Options Trading For Dummies

Dr. Joe Duarte is a financial ­writer, private investor and trader, and former money manager/president of River Willow Capital Management. In addition to Options Trading For Dummies, he is the author of Trading Futures For Dummies and Market Timing For Dummies. Visit his website at joeduarteinthemoneyoptions.com

Introduction 1

About This Book 2

Foolish Assumptions 3

Icons Used in This Book 4

Beyond the Book 5

Where to Go from Here 5

Part 1: Getting Started with Options Trading 7

Chapter 1: Options Trading and You, the Individual Investor 9

Rewiring Your Thinking 10

Preparing to Trade: Take a Pre-Trading Flight Check 11

Understanding Options 12

Getting the complete picture 13

Knowing option essentials 14

Trying different strategies before deploying them in real time 16

Putting options in their place 18

Differentiating between Option Styles 19

Using options to limit your risk 19

Applying options to sector investing 20

Using Options in Challenging Markets 21

Reducing your directional bias and making money in flat markets 21

Controlling your emotions 21

Chapter 2: Introducing Options 23

Understanding Option Contracts 23

Tuning in to option basics 24

Comparing options to other securities 26

Valuing Options 27

Knowing your rights and obligations as an options trader 28

Identifying useful terms of endearment 28

Making Sense of Options Mechanics 30

Identifying options 30

Rotating with the expiration cycle 31

Making a decision: Expiration time is key 32

Detailing your rights 33

Creating Option Contracts out of Thin Air 33

Opening and closing positions 34

Selling an option you don’t own 35

Keeping Some Tips in Mind 36

Chapter 3: Trading Places: Where the Action Happens 39

Identifying the U.S Options Exchanges 40

Navigating the Markets 40

Executing trades 41

Naming the option market participants 42

Eyeing transactions and orders unique to options 43

Making sure you know these trading rules 44

Weighing Option Costs and Benefits 47

Recognizing option risks 47

Identifying costs unique to options 48

Valuing options benefits 49

Grasping Key Option Pricing Factors 52

Introducing option Greeks 53

Connecting past movement to the future 54

Chapter 4: Identifying Option Risks and Rewards 57

Understanding Your Trading Risks 58

Risking money with stocks 58

Calculating option risks 61

Reaping Your Rewards 62

Benefiting from stocks 62

Breaking even with options 63

Profiling Risk and Reward 65

Profiling stock trades with risk graphs 66

Profiling option trades with risk graphs 67

Combining option positions 69

Considering the worst-case scenario 71

Part 2: Evaluating Markets, Sectors, and Strategies 73

Chapter 5: Looking Closer Inside the Algo-Controlled Market 75

Considering a Few Words about Select Macro Factors 76

Assessing the Market’s (the Algos’) Bias 77

Judging the strength of a move 78

(Psycho)-analyzing the market 84

Watching Call and Put Extremes 87

Understanding put/call ratios 88

Using Volatility to Measure Fear 90

Measuring volatility 90

Recognizing impact from changing volatility 90

Spelling fear the Wall Street way: V-I-X 91

Chapter 6: Sector Analysis: Technical and Fundamental 93

Getting Technical with Charts 94

Understanding chart basics 94

Adjusting your time horizon for the best view 95

Visualizing supply and demand 96

Identifying Relatively Strong Sectors 99

Relative ratios 99

Rate of change indicator 102

Using Sector Volatility Tools 104

Displaying volatility with indicators 105

Analyzing volatility with Bollinger Bands 109

Projecting Prices for Trading 111

Support and resistance 111

Trends 113

Channels 115

Price retracements and extensions 117

Projections and probabilities 119

Chapter 7: Practicing Before You Swing 123

Monitoring Option Greek Changes 124

Tracking premium measures 124

Changing volatility and option prices 126

Making Sense of Paper Trading 128

Eyeing the pros and cons to paper trading 128

Implementing electronic paper trades 129

Using Trading Systems 130

Knowing what you’re getting 130

Performing a backtest 131

Adding risk management to a backtest 135

Mastering Your Strategies 137

Setting the right pace 137

Achieving mastery through longevity 139

Chapter 8: Designing a Killer Trading Plan 143

Developing a Reliable Plan 144

Managing Your Costs 145

Optimizing Order Execution 147

Understanding option orders 148

Entering a new position 152

Executing a quality trade 155

Exiting an existing position 157

Part 3: What Every Trader Needs to Know about Options 161

Chapter 9: Getting to Know Different Option Styles 163

Delving Deeper into Index Options 163

Getting to the nitty-gritty of indexes 164

Capitalizing on an index with options 166

Watching Out for Style Risk 169

American-style options 169

European-style options 170

Considering the exceptions 171

Exercising Your Options, American Style 173

Knowing the nuts and bolts 173

What you see is what you get 174

To exercise or not, that is the question 174

Exercising Your Options the Euro Way 175

Tracking index settlement (the SET) 175

Cashing in with exercise 176

Satisfying Option Obligations 176

American-style stock options 177

Expiring options 179

European-style options 182

Breaking It Down: American-Style Index Options 182

Exercising rights 183

Meeting obligations 183

Chapter 10: Protecting Your Portfolio with Options 185

Putting Protection on Long Stock 186

Combining puts with long stock 186

Weighing protection cost versus time 191

Limiting Short Stock Risk with Calls 194

Protecting a short stock position 194

Further reducing short stock risk 195

Hedging Your Bets with Options 196

Protecting a portfolio partially 197

Protecting a portfolio completely 200

Avoiding Adjusted Option Risk 203

Justifying option adjustments 203

Adjusting from adjustments 205

Chapter 11: Increasing Profit Potential and Decreasing Risk 207

Leveraging Assets to Reduce Risk 208

Determining your total dollars at risk 208

Relying on market timing 213

Combining Options to Reduce Risk 216

Spreading the risk with a debit trade 217

Spreading the risk with a credit trade 223

Chapter 12: Combination Strategies: Spreads and Other Wild Things 229

Combining Options with Stocks 230

Creating covered positions 230

Covering the covered call position 232

Reducing protected stock costs 235

Varying Vertical Spreads 237

Changing your vertical spread risk profile 238

Spreading time with calendars 239

Chapter 13: Understanding ETFs, Options, and Other Useful Tricks 245

Exploring the Exchange-Traded Fund 246

Comparing ETFs to indexes 246

Distinguishing ETF and index options 250

Reducing Portfolio Volatility with ETFs 253

Revisiting volatility 253

Investing with ETFs 259

Tilting Your Portfolio with Sector ETFs 266

Adding sector ETFs to tilt your portfolio 267

Selecting the right strategy 271

Part 4: Advanced Strategies for Options Traders 273

Chapter 14: Making Money without Worrying About the Market’s Direction 275

Limiting Directional Risk 276

Capitalizing on a big move — A straddle 276

Reducing straddle risk and reward — A strangle 282

Examining a Neutral View versus a Neutral Position 285

Identifying neutral positions 286

Calculating delta for combination positions 287

Trading with Delta 288

Monitoring two key Greeks 288

Creating a delta-neutral straddle 289

Understanding Trade Adjustments 293

Deciding when to adjust a trade 293

Deciding how to adjust a trade 294

Chapter 15: Letting Volatility Show You the Way to Trading Opportunities 295

Analyzing Implied Volatility Levels 296

It’s all relative but not overly scientific 296

When options are skewed 303

Understanding Ratio Spreads 306

Reviewing ratio spread risk profiles 306

Identifying best conditions for ratio spreads 310

Deciding your strategy 311

Using Ratio Backspreads 313

Defining ratio backspreads 313

Spotting best conditions for ratio backspreads 321

Chapter 16: Trading Profitably When Markets Move Sideways 325

Identifying Winning Positions in Sideways Markets 326

Managing existing positions 326

Identifying other option strategies for sideways moves 331

Understanding Butterfly Positions 334

Defining the butterfly 334

Digging deeper into butterfly risk 343

Creating an iron butterfly 345

Understanding Condor Positions 349

Defining a condor spread 349

Recognizing condor risks 351

Part 5: The Part of Tens 355

Chapter 17: Ten Top Option Strategies 357

Married Put 358

Collar 359

Long Put Trader 361

LEAPS Call Investor 362

Diagonal Spread 363

Bear Call Credit Spread 365

Straddle 366

Call Ratio Backspread 367

Put Ratio Backspread 369

Long Put Butterfly 370

Chapter 18: Ten Do’s and Don’ts in Options Trading 373

Do Focus on Managing Risk 374

Don’t Avoid Losses 375

Do Trade with Discipline 375

Don’t Expect to Remove Your Emotions 376

Do Have a Plan 377

Do Be Patient 378

Don’t Suffer from Analysis Paralysis 379

Do Take Responsibility for Your Results 380

Don’t Stop Learning 381

Do Love the Game 382

Index 383