the following:
✔ Check your financial balance sheet. Before you start trading, go over your living expenses, review your life and health insurances, and put together a financial net worth statement. Make sure it’s healthy before you take extraordinary risks.
✔ Set realistic goals. Don’t trade beyond your experience levels, and don’t risk too much money in any one trade.
✔ Know your willingness to take risks. If you are a cautious person who thinks that mutual funds are risky, you may not be a good options trader. But you shouldn’t count yourself out either. There are many options strategies that could suit you, especially once you understand the built-in safety nets that make some of them really decrease your risk. Just make sure you read through the book and find the ones that make you comfortable before you jump in. The chapters in Part IV have excellent information on this topic.
✔ Become a good analyst. If you like to roll the dice without doing your homework, you could get in trouble with options pretty rapidly. In order to maximize your chances of trading options successfully, place a high priority on improving your technical and fundamental analysis skills. You should do this both for the entire market and for the underlying securities that are the basis for your options.
✔ Don’t be afraid to test your strategies before deploying them. Doing some paper trading on options strategies before you take real-life risks is a good idea. Chapter 7 guides you through this process.
✔ Never trade with money that you aren’t willing to lose. Even though options are risk-management vehicles, you can still lose money trading them. And as you progress to more sophisticated and riskier strategies, your losses could be significant. Bottom line: Don’t trade options with your car payment or your rent money.
Options are financial instruments that are priced based on the value of another underlying asset or financial measure. In this book, the focus is mainly on options with value based on stocks and stock market indexes, although there is also a very useful section on options based on exchange traded mutual funds (ETFs).
There are two kinds of options – calls and puts. When you add them to your current investing and trading tools and strategies, you can participate in both bullish (rising markets) and bearish (falling markets) moves in either underlying you select. You can use options to limit your total portfolio risk or to protect an individual existing position, such as a stock or ETF.
To fully understand and use stock and index options to limit risk or as a standalone trading strategy, you must also have a thorough understanding of the asset on which they’re based. This understanding is likely to require another layer of analysis beyond your current approach. Because volatility is a key component of option prices, for example, you will have to look at the underlying’s volatility more carefully as part of your analysis in order to pick the best possible option for your particular strategy.
This book will help you by focusing on techniques that compare options to their underlying security or other securities. Chapter 9 goes into detail on several approaches that you can apply toward this goal when you analyze stocks and index options.
Contrary to what many in the mainstream may believe, your primary focus for trading any security is not to learn about how to profit from its use, but to understand the risks associated with its use, including all of the following:
✔ Knowing what conditions, both in the markets and in the individual security, to consider when analyzing a trade
✔ Using proper trade mechanics when creating a position
✔ Recognizing, understanding, and following trading rules and requirements for the security
✔ Understanding what individual variables make any position gain and lose value
The sections that follow address these key components of options trading to give you a good platform for creating rewarding positions and cutting any losses before they become catastrophic.
Knowing option essentials
A listed stock option is a contractual agreement between two parties with standard terms. All listed options contracts are governed by the same rules. When you create a new position, one of two things is triggered:
✔ By buying an option, you are buying a specific set of rights
✔ By selling an option, you are acquiring a specific set of obligations
These rights and obligations are standard and are guaranteed by the Option Clearing Corporation (OCC), so you never have to worry about who’s on the other end of the agreement. Chapter 3 provides more information and detail on the Options Clearing Corporation and its central role in options trading.
Time means everything to option traders. The one particular wrinkle in options, and the primary risk involved, is time risk, because options contracts have a limited lifespan. The price of a call option rises when its underlying stock goes up. But if the move in the stock is too late, because it happens too close to the expiration date, the call can expire worthless. You can literally buy yourself more time, though – some options have expiration periods as late as 9 months to 2 1/2 years.
When you own call options, your rights allow you to
✔ Buy a specific quantity of the underlying stock (exercise).
✔ Buy the stock by a certain date (expiration).
✔ Buy the specific quantity of stock at a specified price (known as the strike price).
In other words, the price of the call option rises when the stock price goes up because the price of the rights you bought through the option is fixed while the stock itself is increasing in value.
Conversely, a put option gains value when its underlying stock moves down in price, while the timing issue is the same. The move in price still has to occur before the option contract expires or your option will expire worthless. Your put contract rights include selling a specific quantity of stock by a certain date at a specified price. If you own the rights to sell a stock at $60, but events such as bad news about the company pushes the stock price below $60, those rights become more valuable.
A significant part of your skill as an options trader is your ability to select options with expiration dates that allow time for the anticipated moves to occur. This may sound too challenging at the moment, but as you learn more, it will make perfect sense because it’s all about giving yourself time and giving the option time to deliver on your expectations. Of course, there are some basic trading rules of thumb that help, including the development of proper trade-management techniques, such as planning your exit from a position before you trade. Planning your exit is a simple but required part of any trade, and it is one good habit that will save you money and heartache if a position moves against you.
All stocks with derived options available for trading have multiple expiration dates and strike prices. There are two important pricing factors to keep in mind:
✔ Options with more time until the expiration date are more expensive.
✔ Options with more attractive strike prices are more expensive.
Information about options and your available choices are widely available on the Internet, especially from your broker. It takes time and practice to get to a point where you can pick the best options based on current market conditions and your outlook for the underlying asset. But as you read the different sections in this book, you will start to get a good feeling for how to go about this. Even more important is how