Trading Options For Dummies. Duarte MD Joe

strategy. If you keep these factors in mind as you study each section, the concepts will be much easier to use as you move on to real time trading.

      Use stock options for the following objectives:

      ✔ To benefit from upside moves for less money

      ✔ To profit from downside moves in stocks without the risk of short selling

      ✔ To protect an individual stock position or an entire portfolio during periods of falling prices and market downturns

      Always be aware of the risks of trading options. Here are two key concepts:

      ✔ Option contracts have a limited life. Each contract has an expiration date. That means if the move you anticipate is close to the expiration date, you will lose our entire initial investment. You can figure out how these things happen by paper trading before you do it in real time. You can read more about paper trading in Chapter 7. Paper trading lets you try different options for the underlying stock, accomplishing two things. One is that you can see what happens in real time. Seeing what happens, in turn, lets you figure out how to pick the best option and how to manage the position.

      ✔ The wrong strategy can lead to disastrous results. If you take more risk than necessary, you will limit your rewards and expose yourself to unlimited losses. This is the same thing that would happen if you sold stocks short, which would defeat the purpose of trading options. Options and specific option strategies let you accomplish the same thing as selling stocks short (profiting from a decrease in prices of the underlying asset) at a fraction of the cost. Chapters 9–11 give you details on how you can profit from falling markets through options.

       Comparing options to other securities

      Options are a form of derivative, a type of security that derives its value from an underlying security. Stock options derive their value from the underlying stock. In order to better understand option valuations, it makes sense to know more about other derivatives and exchange traded mutual funds (ETFs), which are quasi-derivatives:

      ✔ Commodities and futures contracts: Like options, commodity and futures contracts are agreements between two parties. The major difference between a commodity or futures contract and an options contract is that the former obligates you, whereas an options contract gives you rights as an owner. This is because commodities and futures contacts set the price for a predetermined quantity of a physical item to be delivered to a particular location on a predetermined date. Options have no delivery date. On the other hand, commodities and futures contracts are similar to options in that they lock in the price and quantity of an asset. However, in both cases, you can trade away your rights and obligations if you exit the contract before expiration.

      ✔ Indexes: Think of indexes as collections of assets whose value is pooled together to measure the price of the group. Stocks, commodities, and futures are all index components. Chapter 9 covers index options in detail. Here is the important difference: Indexes are not securities. That means you can’t buy an index directly. Instead, you buy securities that track the value of the index, such as mutual funds that own the stocks in a particular index – for example, Standard & Poor’s 500 Index.

      ✔ Exchange traded funds (ETFs): ETFs are mutual funds that trade like stocks on an exchange. Most ETFs are designed to track an index or an underlying sector of a particular market. ETFs can be considered quasi-derivatives because they don’t always hold the exact same securities of the index that they track. For example, some leveraged ETFs use more exotic securities known as swaps to mimic the action of the underlying index while adding leverage. Two of the most popular ETFs are the S & P 500 SPDR (SPY) and the Powershares QQQ Trust (QQQ), which tracks the Nasdaq 100 index. These two popular ETFs let you trade their underlying indexes, directly or through options.

      ✔ Stocks and bonds: Stock ownership gives you part of a company, whereas bond ownership makes you a debt holder. Each dynamic has its own set of risks and rewards. Comparison of the three assets, stocks, bonds, and options, yields a fairly straightforward picture. All three asset classes can lead investors to total loss of their investment. And though stocks give you a piece of the company, and bonds offer you income, options offer you no ownership of any tangible assets. Stocks offer indefinite holding periods, and bonds have a maturity date and options have a limited life.

      

A swap is an insurance contract whose terms are privately agreed upon by the participants. They can be thought of as non-exchange traded options and they can be used to bet on the direction of just about anything that the two parties agree upon. By design, swaps are very sophisticated securities that are not available to individual investors because of the financial requirements and the specific agreements required to be signed before you trade them. When you own shares in a leveraged ETF, check the prospectus carefully to see if this is what you are buying. We’re not suggesting that you don’t consider leveraged ETFs if they make sense for your portfolio. We use them often in our personal trading. It’s important for you to always know what you are investing in, even if it’s an indirect investment such as an ETF.

      When swaps get out of control, the markets can suffer. This is what happened in 2008 as lots of big money players bet (correctly) that subprime mortgage holders would not be able to make their monthly mortgage payments. They were right, and the rest, as they say, is history.

Valuing Options

      Part of knowing your risks and rewards results from understanding how an investment derives its value and what affects the rise and fall in its price. In order to value an option, you must know the following:

      ✔ The type of option (put or call)

      ✔ The market value of the underlying security

      ✔ The characteristics of the past trading pattern of the underlying security calm or volatile

      ✔ The time remaining until the option expires

       Knowing your rights and obligations as an options trader

      There are two types of options: calls and puts. By owning a call you have the right to buy a certain stock at a pre-specified price by a certain date. Owning a put give you the right to sell a certain stock at a specific price by a certain date. Put option prices go up when the price of the underlying security falls. Call option prices rise when the underlying security’s price rises. When you own options, you can assert your rights at your own discretion. So, between the time you buy an option and its expiration date, you can

      ✔ Sell the option for a profit.

      ✔ Sell it for a loss.

      ✔ Exercise it.

      ✔ Let it expire with no value (for a loss).

      As an option seller, you are obligated to complete a specific set of requirements. In fact, selling options gives you fewer choices, and the actionable choices are heavily influenced by the action in the markets. As the expiration date nears, you can

      ✔ Buy the option back for a profit.

      ✔ Buy it back for a loss.

      ✔ Let the option expire with no value (for a profit).

      

An easy memory trick to help you keep your rights and obligations in the correct framework is to think about buying the stock as calling it back while selling the option as putting the stock to someone.

       Terms of endearment and importance

      Here are key terms you have to nail down in order to make good option trading decisions:

      ✔ Underlying security: The stock that you buy or sell and that determines the value of the option.

      ✔ Strike price: