Options (eBook)

Michael C. Thomsett, Business Writer

Part I: The Basics 1 Chapter 1: Calls and Puts: Defining the Field of Play  3 Equity Investments  3 Debt Investments  4 Investments with No Tangible Value: Options  5 Trading Options on Exchanges  7 Calls and Puts  10 The Call Option  13 The Long-Term Call Option  20 Investment Standards for Call Buyers  21 How Call Selling Works  22 The Put Option  26 Option Valuation  32 Picking the Right Stock  37 Intrinsic Value and Time Value  38 Chapter 2: The Life of an Option  45 Expiration and Exercise  45 What is “Clearing”?  46 Bid and Ask  47 Order Entry  48 Types of Orders  49 Who Are the Players?  49 Chapter 3: Opening and Tracking: How It All Works  51 Terms of the Option (Standardized Terms)  51 Strike Price  51 Expiration Date  52 Type of Option  53 Underlying Stock  54 A Note on the Expiration Cycle  54 Opening and Closing Option Trades  56 Using the Daily Options Listings  56 Understanding Option Abbreviations  59 Calculating the Rate of Return for Sellers  61 Chapter 4: Buying Calls: Maximizing the Rosy View  65 Understanding the Limited Life of the Call  66 Judging the Call  70 Call Buying Strategies  76 Strategy 1: Calls for Leverage  76 Strategy 2: Limiting Risks  80 Strategy 3: Planning Future Purchases  81 Strategy 4: Insuring Profits  82 Strategy 5: Premium Buying  84 Strategy 6: Pure Speculation  85 Defining Profit Zones  87 Chapter 5: Buying Puts: The Positive Side of Pessimism  93 The Limited Life of the Put  95 Judging the Put  101 Put Buying Strategies  106 Strategy 1: Gaining Leverage  107 Strategy 2: Limiting Risks  109 Strategy 3: Hedging a Long Position  110 Strategy 4: Pure Speculation  114 Defining Profit Zones  115 Chapter 6: Selling Calls: Conservative and Profitable  119 Selling Uncovered Calls  121 Assessing Uncovered Call Writing Risks  126 A Question of Suitability  127 Selling Covered Calls  129 Assessing Covered Call Writing Risks  133 Calculating the Rate of Return  134 Chapter 7: Selling Puts: The Overlooked Strategy  139 Analyzing Stock Value  143 Evaluating Risks  145 Put Strategies  146 Strategy 1: Producing Income  147 Strategy 2: Using Idle Cash  149 Strategy 3: Buying Stock  150 Strategy 4: Writing a Covered Put on Short Stock  153 Strategy 5: Creating a Tax Put  153 Part II: Closing the Position  157 Chapter 8: Closing Positions: Profit, Exercise, or Roll  159 Defining Possible Outcomes of Closing Options  159 Results for the Buyer  160 Results for the Seller  160 Exercising the Option  162 Timing the Decision  168 Avoiding Exercise  171 Chapter 9: Paper Trading: A Test Run of the Theory  183 The Case for Paper Trading  185 Sites Worth Checking  187 www.Optionsxpress.com  187 marketwatch.com  188 www.investopedia.com  188 Proceeding with a Paper Trading Plan  188 The Dangers of Paper Trading  189 Chapter 10: Calculating the Return: A Complex Aspect to Options  193 Finding a Realistic Method  193 Annualizing Models and Guidelines  195 An Overview of Basic Calculations for Calls  198 You Close the Position and Calculate Option-Based Net Return  199 You Close the Position and Calculate Net Return Based on the Entire Position  199 The Covered Call is Exercised, and You Calculate Option and Stock Profits Separately  200 Any Covered Call Outcome Is Computed Strictly Based on Capital on Deposit  200 Anticipating the Likely Return  201 Chapter 11: The Basics of Risk: What Every Trader Needs to Know  205 Volatility as the Definition of Risk  205 Historical Volatility  207 Implied Volatility  210 Pricing Models  213 Risk and Human Nature  215 Confirmation Bias  216 Anchoring  216 Herding  217 Framing  217 Selective Memory  218 Loss Aversion  218 Chapter 12: Strategies in Volatile Markets: Uncertainty as an Advantage  221 Avoiding 10 Common Mistakes  222 Modifying Your Risk Tolerance  228 The Nature of Market Volatility  229 Market Volatility Risk  230 Options in the Volatile Environment  235 Part III: Advanced Strategies  241 Chapter 13: Combinations and Spreads: Creative Risk Management  243 Overview of Advanced Strategies  246 The Spread  246 The Hedge  251 The Straddle  252 The Strangle  253 Vertical Spread Strategies  255 Bull Spreads  256 Bear Spreads  258 Box Spreads  262 Debit and Credit Spreads  265 Horizontal and Diagonal Spread Strategies  265 Altering Spread Patterns  270 Varying the Number of Options  271 Expanding the Ratio  274 Strategies with Moneyness Close to Underlying Prices  277 Variations on the Butterfly  280 Multi-Leg Option Orders  281 In Conclusion  282 Chapter 14: Hedges and Straddles: More Creativity  283 The Two Types of Hedges  283 Hedging Beyond Coverage  286 Hedging Option Positions  288 Partial Coverage Strategies  292 Straddle Strategies  295 Middle Loss Zones  295 Middle Profit Zones  298 Theory and Practice of Combined Techniques  301 In Conclusion  302 Chapter 15: Options for Specialized Trading: Leveraging the Technical Approach  303 Swing Trading Basics  305 The Setup Signal  308 Testing the Theory  311 A Strategic View of Option for Swing Trading  313 Selection of Stocks Based on Value  313 A Stock’s Price Volatility  314 Price History (Recent and Potential)  315 The Price-To-Earnings (P/E) Ratio of the Stock  315 Fundamental and Technical Tests of the Company and Stock  316 Options Used for Other Trading Strategies  316 Swing- and Day-Trading Advanced Strategies  317 Taking Partial Profits  318 Partial Exercise  319 Add More Option Contracts in Times of Price Momentum  319 In Conclusion  320 Chapter 16: Options on Futures: Leveraging Your Leverage  321 Important Distinctions  322 Regulatory Differences  326 In Conclusion  328 Chapter 17: Synthetic Positions: Tracking the Stock  331 Synthetic Put (Protected Short Sale)  333 Synthetic Long Call (Insurance Put, or Married Put)  334 Synthetic Long Stock  336 Synthetic Short Stock  338 Split Strike Strategy (Bullish)  340 Split Strike Strategy (Bearish)  342 Collars  343 Synthetic Straddles  350 In Conclusion  353 Part IV: Risk Evaluation  355 Chapter 18: Risk: Rules of the Game  357 Identifying the Range of Risk  357 Margin and Collateral Risk  360 Personal Goal Risks  360 Risk of Unavailable Market  361 Risk of Disruption in Trading  362 Brokerage Risks  363 Trading Cost Risk  363 Lost Opportunity Risks  364 Tax Consequence Risk  365 Evaluating Your Risk Tolerance  366 In Conclusion  367 Chapter 19: Taxes: The Wild Card of Options Trading  369 Tax Rules for Options  369 Qualified Covered Calls—Special Rules  373 Looking to the Future  378 In Conclusion  379 Chapter 20: Choosing Stocks: Finding the Right Ingredients  381 Developing a Covered Call Action Plan  385 Selecting Stocks for Call Writing  387 Benefiting from Price Appreciation  388 Analyzing Stocks  390 Fundamental Tests  394 Technical Tests  398 Deciding Which Tests to Apply  400 Applying Analysis to Options—the “Greeks”  401 Beta  402 Delta  402 The Rest of the Greeks  404 Acting on Good Information  406 Putting Your Rules Down on Paper  407 In Conclusion  408 Glossary  409 Index  409