Introduction

Welcome to Options Trading For Dummies, 4th Edition!

Although this book is still about introducing you to option strategies for managing risk, delivering profits, and navigating a variety of market conditions, a lot has changed since the last edition. In fact, a lot has changed since I first wrote its predecessor Futures and Options For Dummies in 2006. Indeed, the most radical of all changes in the financial markets is the role of artificial intelligence (AI), otherwise known as trading algorithms, also known as algos or bots. Algos are program or computer traders, and they’re now responsible for more than 80 percent of the trading volume on any given day. Even more spectacular is the fact that options trading volume now dwarfs individual stock trading volume, which means, that as I explain throughout this book, the proverbial tail now wags the dog.

Of course, most investors, especially those who are in the early stages of their career, are in a hurry and their number one goal is profits. And why not? Who wants to lose money? Still, options trading is very different from stock trading. Unlike other investments books, this one is geared to managing risk first, with the knowledge that profits will follow. With that in mind, the approaches I describe here focus on reducing potential losses from traditional stock positions and building an option strategy repertoire that’s designed to increase your chances of making sound trades whether the markets are moving up, down, or sideways. Because I’m an active stock trader and because all the markets are now intimately interrelated via money flows and the actions of trading algos everywhere, I aim to connect the key dots between stocks and options for you so not only you can trade options profitably, but you also actually know why any market is acting in a particular way.

An option contract is a unique security that comes with contract rights and obligations. When used correctly, an option contract strikes a balance between the risk of loss, the amount of money you put at risk, and reward, providing you with leverage, the ability to amplify the amount of profit via the use of margin, while still allowing you to reduce overall trade risk. Of course, there’s another side to that leverage, increased risk. That’s because margin, or the practice of trading with borrowed money, works both ways. But don’t worry, the strategies in this book can help you understand and manage the risks connected with leverage and the tools that allow you to trade them.

When applying for options trading with your broker, the broker will send you the reference guide Characteristics and Risks of Standardized Options. This publication, written by the Options Clearing Corporation (OCC), must be distributed by brokers to their clients prior to allowing them to trade options. It describes option contract specifications, mechanics, and the risks associated with the security. Together, that publication and the one you’re reading right now help you to understand your risks and use options effectively.

About This Book

This book now its fourth edition is great for you. Not only has it stood the test of time, but I’ve been able to address many of the quirks and other technical issues that arose with the book’s earlier editions. Of course, nothing is perfect, but as you find out when you start trading options, the more you do anything, the better it gets. And so it is with this book.

Regardless of the reviews that you may read, comments from friends, or clever marketing on the Internet, options trading isn’t a simple task. Don’t get discouraged. If it were difficult, then why would so many people do it?

You can find hundreds of trading titles out there, including those focusing on option strategies. But this one primarily focuses on approaches aimed at managing risk and in giving you the information you need to trade successfully against clever day traders and algos. And if you’re an experienced trader looking for something specific, feel free to jump around to areas that interest you most. Otherwise, if you’re a beginner, I recommend you start at the front and work your way carefully through each chapter before you risk any money. If, as you read through the book, you find a strategy that’s particularly appealing, feels natural to you, and makes you money as you deploy it, feel free to spend as much time as you need on getting it under your belt.

No matter your trading experience, you certainly can read this book cover to cover or use it as a reference guide, because each strategy provided identifies risks and rewards associated with the position as well as ways to implement those strategies. This book also identifies alternative strategies to consider for risk management, when applicable. There are a million ways to successfully trade the markets, but certain challenges are universal to all of them, especially when you’re trading against algos and other entities in the market — day traders and market makers. To make life as easy as possible for you, I give you tools and techniques to address these challenges throughout.

Foolish Assumptions

This section is a hugely important part of the book, which many readers unfortunately skip and then voice their frustration about things they missed. If you’re a beginner, you may find a lot of the material in this book confusing. And that’s not your fault, or mine. That’s just the way it is because although options trading originated in ancient Greece, in its modern form, it has been modified by guys with PhDs and further altered via trading algos. Thus, my goal is to make it as simple as I can for you. But there is only so much I can do with such a complex topic, so please be patient.

That means reading this material may initially be challenging. But, let me share one thing: I’m a dummy too, and that’s precisely why Dummies books are so important because they make challenging topics like options trading (and algebra and anatomy and the LSAT) easier to understand. By reading this section you can understand my intentions when I wrote this book. Here’s what I assume about you:

• You have some experience. If you’ve chosen this book, you probably have some familiarity with the stock market and the risks and rewards it presents to you. As a self-directed investor, you seek ways to manage those risks and rewards. However, if you’re not familiar at all with options or you’ve just had a little exposure to them, don’t worry — I cover option fundamentals and mechanics, and they may be a great way to improve your knowledge base. Even if you’ve traded these instruments before, you can consider this book a review if you’re looking for one.
• You’re smart enough to know when you’re over your head. If you’ve never traded stocks or are new to investing, I assume that you can figure out whether this book is right for you at this time. I also hope that if that’s the case, you’ll come back to it in the future when you’re ready.
• You’ve read investing books before and you’ll read this section carefully at some point in order to avoid pitfalls and misunderstandings as you go through this book. I assume you know that this book won’t have all the answers to your trading needs, but you also know that I wrote it carefully and thoughtfully. Also keep in mind that options trading isn’t a simple concept. Although I’ve made this content as easy to understand as possible, some readers may find it difficult to initially grasp some of the concepts. That’s okay. When I started trading options, I found them confusing as well. I’ve gone the extra mile and really worked hard to make this material as accessible as possible. I’m not trying to make anything difficult, yet some things are difficult by nature. But if you find something challenging, go to another part of the book and come back to it later. You may find it easier the next time.
• You hold longer-term investments. Regardless of whether or not you choose to actively trade options, you hold or have held longer-term investments such as stocks and mutual funds. For that reason, I include core strategies aimed at managing risk associated with longer-term holdings. The small amount of time needed to implement them may be well worth it.
• You’ve already decided how to allocate your investment and trading dollars. Although I distinguish investment assets from trading assets, I don’t address how to allocate those dollars because everyone’s financial situation is different. I do assume this is something you’ve already completed, because plans should strike a balance between the two (long term and short term) to grow assets.
• You have computer and Internet access. I can’t imagine trading or investing without a computer and reliable access to the Internet … so I assume you have both. High-speed Internet is the best option if it’s available in your area.
• You use a broker. I assume you contact a broker to further manage your risk when needed, and I assume you also have a comfort level with your broker’s web platform. It may serve as a resource for some of the ideas in this book.

Icons Used in This Book

I’ve also added icons to highlight and reinforce different core ideas and give you some hard-earned trading insight. I...