Learn options ebook

Learn Options Option Trading eBook Written By - Adam Beaty Table of Contents BACK TO BASICS HISTORY OF OPTIONS WHAT DOES AN OPTION LOOK LIKE? COMMON OPTION DEFINITIONS FACTORS THAT AFFECT AN OPTION'S PRICE OPTION STRATEGIES 12 LONG CALL 12 LONG PUT 14 SHORT CALL 16 SHORT PUT 18 COVERED CALL 20 COLLAR 22 BULL CALL SPREAD 24 BEAR PUT SPREAD 26 BEAR CALL SPREAD 28 BULL PUT SPREAD 30 LONG STRADDLE 32 SHORT STRADDLE 34 LONG STRANGLE 36 SHORT STRANGLE 38 LONG COMBINATION 40 SHORT COMBINATION 42 RATIO VERTICAL SPREAD WITH CALLS 44 RATIO VERTICAL SPREAD WITH PUTS 46 BACK SPREAD WITH CALLS 48 BACK SPREAD WITH PUTS 50 LONG CALENDAR SPREAD WITH CALLS 52 LONG CALENDAR SPREAD WITH PUTS 54 DIAGONAL SPREAD WITH CALLS 56 DIAGONAL SPREAD WITH PUTS 58 LONG BUTTERFLY SPREAD WITH CALLS 60 LONG BUTTERFLY SPREAD WITH PUTS 62 Trade Smart Win Smart IRON BUTTERFLY 64 SKIP STRIKE BUTTERFLY WITH CALLS 66 SKIP STRIKE BUTTERFLY WITH PUTS 68 INVERSE SKIP STRIKE BUTTERFLY WITH CALLS 70 INVERSE SKIP STRIKE BUTTERFLY WITH PUTS 72 CHRISTMAS TREE BUTTERFLY WITH CALLS 74 CHRISTMAS TREE BUTTERFLY WITH PUTS 76 LONG CONDOR SPREAD WITH CALLS 78 LONG CONDOR SPREAD WITH PUTS 80 IRON CONDOR 82 ADVANCED TOPICS 84 THE GREEKS 84 THE GREEK CHEAT SHEET 89 USING OPTIONS TO PICK UP STOCK 90 TOP MISTAKES PEOPLE MAKE TRADING OPTIONS 93 (SET) AND INDEX OPTION EXPIRATION 99 Back to Basics History of Op ons The US op ons exchange started with the founding of the CBOE (Chicago Board Op ons Exchange) in 1973 At the beginning there were a total of 16 equi es that had only call op ons In 1977 they began to trade put op ons There are now over different exchanges ac vely trading op ons In 1975 the SEC (Securi es and Exchange Commission) approved the OCC (Op ons Clearing Corpora on) with the sole purpose of clearing all US based op ons A clearing firm’s job is to facilitate execu on by transferring funds, assigning deliveries, and guaranteeing the contracts Op ons were a hit when they first appeared In 1975 18 million contracts traded By 1978 that number had more than tripled to 60 million contracts The increase in contracts nued to climb un l the 1987 stock market crash A er the stock market crash investors were s ll uneasy In 1991 only 2/3 of the peak level contracts were traded In 1983 we saw the first op ons traded on an index, the S&P 500 This was a big development since it was from this that led to the forma on of the VIX The VIX is the vola lity index, fear index, based on the prices of S&P 500 op ons Enthusiasm for the op ons market didn’t return un l the 1990s During these mes we saw the introduc on of LEAPS (Long-term An cipa on Securi es) which allowed investors to buy op ons that expired over a year We also saw the forma on of the OIC (Op ons Industry Council) which is a non-profit organiza on developed to educate people on the risk and benefits of op ons Trade Smart Win Smart What Does An Op on Look Like? An op on gives the buyer the right to buy or sell the underlying at a specified price and me At the same me, the seller has the obliga on to take the opposite side and fulfill the op on upon exercise That means that the buyer can choose if they want to exercise the op on, but the seller has to live up to the contract if the buyer does exercise A typical op on: Let’s analyze: XYZ is the underlying instrument This can range from equi es (companies), indexes, futures, and currency In this case we are using the company XYZ January is the expira on month and sets the life of the op on Expira ons are always given in terms of a month It is understood that op ons expire on the third Friday of every month In this example, a er the third Friday in January this op on will no longer exist 170 is our strike price The strike price sets the price of the underlying if it were exercised This is not the price you would pay to buy the op on Call specifies if this is a call or put A call is the right to buy or call the stock away from someone else Too long a call you are making a bet the underlying will appreciate in price A put is the right to sell or put the stock to someone else Too long a put you are predic ng deprecia on in price A put and call can be traded long and short or also in combina on with other puts/calls to create spreads (more informa on on combina ons to follow) Back to Basics Common Op on Defini ons In-the-Money (ITM): For a call op on this means that the underlying is trading above the strike price For example ABC is trading at 30 and the call op on has a strike price of 25 This call op on is ITM For a put op on this means the underlying is trading below the strike price For example ABC is trading at 45 and the put op on has a strike of 50 This put op on is ITM At-the-Money (ATM): This indicates the underlying price is around the strike price For example ABC is trading at 50 and the op on strike is 50 This goes for both puts and calls If you cannot tell which strike is closer than look for the strike with a delta closer to 50 Out-of-the-Money (OTM): For a call op on this means the underlying is trading below the strike price For example ABC is trading at 15 with the call op on strike at 20 This call op on is OTM For a put op on this means the underlying is trading above the strike price For example ABC is trading at 75 and the put op on has a strike of 70 This put op on is OTM Intrinsic Value: The amount the op on is in-the-money Only In-the-Money (ITM) op ons carry intrinsic value Time Value: Sets the value of me ll expira on An op on that is Out-of-the-Money (OTM) only has me value If an op on is In-the-Money (ITM) it is made up of both Intrinsic Value and Time Value Exercise: To exercise an op on contract means you are fulfilling the contract and closing it out If you exercise a call op on you are buying the shares at the strike price If you exercise a put you are selling the shares at the strike price Trade Smart Win Smart Assignment: An op on assignment is the other side of the op on being exercised In this case you are not the buyer of the op on instead you are the seller or writer of the op on When a buyer exercises an op on the writer gets assigned If you are a writer of a call op on that gets exercised then you have to give the buyer your shares If you are a writer of a put op on then you will receive the shares when assigned Op on Chain: An op on chain displays all the necessary informa on for the underlying asset The op ons are listed by the expira on month and then broken down by all the strikes available Usually Calls are listed on the le side and Puts listed on the right side Op on Chains can provide a wide variety of informa on from something basic such as the bid/ask to more specific informa on such as the op on Greeks Back to Basics Example of an op on chain: Trade Smart Win Smart Factors That Affect An Op on's Price Stock Price If a call op on allows you to buy a stock at a certain price in the future than the higher that price goes the more the op on will be worth Which op on would have a higher value: A call op on allows you to buy The Op on Prophet (sym: TOP) for $100 while it is trading at $80 OR A call op on allows you to buy TOP for $100 while it is trading at $120 Obviously no one is going to pay $100 for something they can buy on the open market for $80, so our op on in Choice will have a low value What is more appealing is Choice 2, an op on to buy TOP for $100 when its value is $120 In this situa on our op on value will be higher Strike Price Strike price follows along the same lines as stock price When we classify strikes we it as in-themoney, at-the-money or out-of-the-money When a call op on is in-the-money it means the stock price is greater than the strike price When a call is out-of-the-money the stock price is less than the strike price A TOP call has a strike of 50 while TOP is currently trading at $60, this op on is in-the-money On the flip side of that coin a put op on is in-the-money when the stock price is less than the strike price A put op on is out-of-the-money when the stock price is greater than the strike price A TOP put has a strike of 20 while TOP is currently trading at $40, this op on is out-of-the-money Op ons that are in-the-money have a higher value compared to op ons that are out-of-the-money Back to Basics Type Of Op on This is probably the easiest factor to understand An op on is either a put or a call and the value of the op on will change accordingly A call op on gives the holder the right to buy the underlying at a specified price within a specific me period A put op on gives the holder the right to sell the underlying at a specified price within a specific me period If you are long a call or short a put your op on value increases as the market moves higher If you are long a put or short a call your op on value increases as the market moves lower Time To Expira on Op ons have a limited life span thus their value is affected by the passing of me As the me to expira on increases the value of the op on increases As the me to expira on gets closer the value of the op on begins to decrease The value begins to rapidly decrease within the last thirty days of an op on's life The more me an op on has ll expira on, the more me the op on has to move around Interest Rates Interest rates have a very small effect on an op on's value When interest rates rise a call op on's value will also rise and a put op on's value will fall To drive this concept home let's look at the decision making process of trying to invest in TOP while it is trading at $50 We can buy 100 shares of the stock outright which would cost us $5,000 Instead of buying the stock outright we can long an at the money call for $5.00 Our total cost here would be $500 Our ini al outlay of cash would be smaller and this would leave us $4,500 le over Plus, we will have the same reward poten al for half the risk Now we can take that le over cash and invest it elsewhere such as Treasury Bills This would generate a guaranteed return on top of our investment in TOP Trade Smart Win Smart Like delta, gamma will also change over the life of the op on This is because a delta cannot go beyond 1.0 or -1.0 A gamma must change to slow down the movement of delta The gamma of at the money op ons will be the highest Deep in the money and deep out of the money op ons will have the smallest gamma Gammas are always expressed as posi ve numbers, and will increase drama cally near expira on This factor is what makes the Weekly op ons desirable Even a small move so close to expira on can change the op on price greatly Like delta gamma can be calculated for an en re posi on consis ng of more than one op on We will use our previous example on delta Posi on Delta Posi on Delta Gamma Posi on Gamma Posi on Delta Posi on Delta Gamma Posi on Gamma Short 50 XYZ 1.0 +50 0.0 0.0 Short 20 XYZ November 115 Calls 55 -1100 04 04 x 100 x 20 = -80 Long 30 XYZ November 118 Calls 46 +1380 03 03 x 100 x 30 = +90 Totals +330 +10 As you can see this posi on is posi ve gamma at +10 So if the underlying moves up by 1-point our new delta will be +340 (330 + 10) If the underlying moves down 1-point our new delta will be +320 (330 – 10) We also no ce that the underlying has a gamma of 0.0 The underlying has a 1.0 delta and thus cannot change so we get a 0.0 gamma We also no ce Long Calls and Long Puts have posi ve gammas and Short Calls and Short Puts have nega ve gammas Later we will show you how to make your posi on both delta and gamma neutral As we will discover it is not enough to be delta neutral as that only last un l the underlying moves Theta: The measure of me decay comes from theta One thing all op on traders need to be aware of is an op on’s me decay Time decay is the enemy of the op on buyer and friend of the op on seller Theta is expressed as a nega ve number of cents of decay for each day So a theta of -.06 means the op on price will drop cents each day if everything else remains the same Advanced Topics Time decay is not linear and will increase rapidly when the op on nears expira on Also near expira on most brokerages, op on chains, and models will report theta that is not accurate The majority of the me thetas near expira on that will report a number that will take the op on price below before expira on Unlike delta, gamma, and vega me decay cannot be hedged against so it is usually not of major concern to overall posi ons.Understanding that it is there and how it will affect your posi ons is more important However, you can figure out the overall theta of posi on that has more than one op on Posi on Theta = Op on Theta x Shares per Contract x # of Contracts Vega/Tau/Kappa: Vola lity always gets a wide variety of names because Vega is not actually a Greek le er, so in some cases you will see it referred to as Tau or Kappa.In our case we will also refer to it as Vega since that is the generally accepted name.Vega measures the change in op on price according to the change in vola lity.Vola lity is always the X- Factor in op ons pricing That is because it is always a guess, always misunderstood, and usually not taken into major account Unlike all other inputs into an op on pricing model, vola lity is the only one that is not a concrete number.With that being said,vola lity is the most important factor in op ons A high vola lity means higher op on prices.This is because people expect the underlying to move more so therefor op on prices are higher to reflect that.That means if vola lity goes up your op on price will rise That means if vola lity goes down, your op on price will go down Trade Smart Win Smart This may seem like an elementary concept; however most beginner op on traders will ask the ques on, “Why did my stock go in the right direc on, but my op on lose money” Learning vola lity and how it moves and affects op ons will put you way ahead of the pack when you being op on trading Rho: This is the poor forgo en Greek Rho tracks interest rates and how they affect op on prices With an increase of interest rates we have an increase in call prices and a decrease in put prices When interest rates decrease we see a rise in put prices and a decrease in call prices Rho measures this movement Advanced Topics The Greek Cheat Sheet The Greeks can get very complicated especially when you really start to dive into the plays This cheat sheet is what helped me when I first started in op ons Long Straddle is a neutral delta, posi ve gamma, nega ve theta, and posi ve vega This means it is not direc onal (delta), needs movement (gamma), decays with me (theta), and looks for increasing vola lity (vega) This is a great worksheet to keep around when pu ng on op on posi ons to make sure you are aligning the right strategy with the situa on Strategy Long Stock Short Stock Long Call Long Put Short Call Short Put Long Straddle Long Strangle Short Straddle Short Strangle Bull Spread Bear Spread Calendar Spread Delta + + + N/A + N/A N/A + N/A Gamma N/A N/A + + + + - Theta N/A N/A + + + + + Vega N/A N/A + + + + + Trade Smart Win Smart Using Op ons to Pick Up Stock Most people will use op ons as a means of specula on or a means to hedge Both of these strategies have their place; however what people tend to not use op ons for is to pick up stock Using op ons to go long on a posi on is a great way to make extra money without a real risk How is it done? Well there are a couple of different methods, this is one We will go over the other at a later date Let's start with a company (AAPL) (this is not a recommenda on - just used for demonstra on) At the end of today these are AAPL's numbers, Last Price is $383 This is a bit overpriced for my liking but if Apple were to come down to 370 I would pick up a 100 shares in a heartbeat Maybe I see 370 as a fair valua on of the company or at that price it will be pulling back to a strong support level So now that I have the price I want it at I could sit on my hands and wait for it to drop or I could sell puts to make some money while I wait Here is our op on chain for October: (calls on the left - puts on the right) For our purpose we will only look at the right side When you short puts to pick up the stock you look for the stock to drop in price under the strike and you will be assigned (given) the shares So as you can see there just so happens to be a 370 strike which is the price I want Apple for The last price traded on the 370 puts was 12.15 If we sell contract (100 shares) we collect (12.15 x 100) $1215 while we wait for Apple to drop Sounds simple, right? Well it is, but we are not done yet We still need to discuss how far out we sell our premium, what happens when we get assigned, what happens if we don't get assigned, and what the pitfalls of this strategy are Advanced Topics How far out we sell premium? To answer this ques on we have to level the playing field Obviously an op on expiring in a couple of weeks can't compete on premium to an op on expiring months from now First we need to find out the annual return of our premium The formula we will use is: (( + (Premium) / (Cost of Shares) / (Days to Hold)) ^ 365) - looks like a complicated formula but it is really simple so for our example: (( + (1215 / 37000) / 44) ^ 365 ) - 1= (( + 032837838 / 44 ) ^ 365 ) -1 = (( + 000746314 ) ^ 365 ) - = (( 1.007463145 ) ^ 365 ) - = 1.312985029 - = 312985029 = 31.30% annualized return Yes that is right You have the op on of si ng and wai ng for the stock to come down to 370 before you buy it, or you can sell puts to collect a 31.30% return while you wait Use this method of figuring out the annualized return for different expira on months so you can find out which month is offering a be er return Keep in mind that you don't want to get crazy with the holding period You will have to keep this cash si ng aside just in case your op on gets assigned Typically - month holding periods work the best, but try a couple out to find out for sure If selling puts becomes a normal habit of yours, go ahead and make an excel spreadsheet to make these calcula ons quick and efficient Let me know if you require help crea ng a spreadsheet What happens if we get assigned? Ge ng assigned is having the stock fall below your strike and forcing you to buy the shares This is the scenario you should be coun ng on if you are selling cash-secured puts If at expira on Apple is 01cents below 370 you will be assigned the shares, and have to pay out $37,000 However, since you sold puts your average price is not 370 for the shares but is actually 370 - 12.15 = 357.85 Trade Smart Win Smart Now that you have the stock you can start thinking about selling calls to generate extra cash We will describe this strategy at a later date also What happens if we don't get assigned? If we don't get assigned then the puts will expire worthless and we keep the premium This has its advantageous because we s ll make the $1215 premium, which is a 3.28% return, and we will not have to pay another commission to close out the posi on What are the pi alls of this strategy? Every strategy has its pi alls and this one is no different Let's say you sell the puts but the stock does not come down and begins to move higher At this point you would not be able to take advantage of this run up since you only have puts and not the stock What you can in this situa on is buy back the puts for a cheaper price, thus making a profit, and then sell more puts at a higher strike Another scenario is if the stock falls below your strike and keeps falling This will assign you shares at your price, in our example 370 with a breakeven of 357.85 If the stock falls below that point you will have a loss One way to think about this scenario is that you were planning on buying Apple at 370 anyways, at least this way you have lowered your breakeven Advanced Topics Top Mistakes People Make Trading Op ons Buying out of the money op ons because they are cheap The Problem: A lot of new traders like to start out by buying near term out of the money op ons Why? They are the cheapest so it seems like a great idea at the me The problem is that these op ons are cheap for a reason They have a small probability of finishing in the money so they are not going to be worth anything to begin with Think of these op ons as lo ery ckets You will have to buy lots of them just to get one to pay off and breakeven When you purchase these op ons you HAVE to be right on both ming and direc on Now that seems easy and obvious at first but if you are si ng on these op ons for too long then a move in the right direc on s ll won't help you out The closer those op ons move to expira on the lower the probability becomes that they will finish in the money which means they will s ll be worth very li le The Fix: When purchasing straight long calls and long puts try to get them at the money or in the money The op ons will be more expensive than their out of the money counterpart but the probability of success and the leeway they afford will be worth the money If you s ll want to go out-of-the-money shoot for one strike out Ge ng overleveraged The Problem: When star ng into the world of op ons you will undoubtedly come from trading stock first, this is just the natural progression As a stock trader you probably have rules for how big of a posi on you are going to trade Typically, traders will buy in blocks of shares: 100 shares a posi on, 200 shares a posi on, etc and spend anywhere between $1,000 - $5,000 on a posi on The problem forms when they try to make this move into op ons Op ons, by their nature, are cheaper than stock so it will allow you to take on more shares for less money then you are used to This leads to ge ng over leveraged in these posi ons If you are used to spending $1,000 for a posi on buying the same amount in op ons will leave you will much more leverage and risk The swings in op ons can make or break a posi on very quickly and if you are not use to the swings then you can end up in a lot of pain Trade Smart Win Smart The Fix: When you start op ons try to keep you posi on size small In fact, one of the best things about op ons is that you can s ll be profitable by trading only one contract Commissions are typically so cheap you don't need to trade large posi ons to break even Any me you are learning a new op on strategy or play always start small so you keep your risk low Use small posi ons to learn how op ons move with the market, vola lity, and me Once you have a clear understanding of the types of plays you are running then you can begin to build your posi on size bigger loss If the spread is 20cents or 30cents that means you already begin $20 to $30 down Not Having A Plan The Problem: Op on trading is a lot more complex versus trading regular stock posi ons There are a lot more factors to watch and there are a lot more op ons to take when you are already in a posi on The nice part about op ons is that you will rarely want to simply enter and exit a posi on There are a lot of adjustments that can be made that will allow you to capture some profit or reduce your risk When you trade without a plan you will enter a posi on and then have it move against you which will leave you frozen like a deer in the headlights When trading without a plan you let emo on take over your decision making It is impossible to leave emo on out of trading but le ng it make the decisions for you is a great way to blow out your por olio The Fix: With all trading, stock or op ons, you need to set a plan before you enter the posi on This plan should include when you are ge ng in, the strategy you will use, what your profit target is, adjustment levels are, the adjustments you are going to make, and your max loss Now this may seem like a long list to prepare before even making the trade but having this plan ready will keep you in the game longer Kirk at Op onAlpha.com reaffirms that the three numbers you need to know before you click send on a trade are: the percentage profit target, adjustment points, risk and maximum loss Have you thought about when you are going to adjust a posi on? Will you adjust when a stock reaches a certain point, when you are a percentage away from your max loss, like we describe in our Iron Condor Trade, or will you it when the deltas reach a certain point? These are the things that need to be planned before you reach that level Let me tell you from experience, if you wait un l you are already underwater on a posi on your emo on will take over and you will make poor decisions about the trade As you progress in your trading and learn more about op ons some parts of this plan will just natural fill in itself Certain types of trades lend themselves to having the same types of adjustments done at various levels, but when you are first star ng these items need to be detailed out Advanced Topics Limi ng Yourself To Simple Long Call and Long Put Strategies The Problem: When you first start trading op ons you will, inevitably, start with long calls and long puts for stocks you want to trade long and short There is nothing wrong with that Your first trade should not be an Iron Condor The problem is that traders will allow themselves to get pigeon-holed into this strategy and never venture out into other strategies, which is a real shame because op ons allow for so many unique strategies that you cannot get with stock The Fix: Only with op ons can you trade an upward move, downward move, a move in either direc on or no move at all, an increase in vola lity, drop in vola lity, or just a passing of me To not explore these strategies would be a tragedy because you will be short a lot of useful tools in your trading toolbox Now, not all op on strategies will be for you There are some plays that we simply not enjoy running or have no luck with, looking at your calendar spreads, so don't run them but it doesn't hurt to know about them and have tried them in the past Begin your journey into new op on strategies by first studying them and then trying them out in small sizes As we men oned in the Ge ng Over Leveraged fix, op on commissions are cheap and they allow you to trade small sizes without raising your breakeven point You never know when you will find your next favorite op on strategy Trading Op ons Without Fully Understanding Them The Problem: Here is the story we hear from most new traders, "I bought a call on XYZ and then XYZ moved up in price but my call lost money I don't understand, what went wrong?" Most beginning op on traders will find themselves in this situa on and the answer is always the same, "vola lity dropped" This is a perfect example of the pains involved in not knowing about the inner workings of op ons The Fix: You don't have to know every minute detail about every op on trade before you start trading but you be er know something Start by Downloading Our Op on Trading eBook This will give you a good start as it details out every op on strategy available and how they react to vola lity, me, and direc on Now when you place a trade you can use it as a quick reference to make sure you are not surprised a er the trade is already on Once you have a good idea of how the strategies work start to dive into the Greeks The Greeks can and will be confusing but a basic understanding is needed to understand how your strategy will move The Greeks should be learned in this order: delta, gamma, theta, and vega Trade Smart Win Smart Le ng Short Op ons Go Unmonitored The Problem: Short op ons carry with them several interes ng proper es One of the most notable and usually the head scratcher is the fact that short op ons have limited rewards and unlimited risk Now this is usually a turnoff to most op on traders, but don't let it stop you from exploring these strategies Short op ons can be a great way to generate income but you have to stay on top of them This doesn't just relate to monitoring the downside The upside needs to be monitored too Op on traders will push to squeeze every dime of profit out of a trade only to have it turn on them and have it end up a loss The Fix: Remember when we talked about Not Having A Plan well this is not where you want to break that rule Your first and most important rule is to never let short op ons go in the money unless you are trading covered calls or using puts to pick up stock If you are not running those strategies and let the op on go in the money you run the chance of ge ng assigned and this is not a good situa on if you are not seeking it Before you begin to trade short op ons set your get out points whether that is dependent on a technical analysis or a max loss number Not Being Informed The Problem: Not being informed of market events is a problem not only for op on traders but for all traders in general What happens is they find this perfect trade, dot their i's cross the t's, but forget to account for one variable that ruins the whole trade With op on trading these mistakes can be magnified and can cause a play that should profit to turn a loss instead Most traders are aware that company earnings will affect a trade but what about dividends? A company coming up on their ex-dividend date can cause short op ons to be assigned The Fix: When you are in the market you need to be dialed into what is going on both from a macro and a micro standpoint For a macro perspec ve you should always keep your eye on an economic calendar and look for any major economic news releases that could affect the overall market A couple of items you want to keep your eye on are employment numbers, GDP numbers, and whenever the Federal Reserve talks Advanced Topics Looking more into the company, the micro level, we want to focus on any scheduled announcements As men oned above, short op ons have a higher probability of being assigned when a company reaches its ex-dividend date This is due to the fact that op on traders have no rights to the dividend so they must convert to stock to get that dividend You will want to keep an eye on earnings announcements too When a company releases earnings it can send the stock roaring or tanking This uncertainty causes vola lity to increase which in turn increases op on prices This will also lead you to experience vola lity crush a er the announcement which can drop the op on price drama cally It is okay to trade around these events but you need to understand what they are and the affect that they could have on your strategies Trading Illiquid Or Low Volume Op ons The Problem: Liquidity is how fast you can get in and out of a posi on at a desirable price The lower the liquidity the higher the chance you won't get a price you like or you will have to wait an excessive amount of me before you This also has the effect of increasing the spread size between the buy price and the sell price If you purchase an illiquid op on you could begin the trade down 10-20% right from the start That is not something you want to have to work back from just to turn a profit Not all op ons are created equal Unlike straight stock where you always trade just the company common stock, op ons have a wide variety of choices Just on one company you are faced with several expira on dates that could venture out three years (as is the case with LEAP Op ons) and a mul tude of strikes both on the put and the call side A lot of op ons are simply not going to trade and you don't want to get caught in that posi on The Fix: Just because the op ons are listed on the screen doesn't mean they are liquid or good to trade Most op ons won't be traded The smaller the company the more illiquid op ons it will have The further out of the money and in the money you go the more illiquid the op on will be There are two numbers you want to focus on before you decide to purchase or sell an op on The first is Open Interest which will let you know how many open contracts are on that strike Each strike will have its own separate open interest and it will fluctuate daily depending on the trades placed Avoid strikes with li le to no open interest Trade Smart Win Smart The next number is Volume which is exactly like stock volume in that it tells you how many shares have been traded that day Again, you will want to focus on op on strikes that actually carry some volume The higher these numbers are the more liquid that strike is and the easier it will be to trade at prices you desire Advanced Topics (SET) and Index Op on Expira on A lot of investors like to incorporate index op ons into their strategies because they are more stable and easier to predict These are usually be er for using neutral strategies like iron condors An index op on is simply an op on based on one of the major indexes such as: S&P 500, Russell 2000, NASDAQ, etc… Most investors also know that index op ons are AM se led Typical op on expira on occurs at the close on the 3rd Friday of each month However, index op ons expire that Friday morning giving investors one less day to worry about Now AM se lement might seem like a good idea but it carries with it one major drawback, which is SET SET is the se lement value given to the indexes on Friday morning Let's look at an example: October 21, 2011 was op on expira on The day before, that Thursday the SPX (S&P 500) closed at 1215 Friday Morning the SPX opened at 1215 SET Value is 1228 a 1.06% difference Why does this ma er? Let's say you are short the 1225 calls and you see the market close at 1215 on Thursday You can now go to bed happy because your op ons will expire worthless and you will collect a nice premium Unfortunately, when the market opens that Friday the CBOE (Chicago Board of Op on Exchange) calculates all the opening prices for every component in that index and uses that as the se lement value Some stocks gap higher, gap lower, or don't even trade in the morning but all of these values are taken into account Through this process we can get a big swing in SET value over the close/open price of that index The real crummy part is that your op ons stop trading Thursday at the close, and if you are s ll holding then you are at the mercy of SET So now those 1225 calls you had a profit on are now showing a loss You should not hold index op ons into the close on Thursday if they are around the closing value Go ahead and close it out early to guarantee you get the price you want Don't get caught looking at a profit on Thursday only to have it turn to a loss on Friday morning ... 82 ADVANCED TOPICS 84 THE GREEKS 84 THE GREEK CHEAT SHEET 89 USING OPTIONS TO PICK UP STOCK 90 TOP MISTAKES PEOPLE MAKE TRADING OPTIONS 93 (SET) AND INDEX OPTION EXPIRATION 99 Back to Basics History...Table of Contents BACK TO BASICS HISTORY OF OPTIONS WHAT DOES AN OPTION LOOK LIKE? COMMON OPTION DEFINITIONS FACTORS THAT AFFECT AN OPTION'S