Trading Options For Dummies

Joe Duarte, MD is a financial writer, private investor and trader, and former money manager/president of River Willow Capital Management. His work has been quoted in Barron's, Marketwatch.com, and The Wall Street Journal. He is the author of Trading Futures For Dummies and Market Timing For Dummies.

Introduction 1


About This Book 1


Foolish Assumptions 2


Icons Used in This Book 4


Beyond the Book 4


Where to Go from Here 4


Part 1: Getting Started 7


Chapter 1: Options Trading and the Individual Investor 9


Giving Yourself a Financial and Strategic Checkup 10


Understanding Options 11


Knowing option essentials 12


Trying different strategies before deploying them in real time 14


Putting options in their place 15


Differentiating Between Option Styles 16


Using options to limit your risk 17


Applying options to sector investing 17


Using Options in Challenging Markets 18


Reducing your directional bias and making money in flat markets 18


Controlling your emotions 19


Chapter 2: Introducing Options 21


Understanding Option Contracts 21


Tuning in to option basics 22


Comparing options to other securities 23


Valuing Options 25


Knowing your rights and obligations as an options trader 25


Terms of endearment and importance 26


Making Sense of Options Mechanics 27


Identifying options 27


Rotating with the expiration cycle 28


Options expiration is decision time 29


Detailing your rights 30


Creating Option Contracts out of Thin Air 30


Opening and closing positions 31


Selling an option you don’t own 31


Keeping Some Tips in Mind 33


Chapter 3: Trading Places: Where the Action Happens 35


The U.S Options Exchanges 36


Navigating the Markets 36


Trade execution 36


Option market participants 37


Transactions unique to options 38


Trading rules you should know 39


Weighing Option Costs and Benefits 42


Identifying costs unique to options 43


Valuing options benefits 44


Grasping Key Option Pricing Factors 47


Introducing option Greeks 48


Connecting past movement to the future 49


Chapter 4: Option Risks and Rewards 53


Understanding Your Trading Risks 54


Risking money with stocks 54


Calculating option risks 57


Reaping Your Rewards 58


Benefiting from stocks 58


Breaking even with options 59


Profiling Risk and Reward 61


Profiling stock trades with risk graphs 61


Profiling option trades with risk graphs 63


Combining option positions 65


Considering the worst-case scenario 67


Part 2: Evaluating Markets, Sectors, and Strategies 69


Chapter 5: Analyzing Mood Swings in the Market 71


A Few Words About Select Macro Factors 72


Assessing the Market’s Bias 73


Judging the strength of a move 73


(Psycho)-analyzing the market 79


Watching Call and Put Activity 81


Understanding put-to-call ratios 81


Using the put volume indicator 84


Using Volatility to Measure Fear 85


Measuring volatility 85


Recognizing impact from changing volatility 86


Spelling fear the Wall Street way: V-I-X 86


Applying Breadth and Sentiment Tools 88


Locating neutral areas for indicators 88


Identifying indicator extremes 89


Chapter 6: Sector Analysis: Technical and Fundamental 91


Getting Technical with Charts 92


Chart basics 92


Adjusting your time horizon for the best view 93


Visualizing supply and demand 94


Identifying Relatively Strong Sectors 97


Relative ratios 97


Rate of change indicator 99


Using Sector Volatility Tools 101


Displaying volatility with indicators 102


Analyzing volatility with Bollinger bands 106


Projecting Prices for Trading 107


Support and resistance 108


Trends 110


Channels 111


Price retracements and extensions 114


Projections and probabilities 116


Chapter 7: Practicing Before You Swing 119


Monitoring Option Greek Changes 120


Tracking premium measures 120


Changing volatility and option prices 121


Paper Trading a Trading Strategy 123


Trading on paper: Pluses and minuses 124


Implementing electronic paper trades 124


Using Trading Systems 125


Knowing what you’re getting 126


Performing a backtest 126


Adding risk management to a backtest 130


Shifting from Knowledge to Mastery 132


Setting the right pace 133


Achieving mastery through longevity 135


Chapter 8: Designing a Killer Trading Plan 137


Developing a Reliable Plan 138


Managing Your Costs 139


Optimizing Order Execution 141


Understanding option orders 141


Entering a new position 146


Executing a quality trade 148


Exiting an existing position 150


Part 3: What Every Trader Needs to Know about Options 153


Chapter 9: Getting to Know Different Option Styles 155


Nailing Down Index Options 155


Getting to the nitty-gritty of indexes 156


Capitalizing on an index with options 158


Watching Out for Style Risk 160


American-style options 161


European-style options 162


Exercising Your Options, American Style 164


Knowing the nuts and bolts 165


What you see is what you get 165


To exercise or not, that is the question 166


Exercising Your Options the Euro Way 167


Tracking index settlement (the SET) 167


Cashing in with exercise 167


Satisfying Option Obligations 168


American-style stock options 168


Expiring options 170


European-style options 173


Breaking It Down: American-Style Index Options 174


Exercising rights 174


Meeting obligations 175


Chapter 10: Protecting Your Portfolio with Options 177


Putting Protection on Long Stock 178


Combining puts with long stock 178


Weighing protection cost versus time 183


Limiting Short Stock Risk with Calls 185


Protecting a short stock position 185


Further reducing short stock risk 186


Hedging Your Bets with Options 187


Protecting a portfolio partially 188


Protecting a portfolio completely 191


Avoiding Adjusted Option Risk 194


Justifying option adjustments 194


Adjusting from adjustments 196


Chapter 11: Increasing Profit Potential and Decreasing Risk 199


Leveraging Assets to Reduce Risk 200


Determining your total dollars at risk 200


Relying on market timing 205


Combining Options to Reduce Risk 207


Spreading the risk with a debit trade 208


Spreading the risk with a credit trade 215


Chapter 12: Combination Strategies: Spreads and Other Wild Things 221


Combining Options with Stocks 222


Creating “covered” positions 222


Covering the covered call position 223


Reducing protected stock costs 226


Varying Vertical Spreads 228


Changing your vertical spread risk profile 229


Spreading time with calendars 230


Defining diagonal spreads 233


Chapter 13: ETFs, Options, and Other Useful Tricks 237


Exploring the Exchange-Traded Fund 237


Comparing ETFs to indexes 238


Distinguishing ETF and index options 241


Reducing Portfolio Volatility with ETFs 244


Revisiting volatility 244


Investing with ETFs 249


Tilting Your Portfolio with Sector ETFs 256


Adding sector ETFs to tilt your portfolio 256


Selecting the right strategy 260


Part 4: Advanced Strategies for Options Traders 263


Chapter 14: Making Money without Worrying About the Market’s Direction 265


Limiting Directional Risk 266


Capitalizing on a big move 266


Reducing straddle risk and reward 272


Neutral View versus Neutral Position 275


Identifying neutral positions 276


Calculating delta for combination positions 276


Trading with Delta 277


Monitoring two key Greeks 278


Creating a delta neutral straddle 279


Understanding Trade Adjustments 282


Deciding when to adjust a trade 283


Deciding how to adjust a trade 284


Chapter 15: Letting Volatility Show You the Way to Trading Opportunities 285


Analyzing Implied Volatility Levels 286


It’s all relative but not overly scientific 286


When options are skewed 293


Understanding Ratio Spreads 296


Reviewing ratio spread risk profiles 296


Identifying best conditions for ratio spreads 300


Deciding your strategy 301


Using Ratio Backspreads 303


Defining ratio backspreads 303


Spotting best conditions for ratio backspreads 312


Chapter 16: Trading Profitably When Markets Move Sideways 315


Winning Positions in Sideways Markets 316


Managing existing positions 316


Option strategies for sideways moves 321


Understanding Butterfly Positions 323


Defining the butterfly 324


Digging deeper into butterfly risk 332


Creating an iron butterfly 334


Understanding Condor Positions 338


Defining a condor spread 338


Recognizing condor risks 340


Part 5: The Part of Tens 343


Chapter 17: Ten Top Option Strategies 345


Married Put 346


Collar 347


Long Put Trader 348


LEAPS Call Investor 349


Diagonal Spread 351


Bear Call Credit Spread 352


Straddle 353


Call Ratio Backspread 355


Put Ratio Backspread 356


Long Put Butterfly 357


Chapter 18: Ten Do’s and Don’ts in Options Trading 359


Do Focus on Managing Risk 360


Don’t Avoid Losses 361


Do Trade with Discipline 361


Don’t Expect to Remove Your Emotions 362


Do Have a Plan 363


Do Be Patient 364


Don’t Suffer from Analysis Paralysis 365


Do Take Responsibility for Your Results 365


Don’t Stop Learning 366


Do Love the Game 367


Index 369