all four, so that you will possess a solid understanding of this most powerful weapon in options trading. Then you can begin to utilize this knowledge in your trading strategies to make better decisions, fluidly manage risk, and bank more profits.

Before we can talk about the different types though, we need a working definition of volatility that will carry us through the ins-and-outs of how all the types relate to and effect option prices.
Volatility is either a measure of past price fluctuation over some period of time, or it is a prediction about future price movement over some period. We’ll start in this lesson with the past usage, whose mastery is necessary before we can use the 3 future tenses.
Since vol is a measure of price fluctuation in an asset that we may wish to buy or sell, we can also think of it as a measure of risk.

So what does this measure of price changes and risk do for us?

For starters, as soon as we get a past volatility measure for a stock, we can plug it into an option pricing model and determine a relatively accurate option value. But, if we want to improve our accuracy, we will learn to adjust this past vol based on our assessment of the future.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Lesson 2: what is volatility and why is it so important?

Welcome back to our video series on volatility. This is part ii of the introduction.

Question: if a stock was trading at $50 one year ago, and today, a year later, it is trading at $50; do we know anything about its volatility? It seems tame enough…

But, of course, the stock could have been to $100 and back for all we know. Knowing the 52-week high and low would help, but that still doesn’t quantify vol for us, because that doesn’t tell us if the dramatic up and down—from $50 to $100 and back—happened in one week, or more gradually over the course of a year.

So how do we measure price changes to give us an accurate reading on volatility?

To start with something manageable, we can get an idea of how much the price of a stock changed last month, simply by measuring the daily price changes from close to close. We can get that info right off a price chart w/ closing data.

We might observe that our $50 stock moved more than 50 cents on 75% of the days last month, and over $2 on 20% of those days, with 5% of the days recording a $4+ move.

Now we are getting closer to quantifying volatility. From this past data, we may or may not conclude that the stock was indeed “volatile” last month.

But to get a more accurate interpretation, we would need to crunch the daily net change data into a mathematical formula to give us a single number that represents that stock’s volatility over some time period.

Don’t worry—I’m not going to ask you to do any equations. I just want to refresh your memory regarding something you may already know about vol. If you took statistics in college, you probably can’t forget that freshmen scourge “standard deviation.”

Well, that is exactly what volatility is—a statistical calculation of price fluctuation over time. Vol is just another name for the standard dev of price changes. It is expressed as a percentage and describes how much a stock moved, on average, over a one year period in the past.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Lesson 3: how probability can put profits in our pockets

In our first two lessons in this series, we introduced volatility and are still learning to define it in its statistical terms.

The probability functions of volatility will allow us to make weighted predictions in our stock and option trades. And that will improve our profits and risk management tremendously! In fact, we will be mimicking the highly successful approach of professional options traders.

Do you like to play poker or maybe chess? Both of those games are all about probability, weighted to your particular view of risk and reward. Well options can be as simple or as complex as those games—the complexity is up to you—and if you learn to use the probabilities it consistently hands you every day, options trading can be ten times more profitable than either—and twice as much fun because the combinations are nearly endless!

In a poker game, there are 2,598, 960 5-card hands. In options trading there are at least that many stock and option combinations—but when you combine that with all the other variables of volatility, stock stories, and your own completely self-determined “hands,” you get a never-ending flow of ideas and opportunities!

Now, let’s look at an example of vol so we can begin to learn how to use it. A 20% volatility reading for a stock really says, “in the past 12 months, this stock was known to have made daily moves that, randomly and on average, would carry it as much as 20% higher or lower from its starting point in one year’s time about 2/3 of the time.”

There’s that probability component. A 20% vol or s.d. simply tells us that this stock can be expected to trade in this range—20% higher or lower—about 2 out of 3 times one year from now. We’ll go over an example like this again, don’t worry.

What we are most interested in now is, “where did this 2/3 probability come from and how can we use it?” Follow me right now over to lesson 4, “how probability can put profits in our pockets—part ii” and we’ll dive into it!

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Lesson 4: how probability can put profits in our pockets

When some rocket scientists figured out statistical analysis of frequency data a couple hundred years ago—actually they didn’t have rockets back then… let’s just say they were really smart Swiss, German, and French math freaks—anyway, what they came up with was all sorts of calculus stuff that we now accept as quantitative law, and one of the most useful things they discovered was the probability aspect of standard deviation.

Remember from lesson one, we wanted to know if a stock’s price fluctuation over the past month was volatile or not. Well, we now know that of course it was volatile, but the real question is how volatile, relatively speaking. To answer that, we want to compare it to some longer period in the past.

To really know if our one month period was volatile, we should compare our calculation to a longer series of past data; say the trailing 12 month volatility.

And this is the way that historical volatility is normally expressed—as the annualized standard deviation for a stock’s price fluctuation in the past year.

Why would this be useful?

Well, you might be interested in investing in or trading stocks with high volatility, and avoiding stocks with low volatility. Or, vice versa.

And if you are an options trader, you are really interested in volatility measurements because they not only tell you which option prices are changing a lot, in percentage terms, due to their volatile underlying stocks or due to the market’s perception of future risk—but also how to evaluate those prices.

Once you begin to investigate various volatility levels in your favorite stocks and how they affect option premiums, you will be more knowledgeable, more confident, and more skilled in your approach to trading option spreads.

Here’s a graph of a price distribution, with the most frequent price changes grouped together in the middle, and the less frequent occurrences spreading out in a gradual decline toward the edges, or tails.

You may recognize the bell-shaped curve that defines a normal distribution. Notice also that the curve spreads out from its peak in a symmetrical fashion. This is because standard deviation calculates up or down price movement as having almost the same probability. A stock can go either way, on any day, and to trade options profitably, all we need to know is how much and how fast it might move. And that is what volatility tells us—not direction, but speed.

If you want to evaluate and profitably trade stocks and options for yourself, then all you need to know is how to use the laws of probability to effectively gauge and monitor the speed of a stock and its options.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Understanding volatility—the 4 varieties you need to know

We said in lesson 4 that profitable options trading is based largely on knowing how to gauge and monitor the volatility of the stock and its options. This is easy to do once you understand vol as the speed and probability of the instrument you are trading.

Let’s look at another set of probability distributions for 3 different stocks, all trading at a price of $50, overlaid against one another. This graphic allows us to compare both the speed of the stocks’ movements and their probability-weighted degrees of fluctuation.

Volatility, expressed as a 1 s.d. move in a stock, defines what the chances are of that stock either staying within or exceeding a certain percentage change from the mean, or average, over the next year. That was a mouthful, so I’ll explain.

In the case of a stock price, the current price is always the mean. And vol is always expressed as the 1-s.d. percentage move that estimates the farthest we can expect our stock to travel away from that mean in one year, about 2/3 of the time. And this is based solely on the past data of price fluctuations.

The 3 probability distributions, or volatility curves, all behave differently. A 1-s.d. move on the tall, narrow curve where prices are grouped closely stays closer to the mean than a 1-s.d. move on the shorter, wider curve that spreads out quickly. Thus, the wider curve is faster, and has a higher vol. The slow, tall distribution might have a vol of 10%, and the faster, wider curve might have a vol of 30%. Remember the more spread out the distribution of data, the higher the vol.
What the curves share in common is the probability of staying within or exceeding their own vol measurements. Based on the specific math of stats…

For the purposes of an options trader estimating probabilities, we can round these calculations the following way:

If you think about it, this last description of 3-s.d.’s means that only one time in 370 occurrences, or 0.27% of the time, will you have a 4-s.d. move. To exceed a 4-s.d. move, the probability shrinks even more dramatically to something like once in every 10,000 occurrences. But that doesn’t mean they don’t happen more often.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Lesson 6: volatility is all about speed and probability!

What can we do with our knowledge of statistical probabilities? For starters, you can now make predictions about stocks and their options simply by looking at historical volatility. Based on past data and a little statistical breakdown done by an s.d. calculator, we can surmise the likelihood of certain ending points for our stock one year from now. How? Simple. The volatility measurement already tells you the relative probability that a stock will be that much higher or lower 12 months from now.

For instance, if a stock’s historical vol is 20%, with the stock currently at $50, there is about a 2/3 chance the stock will be between $40 and $60 one year from now—in other words, 20% lower or higher than it is now. And there is a 95% chance that the stock will be within 2 s.d.’s one year from now. Finally, there is a better than 99% chance that the stock will be within 3 s.d.’s at the end of 12 months.

The historical vol we’ve been talking about is simply the “crunched” data about price changes from the past. When we learn how to compare this volatility to the other 3 varieties, we are on our way to using volatility to our advantage—and our profit.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Lesson 7: Historical Vol vs. “Future” Vol—The Recipe For a Prediction

Up until now, we have been talking about historical volatility—the vol that is measured from past data of price changes. We know what a stock did in the past, but is that a reliable source of information about what it might do in the future and how cheap or expensive its options should be?
We are still faced with the unknown future and hist vol is only a reading of past data that tells us only what is likely to happen based on that history. What option traders would really like to know is future volatility. If they knew exactly how volatile a stock was going to be, they could know exactly at what prices to buy and sell its options and make gobs of money. Good luck, right? And if only I knew where Google was headed…

If you ever hear anyone mention future vol, this is the sort of thing they are referring to—quite simply, the one thing that no one knows, but every one wants to know—what vol will be in the future. It is the actual vol that will happen in the time between now and an option’s expiration, and then eventually become historical fact. Since we can’t know the exact future, it seems silly to talk about it, right? You probably won’t hear it mentioned very often, but it is in the textbooks, so to speak, so I just wanted you to know what traders or professors are talking about when they say “future vol.” It is sort of like talking about whether it will rain 3 months from now on June 21st. We have no way of knowing and aren’t really concerned about that kind of precise prediction—unless of course it’s the day of your daughter’s wedding.

Instead of pretending they have a crystal ball, pro option traders focus on making more reasonable predictions about general levels of volatility which help them to quantify the appropriate risk for a given stock, or index, and its options. So even though “future vol” might be irrelevant from a practical standpoint, it is useful in one sense that aids our understanding of the more critical types of volatility we want to know about. Because it begs the question, “How useful is the historical vol in helping me formulate an opinion about the future?”

It captures the essence of what we want to achieve. Together these two descriptions of vol, one mathematical and factual and the other mere fantasy, form the sidelines of time that define the playing field we find ourselves on. In between them is where the action happens. In between the past and the future, between historical volatility and future volatility, lie our 2 most-active, most-used types of volatility.

These two volatilities help us determine option price values and compare them to each other, sort of like a stock’s p/e ratio tells you more about the stock’s value than its price and gives you a good, relative basis to compare it to lots of other stocks or to an index.

Option traders are free to decide on their own how relevant the past volatility is to their own predictions about the future. Thus historical volatility is only related to an options price in the sense that traders base their forecast volatility on some reading of the past.

If historical volatility is 20%, but traders perceive more risk in the market currently or in the next few weeks and months, they will adjust their forecast volatility upwards, say to 35%, or 60%, or even higher!

And this affects the premiums they are willing to buy and sell options at because this forecast vol is input into their option pricing model—and a higher volatility input always increases option premiums! We’ll see how this works next in lesson 8!

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.

Open a virtual trading account to practice what you pick up in each module

Lesson 8: Forecast Volatility—or, How to Cook Your Own Option Prices

If you are comfortable with your understanding of historical volatility and future volatility, you will have no problem with what’s next.

Now we want to get a grasp of the other two more active volatilities—the volatilities that are being used on a daily basis by option traders around the globe.

First, we want to understand how option market makers use forecast volatility, which is their estimate of expected volatility in the stock and option markets.

Next, we want to know the what and how of implied volatility, which is what actual option prices tell us about the volatility that is currently being traded in the market and is therefore what the market as a whole–the total combined effect of all buyer and seller activity–is expecting for the stock or index.

Forecast volatility is what individual traders expect. It is the estimate they will use in their pricing model. They will likely look at historical volatility to help them formulate their estimate.

Again, because option traders are free to decide on their own how relevant the past volatility is to their own predictions about the future, historical volatility is only related to an options price in the sense that traders partially base their forecast volatility on some reading of the past.

Once a trader has decided what forecast volatility he or she wants to use, that volatility estimate is input into the option pricing model the trader is using to produce theoretical option values.

An option pricing model has several inputs that, like ingredients in a stew, combine to produce a theoretical value for the option based on 6 variables: stock price, strike price, time left to option expiration, interest rates and dividends, and finally, the forecast vol. We cover the mechanics of option pricing models in another video, so I won’t get too deep into that here.

For a given option, with a particular strike price and expiration, the only variables in the pricing model that will change enough to significantly affect the option premium over its life will be the stock price and the forecast vol.

The stock price we have no control over. But the forecast volatility is where analysis and strategy comes in for professional traders.
Here’s our option pricing model. We’ll pretend it’s the Black-Scholes model.

Hey do you think that’s where the expression “black box” trading comes from? (sorry, a bad double pun there)

Remember forecast volatility is the one input that can be the most variable among different traders, and thus has the most effect on option prices.

So, in goes the forecast volatility into the option pricing model… And out comes our option price!

The option pricing model crunches the numbers and spits out a “fair” theoretical value for the option, at that point in time, given all the inputs.
Keep in mind that tomorrow is a new day, with at least one input changing as we are one day (or weekend) nearer to expiration.
We now understand forecast volatility–where it comes from, how it is used, and what its important role is.

The bottom line of volatility prediction and forecasting is this: the future volatility of say, a 3 month option, might be a completely different story than the historical volatility can help us with! That’s why we need to not only do our homework about what accurate historical volatilities are relevant to the current market environment, and to our risk tolerance. We also need to pay attention to what volatility levels are actually trading in the market. We’ll cover that next when we talk about implied vol.

Our final lesson in this video series will explain—in less than 60 seconds—what implied volatility is and where it comes from. Let’s wrap this up with the most important volatility yet. I’ll meet you over at lesson 9 right now!

Open a virtual trading account to practice what you pick up in each module

Lesson 9: Implied Volatility—What the Current Market’s Speedometer Shows 

This is so easy, you’ll wonder what all the fuss is about! Implied vol is not mystical fortune-telling, and it’s not rocket science either.
Let’s flip the option pricing model

It’s just a simple flipping of the option pricing model to give us one output instead of the other, just by switching inputs.

Input a price variable to get the volatility

Instead of inputting a volatility variable, we input a price variable—a real option premium level currently trading in the market—and that gives us a vol reading as the output.

In other words, implied vol is the vol we can “reverse out” of the option pricing model, just by knowing the option premiums that are trading.
Let’s grab our Option Pricing Model again and see how it works…
We simply leave any known or forecast vol out of the equation as the unknown, input an option price that is relevant to us—say that day’s atm call and put prices—and the model solves for volatility, spitting out the implied vol that the options are trading at, all other variables being equal.

Instead of inputting forecast vol to get an option price, we input an actual option price and got implied vol!

The option price implies a particular vol, which describes where the market is actually trading. Options might be trading at much higher or lower vols than the historical average.

Implied vol tells traders what option prices say about risk

And this is important knowledge pro traders use to make $$. They can update their pricing models with new volatilities to reflect new market information—any time during the day. Even trading-floor-based option market makers can change their volatility forecasts, or use option prices to tell them what IV is trading—especially if they have a wireless notebook with their pricing model software built in, or connected to their firm’s computers.

Option market makers update their vol inputs often

When I first worked as a clerk in options trading pits back in the 90’s at a commodities and financial futures exchange, most of the traders had their “sheets” with all the price and risk data for every option and strike they were interested in making markets for. You may have seen these sheets, loaded with tiny little numbers in neat little columns and rows—seemingly impossible to read, but you’d never know it watching the pros. When an order-filler asked for a market in a given option month and strike, the whole pit would look at their sheets and begin barking out bid/ask spreads as quickly as possible. Sometimes they were like synchronized swimmers—broker says “June 50 puts…” and the crowd looks and yells in unison… 20 30!” Other times it’s a cacophony of noise, because a couple of market makers were quoting May, or the 60 puts, and the broker has to yell again “June 50 puts!”

Sheets have theoretical values for different vols

Many futures options pits have traders that still use sheets, even thought the majority of equity options traders now rely on notebooks. My main point is that even those traders using sheets could carry sheets with different volatility forecasts so that they could quickly respond to changing levels of risk or fear in the market. For pro option traders, information is the currency of profit and they are masters at managing the right info for maximum gain. That “right” info is Implied Vol and its associated risk tools, the greeks.

So, how can we learn to use implied vol?

Well, that is where the rocket science and fortune-telling art come in. We talk about this vital dimension of your options trading strategies in our video “Making Money with Implied Volatility.”

Hey, you’re still here…

Tell you what, you’re in luck—if you’ve got another 90 seconds, I’ll share an example of how traders use IV…

Say you are watching a pharma or biotech stock that has a new drug in clinical trials or is rumored to have troubles with an old drug that might lead to patient lawsuits. The stock itself may have a historical volatility of only 40%, but the options Implied Volatility begins trading at levels that are twice that. Is the options market predicting the stock’s volatility to double in the near term? In a sense, yet it is.

For some option investors and traders, who are hopeful or concerned about the company’s volatility, they may be expecting a larger move in the stock than its historical vol indicates is likely. And their activity of bidding up the premiums of calls and puts is pushing IV to much higher levels.

So, how does an option trader make money off of this situation? First you have to decide if you think the market is “right” about a doubling of the volatility. This is still subjective, and your research, or your access to the rumor-mill, may be no better than the rest of the markets. Maybe this extreme push in volatilities is not justified by any available market intelligence and you feel you can sell some of these “over-priced” options to profit from the market’s currently exposed fear after it subsides. Or, maybe the higher IV is a correct barometer but the market is only partially correct, and you are willing to pay 95 or a 110% IV for some calls or puts. If that’s the case, you will buy these options now at 80% IV in the hopes of selling them at say 120% IV when the news or fear reaches a crescendo.

More important than your assessment of the whether the IV is the right volatility for this stock and its options and will thus become the actual or realized vol over the life of these options, is the challenge of being able to trade this extremely high IV and not be hurt by it. The pro option trader may look for ways to partially hedge his exposure to the actual moves that might occur after all the news is out. He or she may decide to sell the front month options with 80% IV and spread them against farther out options that have only 50% IV in what is known as a Calendar, or Time Spread.

Traders might also opt to take a calculated bullish or bearish position, based on their view of the stock, by selling high IV OTM options and hedging partially, or completely, with the stock itself. For instance, they might be bullish on the stock and choose to sell overpriced OTM calls as they simultaneously buy the stock. Or they could be bearish and choose to sell overpriced OTM puts that they hedge by selling stock. These hedged trades may be done in such a way as to gain maximum profit from a stock move with a little more risk, or they may done so that they the P&L is affected only partially when the stock moves, something known as delta-neutral trading. And many variations of these types of volatility trades can be done without having any bullish or bearish opinion.

These are just a few examples of the kinds of money-making opportunities that exist when you know how to use Implied Volatility.
I want to thank you for joining me in this 9-Lesson intro to Understanding Volatility. If you’ve made it this far, you have done yourself a huge favor by establishing a clear foundation of basic definitions and concepts that will enable you to advance your knowledge of options volatility quickly.

When you join us in our Advanced series “Making Money with IV,” you’ll start to learn about different time-frames of IV and how pro traders use them to extract profits from the options markets every day. I hope to see you there!

LONG CALL PRACTICAL BASICS #1

Now that you have learned the basic academics of the long call, let’s take a look at the application and practical side of the strategy, with some specific examples.

Trading any strategy should involve the development of a set of rules and guidelines that you set out for yourself , a checklist if you will. Rest assured, we will set up a checklist for each strategy we discuss. The aforementioned checklist will make sure that certain parameters exist, parameters that must be met before any trade is made. These parameters, along with a trading plan (which lays out your risk tolerance and money management guidelines) is an essential strategy if you want to take steps toward consistent trading success.

Let’s take a look at the concept of the Call option, which is the most basic and the most common of all options strategies. It is much like a coupon; we will discuss that concept later on.

There are many choices when it comes to buying a call; many different strikes offered, along with many expiration months to choose from. All of these choices could make finding the right option seem like a daunting task for most beginners.

Let’s bring this discussion to layman’s terms, shall we?

Calls are comprised of 2 types of value, intrinsic (or real value) and extrinsic (or time value). How are these values determined? The intrinsic value is determined by the price of the stock, and is all that is left of an option at expiration. The extrinsic value of the option is the eroding value of the option as it approaches expiration, the time value is calculated by a mathematical model, for this example we are not going to focus on how it is calculated, just how much is there.

Let’s say you went to your local gas station to fill your tank for $4.00 per gallon. You walk into the store to pay for your purchase, and the clerk offers you the right to purchase a gallon of gas for a specific price, $3.50 for the coming year this costs you $1.00… some deal, right?

You take the clerk up on the offer and you purchase the call option for $1.00 (for this illustration, let’s call it a voucher). No matter how high, or low (this is key), the per-gallon price of gas fluctuates, you will pay $3.50 per gallon. A day later, Saudi Arabia announces that it will cut production, raising demand – which eventually translates into a per-gallon price of $6.00 for gas.

You are sitting pretty since you have the right to purchase gas for $3.50 per gallon for the next year. If this happens, your voucher is then worth $2.50 – the current gas price less the face value of the voucher.

You could then sell your voucher to someone else, if you were so inclined, at a price better than what you originally paid. Of course, you then transfer your $3.50-per-gallon right to whomever purchases the voucher.

Unfortunately, you aren’t always a winner.  

What if gas supply far outstrips demand? If this happens, the per-gallon price of gas could drop to $1.00 per gallon. What then? Well, you are still going to go to the pump and pay $3.50 per gallon if you use the voucher. Of course, you could always decide to pay $1.00 a gallon and is the most you could lose is the dollar you paid for your voucher. Regardless, your max risk is the dollar you paid for the voucher.

Let’s substitute ABC stock for the voucher. The same concepts apply, ABC stock currently trades at $50.00 per share, and you are thinking about purchasing the Jan 45 call which expires in 180 days and the call is trading at $6.00 (ask price). If the call is trading for $6.00, it can be assumed that $5.00 of that call is intrinsic (or real) value ($50 stock price – $45 strike price)and $1.00 is extrinsic (or time) value ($6 option value-$5 intrinsic value). That $1.00 of time value will decay at a certain rate, which will be discussed later. If the stock rises to $55.00 by its expiration date, it will then have $10.00 of intrinsic value ($55 stock price – $45 strike price). Although we have lost all our time value, the call should be trading for its intrinsic value – or very close to it. If that is the case, we would have realized a 66.5% return (excluding commissions).

The good thing about buying a call is that you can’t lose more than your premium. This fact means that if I paid $6.00 for the 45 call when the stock was at $50.00 and the stock dropped to $10.00, I would lose my $6.00 investment. Of course, this limited loss does not mean that calls are low risk all the time. You still have to be correct in the direction of the stock before the expiration date and manage how many contracts you buy. Try not to think that the more contracts purchased, the better. One thing I want to note is that on expiration, the call will be worth its intrinsic value only. It is a common misnomer that all options are worth nothing at expiration.

So what are the risks? Risks are unique in every situation because every underlying issue is distinct. First, the long call trader needs that stock to move higher than the strike price plus premium paid, or they likely won’t make any money on the trade.

Next – depending on the delta (one of those Greeks we’ll discuss later) the trader purchases – the stock needs to move a certain amount. Finally the trade needs to happen within the option’s lifespan. Because most call buyers have an opinion on which direction the stock is going to move they want to find an option that will not only move when the stock moves, but one that also reduces their risk compared to buying the stock.

Unfortunately, many options traders don’t use advanced Greek analytics, so they need a simpler method of finding the right option to trade. Let’s look at a simple way to analyze an option’s price and a method for choosing an option.

Start off by determining how much of a desired option is time value and how much is intrinsic. Remember, time value is the part of the option that deteriorates throughout the option’s life span. For instance, if the option you select has $2.00 of time value and is already in the money, you know that by expiration you need that stock to move greater than $2.00 from its current point. The key words here are BY EXPIRATION, if you held this option till expiration, you would only be left with intrinsic value. Holding a long call till expiration is not always the best strategy as time value is going away every single day. (explain why it is ‘needed’, because the next two sentences say that you don’t need it to move $2 in order to make a profit). The good news is that you can potentially profit, even if the stock makes a smaller upside move. If the stock makes a move fairly quickly (within a day or so), let’s say it increases $1.00, you may profit from that move because the stock moved faster than the option was losing time value. we will discuss this in our later lessons.

LONG CALL PRACTICAL BASICS #2:

Now we know that you can profit – and lose for that matter – from an option with its intrinsic value. Some investors actually trade options simply using the technique we just discussed. As you progress in your option education, you will come across some terms that may seem a bit foreign. One of those terms may be delta, which is a concept I will introduce to you in this session.

A call option is a derivative, meaning that its value is derived from the price of the stock. Different options have different relationships to the stock. Think of delta as the link between the stock and the option.

The higher the delta, the more solid that link is – almost like a steel bar. The lower the delta, the more that link becomes like a weak rubber band – which, in turn, makes the relationship less dependent on stock movement and more dependent on other factors.

If there is one Greek that you learn, get to know delta, it’s a fairly easy concept to master. Primarily, delta tells us the rate of change in an options value for every $1 move the stock makes. So, if you have a delta of .80 and the option is worth $5.00 with the stock at $50, and the stock moves to $51 this means the value of your option will increase roughly $0.80 cents. Delta is also a good indicator of the ratio of intrinsic to time value. Basically, the higher the delta, the higher the intrinsic-to-time-value ratio. Another way of thinking about this is the higher the delta, the more expensive the option.

An option with a delta of .90 will usually be in the money, meaning that it will have real value (intrinsic value). This option may have a large amount of intrinsic value and a small amount of time value, where an option with a delta of .30 may have zero real (or intrinsic) value and a fair amount of time value. You can learn more details about delta in our other sessions.

As I said earlier, there are several ways to think about buying call options. Some traders buy lower delta options for less money.. While these have less of a chance of being worth anything before expiration, they are attractive because of their price. These out-of-the-money options are cheap and may have a higher percentage return if they are successful because of their relatively low cost (excluding commission). Other traders prefer deep in-the-money options which can be more costly, but tend to mimic the stock more accurately. This does not mean go out and just buy the largest delta possible, when considering an option with more than 30 days until expiration, the higher a delta gets, the more expensive it becomes, for me personally I typically don’t purchase an options with a delta greater than a 0.92 delta because higher deltas can diminish your leverage excessively, this is a personal preference. Certainly an option with a .99 delta will behave much like the stock, but it may cost a bunch relative to the other options. Remember, the name of the game is risk reduction.

Speaking of cost and risk reduction, retail traders are typically attracted to options because of the leverage and limited risk that they may provide (remember buying options has limited risk, selling options may expose you to potentially unlimited risk).

Because of this attraction, investors are sometimes drawn to inexpensive options, because at such a cheap price they can be quite alluring (they can also be dangerous). If you remember the previous section on delta, you know that delta not only tells us the rate of change in an options theoretical value, it also tells us the percentage chance that the option will expire in the money. For example, if you continuously purchase options with a 0.10 delta, you have a roughly 10% chance that option will be worth anything at expiration. What is worse is that some traders feel that since these options are so cheap, they “load the boat” and buy many contracts. Think about it like this, you’re about to place a bet on a horse race, odds are 10 to 1 that the horse will win, and the ticket costs you $1.00. Whether you buy one ticket or 100 tickets, your ODDS of winning remain the same – you only increase your investment. It’s not like a fixed-ticket raffle where the more tickets you buy the better your chances of winning (even though you’re paying for it in that case!). This is the mistake that many new traders – or traders without a plan – make, they take the fixed sum of money they have to invest and think that more options will get them to profitability quicker. This is completely false and we can prove it!

We’re going to take you through the basic catalog of the different ways options are used, alone and in combination, by the vast majority of traders and investors.

We will first give an overview of the strategy – what sort of view it implies and how the strategy might be expected to perform if you used the strategy as a matter of course, that is, if you did it regularly and consistently. In fact that’s what a strategy is – a plan that you carry out to achieve an objective.

Carrying out a strategy requires you to first do your homework on the stock, finding out what the market thinks of its prospects, deciding whether you agree with that assessment, and looking carefully at the option market as well (particularly the level of implied volatility and understanding what that important variable is indicating about future uncertainty in the stock’s return).

Always keep in mind that chance plays a large role in the market. This caution doesn’t mean that there is no order to how the market works, just know that no matter how well thought out your plans may be and how much evidence there is that your view is correct, no one can control the oft-random-seeming events in the market along with unforeseeable developments for a specific company.

You can never predict when a CEO is going to get caught committing fraud, causing the share price to plunge, or when a company is going to get a favorable bid to be taken over with the resulting uptick in the share. You should see our discussion about uncertainty and distributions for more depth on this.

After giving the overview, we will take you through the basic analysis of the strategy, looking at value and potential profit and loss.

Then we’ll show some examples of the strategy in action, using scenarios we will construct for the purpose.

Finally we’ll look at some prices taken from the actual markets to give you a sense of what the conditions might look like if we were to implement the strategy under those conditions. Always keep in mind that market conditions are continually changing, so you will have to evaluate the prospects for the strategy in the market when you execute the strategy. 

Whether you are an investor hoping to improve the returns on your portfolio, an occasional options trader wanting to supplement your income, or a person determined to earn a living by trading the options market, you need to know the basic concepts we will present to you in this series.

We wish you the best of good fortune in whatever your personal objective may be.

Expiry

Now, what about choosing an expiry for an option trade? Generally longer term options cost more than shorter term options on the same shares with the same exercise price. Although price is a consideration, the investor also has to incorporate his/her view on the timing of any movement in the share price. The investor may think that good, or bad, news may come out about the company over a period of months.  This argues for buying longer term options to give the market time to adjust. Or the investor may think that a specific event, like a quarterly earnings report, will have a dramatic effect on the share price. If that report is due soon, this would argue for a shorter term option. But timing the market is difficult under any circumstances. So the term of the option may depend on the investor’s conviction regarding when the share price will respond to news.

That said, option premiums are not proportional to the time to expiry. If a one month ATM option on ABC shares costs $1.70, a three month ATM option priced using the same values for interest rates and volatility might cost $3.00, less than twice as much even though it’s time to expiry is three times as long. For Out-of-the-Money options though the relationship is reversed: if the 1 month 55 Call on ABC costs about $0.35, the three month Call, once again using the same inputs for interest rates and volatility, might be worth $1.30 – almost four times as much. The reasons have to do with probability. For the OTM options, a movement of 10% or more in 1 month is very unlikely, so the one month option has a low value corresponding to a high probability that it will be worthless at expiry. The three month option has a higher, but still not high, probability of being worth something at expiry so its value is greater. For the ATM options the relationship has more to do with how much the shares are likely to move in three months compared to one month. The assumptions used by the market to price options imply (in most cases) that the likely movement in three months is not three times as much as in one month.

Summary

Well that was a lot to take in at once, so maybe you’d like a quick summary? Choosing a strike price is determined by how strong your view is in the directional movement of the share price, combined with how much risk of loss you are willing to accept relative to buying the shares outright. With any option you face the possibility of losing your entire investment but that possibility is much greater for higher strike calls, which represent highly leveraged positions in the shares. Longer term options cost more than shorter term ones: for ATM options the premium increases less than the time to expiry but for OTM the reverse is true. So when you are thinking about buying a Call option, ask yourself: how much do I think the share price will change, with what probability and in what time frame and how much am I willing to risk if I’m wrong? Your answers to these questions will help you make your decision.

Option Strategies – Choosing an Option

So let’s say we have decided to buy a call option on the shares of company ABC. What’s next? We have to decide on the strike price and the time to expiry. With ABC trading at $50 let’s suppose we have some choices – for strike prices, 45, 50 and 55 and – for expiry, 1 month, 3 months and 15 months. The longest term option is called a Long-Term Equity Anticipation Securities (LEAPs) on the exchange. Not every share will have all of these expiries available but let’s suppose that ABC does. How shall we choose?

Strike Price

First let’s just consider which strike price to choose. In our piece on Options as Investments, in this series, we said Call options have two primary characteristics: leverage and limited downside exposure compared to a fully funded position in the shares.  If we compare the 45 Call (In-The-Money or ITM) to the 50 Call (At-The-Money or ATM), the 50 Call is more leveraged – not so good from a risk point of view – but limits our downside exposure below 50. The 45 Call has less leverage – good from a risk point of view – but only limits our downside exposure below 45. To make the point more forcefully, suppose the 45 Call costs $6 and the $50 Call costs $3.00 (plus commissions). At expiry if the share price is above $50, the 45 Call will be worth $5 more than the 50 Call. But we are only paying $3.00more for it today. Why? On the downside, if the share ends up below 45 we lose $6 on the 45 Call and $3.00 on the 50 Call. The 45 Call exposes us to more downside than the 50 Call. Remember buying a Call option is partially motivated by a desire to limit downside exposure. As noted, in either case you can lose all of your investment.

What about buying the 55 Call? Suppose it is trading for $1.30. This is an Out-of-the-money Option (OTM). These options are a somewhat different story. First the option is highly leveraged – at expiry you will have lost all of your investment if the share price doesn’t go up at least 10%. So buying the 55 Call requires the investor to have a strong view on the stock. Many investors are attracted to the relatively low price of OTM options. But along with this low price goes an increased probability of losing the entire sum.

We can think of buying these three options in the following way: buying the 45 Call for $6 is saying – I really think the share price of ABC is going up from its current level of $50. I’m willing to take the $5 loss from 50 to 45 if I’m wrong, but if it goes below $45, I don’t want any further exposure. I’m paying the additional $1.00 to limit my downside compared to buying the shares outright. By comparison, someone who buys the 50 Call for $3.00 may be thinking – I like the prospects for ABC and I think it’s going up from here, but if I’m wrong and it goes down, I don’t want any additional exposure to the downside. I’m willing to pay $3.00 to have the opportunity to the upside but limit my downside losses compared to buying the shares outright. And lastly the person who buys the 55 Call for $1.30 is taking the outright risk that the share won’t go up by at least 10% before the option expires. Buying this option is a strong statement of belief in the upside on the shares. The investor is saying – I believe so strongly in the likelihood that ABC will rise by at least 13% (buying the 55 Call for $1.30, only breaks even at $56.30, about 13% up) that I’m willing to risk my investment in the hope of getting a high percentage return if I’m right. Of course all three investors must realize they can lose their entire investment but each of them faces a different probability of this happening, with the buyer of the 45 Call having the lowest probability of a total loss and the buyer of the 55 Call having the highest probability.

Kevin Cook invites Jared Levy to help him review the “Stock Repair Strategy with Ratio Call Spread” on JPM.

Kevin Cook and Joe Troccolo talk Options in a Special Edition of Options Physics Basic.

Fast Money Hits LaSalle Street

On Friday, a few of us here at the Options News Network went to the CNBC Fast Money show. They came to town for a good time and broadcast live from a great venue, the Cadillac Palace. Guests included Playboy CEO Christie Hefner and CME Group Chairman Terry Duffy. Coincidentally for the CME, it was the last day of trading in the old pits at the Merc building by the river, as all of the floor trading had been moved over to the landmark CBOT facility.

Host Dylan Ratigan and Chairman Duffy traded jokes about “how many zeros in a quadrillion?” as a sidebar to the true weight of CME Group’s staggering volume. What they were referring to was the notional value of those contracts. For instance, to trade a CME Euro FX contract that is worth 125,000 Euros may only take $3,500 in performance bond, or margin deposit in your account. But, with the Euro/dollar exchange rate at around $1.5800, this makes the notional value of the futures contract worth $197,500!

Even veteran market commentator Rick Santelli made a cameo and talked about the role of speculators in the recent all-time highs in grain prices. In typically Santelli fashion, Rick made a convincing and passionate argument about why the government should let markets do their job even as everyone is quick to blame speculators for the 80% rise in the cost of food. To paraphrase him, markets may not be perfect, but there’s no way to design a better system. The free and fair auctions of futures markets bring enough diverse interests and financially-backed opinions to one place where people vote with their dollars, not their political agendas, that the markets always sort thing out better in the end than law makers. It’s easy for any of us to be affected or manipulated by pictures of third world countries without enough access to food, but it’s much harder to conclusively draw the line connecting events from free markets to those hardships.

Other than that heavy issue, the show at the Cadillac Palace had some fun moments when they showed the tape of the day’s earlier big trade. Dr J took Dylan R. into the SPX pit at the CBOE and taught him how to buy 1,000 call options! Dylan made a cool $125k profit on Dr J’s 2.3 million in capital for the trade. Not a bad day. If you want to learn more about trading SPX index options or any equity options, be sure to head over to the CBOE website and visit their Learning Center, The Options Institute.

Great story in this morning’s WSJ about how billionaire buy-out king Carl Icahn has been establishing a big stock position in Yahoo shares this week using options. The Journal highlights Icahn’s position of 59 million shares of Yahoo stock that he created using only 9.9 million actual shares. “How can Mr. Icahn hold the rest without actually owning them?” the paper asks.

Well, this strategy might be news to most people, but to options traders it’s old hat. Icahn simply created 49 million shares of synthetic stock by buying 490,000 call options on Yahoo stock and selling 490,000 put options. If you caught the piece on the “Deals and Deal Makers” section, you might have noticed that the Journal incorrectly describes his trades as involving 49 million options. But to control 49 million shares of stock, you need only buy 490,000 option contracts since each option contract is equivalent to 100 shares of underlying stock. The paper obviously meant to say options worth 49 million shares, or something similar.

Now synthetic positions are how investors and traders can replicate the performance and returns of stock without owning any actual stock. Buying a call and selling a put, usually of the same exercise price and expiration, is equivalent to being long the underlying stock. The long call option grants the right to buy the stock at a certain price before expiration, if the stock goes higher. And the short put serves two purposes: first, selling the put helps pay for the cost of the call, and second, if the stock falls below the exercise price, or strike price, the holder of the short put position could be assigned and have the stock put to him. In other words, since he sold the right for someone else to be short the stock, if the long put holder decides to exercise their right, he will have to buy the stock at the strike price.

The synthetic option position doesn’t give Icahn the same rights as shareholders who own actual stock, like voting in corporate affairs or gaining a seat on the company’s board. But, the call options definitely give him the right to buy Yahoo stock at a certain price before they expire. And if he chooses to exercise these call options, he will become a large enough shareholder to throw his weight around concerning the company’s business.

We don’t care what he’s up to jumping in to the battle between Microsoft and Yahoo. We just want to know how and why he’s using options to do it. There are several interesting aspects to this particular synthetic options trade. Not only did Icahn create a cheaper way to control 49 million shares of Yahoo stock, by buying relatively inexpensive calls and financing them with short puts, he did so without the market noticing. If he had tried to buy the total 59 million shares of stock, lots of market players would have noticed and run the price up on him before he was done. But, large option trades like this can often be done quietly and under the radar.

Another interesting thing about this trade is that Icahn bought American-style call options, which can be exercised anytime before expiration, and he sold European-style put options, which can only be exercised, and force him to buy the stock, at expiration. We don’t know all the details of this trade, but the Journal does have price and contract information for the puts. They report that Icahn sold puts with a strike price of $19.50 and an expiration date of November 5th, 2010. The unique terms of this leg of the trade are the result of a customized deal between the billionaire and the investment bank who took the other side. This sort of deal is nothing new for him. Last year, Icahn used billions of dollars worth of options on Motorola stock to gain a significant position and win board seats in the tech company. This strategy has one more benefit that dates back to the LBO-crazy 1980’s. Big options positions used to gain control of big share positions are not regulated the in the same way by securities laws.

Heavy Metal: What’s All the Confusion about Iron Butterflies and Condors?

I’ve read a lot of articles and books by option traders over the years that all seem to have their own unique way of explaining what iron butterflies and condors are. The confusion is sort of understandable because pro traders usually know what they are doing, even if they use different terminology in different markets.

Here in Chicago, between the trading floors of the CBOE, the Merc, and the Board of Trade–and thus between the homogenous markets of equity options and the more-diverse markets of futures options–there are always variations in spread names and strategy terms. But, I say, it’s time somebody cleared things up for the online trader who can gain solid strategic benefits with these multidimensional flying creatures—which, by the way, are designed primarily to can help us capture profits in quiet or range-bound markets, but can also be used as long volatility plays.

If you need a refresher on how conventional butterflies and condors work, please visit our introductory-level article series Butterflies and Condors at OptionsNews.com. There you will find a complete description of their construction, function, and uses, including their unique reward/risk dynamics. Once you have a good grasp of the basic mechanics of these “winged” profit strategies, you will have no trouble eliminating any confusion about their “iron” cousins.

Ready for the fastest explanation in the history of options training? Iron butterflies and condors are just the same strategies as their simpler cousins, except that they use both calls and puts at the same time. So, instead of combining two call (or put) spreads, the “iron-winged” flying club combines straddles and strangles!

The short iron butterfly is selling a straddle at the middle strike, and buying a strangle using the outer strikes. And the short iron condor is selling a strangle using the two middle strikes, and buying a strangle using the outer strikes. If you check out the strategy graphs for their profit-loss profiles and credit vs. debit characteristics, you might notice that what we call short iron flies or condors, look exactly like regular long flies and condors that use only calls and puts.

The differences and similarities have to do with whether you pay a net debit to buy and be long the spread, or you receive a net credit to sell and be short the spread. Once you “go iron,” the credit and debit characteristics get flipped. This means that long iron flies and condors have profit-loss profiles that look just like short all-call or all-put flies and condors.

You may also notice that long iron butterflies and condors have an additional advantage compared to their simpler volatility cousins. They can be used to speculate on an impending market move, of unknown direction, much the same way we would buy conventional straddles and strangles–except that when we apply the “full metal profit” potential of their heavy wings, iron butterflies and condors limit our loss potential too.

And, of course, you always have the options, so to speak, of creating these strategies with separately legged transactions, because when you break down any butterfly or condor, you find they are simply different combinations of call spreads and put spreads. This means you can adjust your risk and reward on any strategy as conditions change.

Whether you want to sell volatility or buy volatility, the iron-winged versions of butterflies and condors give you more ways to do it. Be sure to learn more about these heavy-metal spreads so you can take advantage of their precision risk and profit dynamics!

Have you seen the new film “21?”

It’s about a group of MIT math students and their professor who learn to count cards and make a bundle in Vegas.

Based on the true stories of groups known collectively as the MIT Blackjack Team—who actually did it in the 80’s and 90’s—Kevin Spacey stars as the teacher who finds a 20-year old book by Ed Thorp, the original card-counting math whiz from MIT. In a minute, I’ll tell you something else Thorp did related to options trading that will definitely surprise you.

First, let’s talk Vegas! Ed Thorp’s Beat the Dealer was published in 1962 and it detailed his system for not only exploiting the simple mathematical advantages to be found in blackjack, but also how to systematically bet in any gambling game for maximum long-term profit. His ideas were based primarily on the work of a Bell Labs scientist named John Kelly, who developed a theory of gambling, that became known as the Kelly criterion.

Kelly’s formula was also called Edge/Odds tells you when and how much to bet, because it simply took the theoretical advantage one expected from a given gamble, based on your information “edge,” and divided that by the actual odds of winning. This number told you how much of your bankroll to bet on the next go. So, you can see that counting cards is only half the battle–you have to know when and how much to bet to leverage that information successfully.

Smart traders, especially options traders, figured out systems for controlling information and risk to take mathematical advantages and profits out of the market. But, you know who figured this stuff out first? It wasn’t the finance professors who won Nobel prizes for theoretical pricing models. It was the gamblers! Gamblers and math junkies discovered probability dynamics 300 years ago; dice-playing math junkies carved out the initial components of probability theory that still help casinos and options traders today gain their consistent advantage. And Ed Thorp, back in the 1950’s and 60’s, over a decade before the Black-Scholes formula for options became widely available to traders, did something else to put him in the history books: while he was busy taking Vegas to the cleaners, Ed Thorp created a simple option model before Black-Scholes he was also able to scratch out the first primitive option pricing model because the roots of it were all in basic probability and gambling theory.

Today, expert gamblers like poker champ Daniel Negraneau know Edge/Odds simply as “When you get the best of it, make the most of it.” Expert option traders, who don’t live and die every day with “all in” type bets, call it volatility trading.

Whatever happened to Ed Thorp? In the late 60’s, he went on to start the famous hedge fund Princeton-Newport Partners which achieved a 15% annual rate of return for over 20 years. His story is detailed in this book by mathematician William Poundstone, Fortune’s Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street.

Click here to download a copy of the OCC’s Characteristics and Risks of Standardized Options.