by George Fontanills Trading Options FOR DUMmIES ‰ 01_241769 ffirs.qxp 2/22/08 3:06 PM Page iii Trading Options For Dummies ® Published by Wiley Publishing, Inc. 111 River St. Hoboken, NJ 07030-5774 www.wiley.com Copyright © 2008 by Wiley Publishing, Inc., Indianapolis, Indiana Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permit- ted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600. 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Library of Congress Control Number: 2008923121 ISBN: 978-0-470-24176-9 Manufactured in the United States of America 10 9 8 7 6 5 4 3 2 1 01_241769 ffirs.qxp 2/22/08 3:06 PM Page iv About the Author Since 1993, Optionetics has provided investment education services and trading tools to more than 250,000 people from over 50 countries. Every day, Optionetics helps traders navigate the markets and chart paths to financial security. In fact, it not only stands by its pledge to provide the highest quality investment education possible, but it also guarantees it. Optionetics high-profit, low-risk, low-stress strategies are based on over dozens of trading techniques perfected by master trader George Fontanills, founder of Optionetics. Avoiding overly theoretical or technically compli- cated material, Optionetics represents a practical, balanced approach to trading profitably in today’s markets. Optionetics diverse range of educa- tional offerings includes seminars, publications, workshops, CDs and DVDs, home-study materials, books, and software. Choose Optionetics for the premier educational resources and tools to help you become the successful trader you’ve always wanted to be. Visit www.optionetics.com for more information. 01_241769 ffirs.qxp 2/22/08 3:06 PM Page v Dedication This book is dedicated to the students of Optionetics and the readers of this book who may follow in their footsteps. Author’s Acknowledgments Special thanks to Clare White, C.M.T., for all her hard work in creating an excellent options education tool. 01_241769 ffirs.qxp 2/22/08 3:06 PM Page vii Publisher’s Acknowledgments We’re proud of this book; please send us your comments through our Dummies online registration form located at www.dummies.com/register/. Some of the people who helped bring this book to market include the following: Acquisitions, Editorial, and Media Development Project Editor: Jennifer Connolly Acquisitions Editor: Stacy Kennedy Copy Editor: Jennifer Connolly Technical Editor: Noel Jameson Senior Editorial Manager: Jennifer Ehrlich Editorial Supervisor: Carmen Krikorian Editorial Assistants: Erin Calligan Mooney, Joe Niesen, Leeann Harney, and David Lutton Cartoons: Rich Tennant ( www.the5thwave.com) Composition Services Project Coordinator: Kristie Rees Layout and Graphics: Reuben W. Davis, Melissa K. Jester, Christine Williams Proofreaders: Jessica Kramer, Tricia Liebig Indexer: Potomac Indexing, LLC Publishing and Editorial for Consumer Dummies Diane Graves Steele, Vice President and Publisher, Consumer Dummies Joyce Pepple, Acquisitions Director, Consumer Dummies Kristin A. Cocks, Product Development Director, Consumer Dummies Michael Spring, Vice President and Publisher, Travel Kelly Regan, Editorial Director, Travel Publishing for Technology Dummies Andy Cummings, Vice President and Publisher, Dummies Technology/General User Composition Services Gerry Fahey, Vice President of Production Services Debbie Stailey, Director of Composition Services 01_241769 ffirs.qxp 2/22/08 3:06 PM Page viii Contents at a Glance Introduction 1 Part I: Getting Started 7 Chapter 1: Options Trading and Investing 9 Chapter 2: Introducing Options 19 Chapter 3: Trading Places: Options for Stocks 33 Chapter 4: Option Risks and Rewards 51 Part II: Evaluating Markets, Sectors, and Strategies 65 Chapter 5: Tapping Into the Market’s Mood 67 Chapter 6: Targeting Sectors with Technical Analysis 85 Chapter 7: Kicking the Wheels of a New Strategy 111 Chapter 8: Mapping Out Your Plan of Attack 127 Part III: What Every Trader Needs to Know About Options 141 Chapter 9: Getting a Handle on Option Styles 143 Chapter 10: Guarding Your Assets with Options 163 Chapter 11: Limiting Your Downside When Trading the Trend 183 Chapter 12: Combining Options to Limit Your Position Risk 201 Chapter 13: Benefiting from Exchange-Traded Funds 215 Part IV: Advanced Strategies for Option Traders 237 Chapter 14: Profiting Without a Market Outlook 239 Chapter 15: Keying In on Volatility for Trading Opportunities 257 Chapter 16: Capitalizing When Markets Move Sideways 283 Part V: The Part of Tens 309 Chapter 17: Ten Top Option Strategies 311 Chapter 18: Ten Do’s and Don’ts in Options Trading 323 Glossary 331 Index 345 02_241769 ftoc.qxp 2/22/08 3:07 PM Page ix Table of Contents Introduction 1 About This Book 1 Conventions Used in This Book 2 What You’re Not to Read 2 Foolish Assumptions 2 How This Book Is Organized 3 Part I: Getting Started 3 Part II: Evaluating Markets, Sectors, and Strategies 4 Part III: What Every Trader Needs to Know About Options 4 Part IV: Advanced Strategies for Option Traders 4 Part V: The Part of Tens 5 Glossary 5 Icons Used in This Book 5 Where to Go from Here 6 Part I: Getting Started 7 Chapter 1: Options Trading and Investing . . . . . . . . . . . . . . . . . . . . . . . . .9 Understanding Options 10 Knowing option essentials 10 Gaining comfort with option mechanics 12 Recognizing option risks and rewards 12 Incorporating Options into Your Routine 12 Adding options to your analysis 13 Trying out investing and trading strategies 14 Putting Options to Work 14 Understanding option styles 15 Using options to limit your risk 15 Applying options to sector approaches 16 Using Options in Challenging Markets 16 Reducing your directional bias 17 Benefiting when the markets go nowhere 17 Considering your obstacles 17 02_241769 ftoc.qxp 2/22/08 3:07 PM Page xi Chapter 2: Introducing Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 Understanding Option Contracts 19 Getting a grasp on option basics 19 Comparing options to other securities 21 Uncovering an Option’s Value 22 Understanding options rights and obligations 23 Taking in some terminology 23 Accessing All Your Options 24 Identifying options 24 Expiring options gracefully 28 Dissecting your rights 28 Creating Contracts 29 Opening and closing positions 29 Selling an option you don’t own 30 Keeping Some Tips in Mind 32 Chapter 3: Trading Places: Options for Stocks . . . . . . . . . . . . . . . . . . . .33 The U.S. Options Exchanges 33 Navigating the Markets 34 Trade execution 34 Option market participants 35 Transactions unique to options 36 Trading rules you should know 37 Weighing Option Costs and Benefits 39 Identifying costs unique to options 39 Valuing options benefits 41 Grasping Key Option Pricing Factors 44 Introducing option Greeks 44 Connecting past movement to the future 46 Chapter 4: Option Risks and Rewards . . . . . . . . . . . . . . . . . . . . . . . . . . .51 Understanding Your Trading Risks 51 Risking money with stocks 52 Calculating option risks 54 Reaping Your Rewards 55 Benefiting from stocks 55 Breaking even with options 56 Profiling Risk and Reward 57 Profiling stock trades with risk graphs 58 Profiling option trades with risk graphs 59 Combining option positions 61 Considering the worst-case scenario 63 Trading Options For Dummies xii 02_241769 ftoc.qxp 2/22/08 3:07 PM Page xii Part II: Evaluating Markets, Sectors, and Strategies 65 Chapter 5: Tapping Into the Market’s Mood . . . . . . . . . . . . . . . . . . . . . .67 Assessing the Market’s Bias 67 Judging the strength of a move 68 (Psycho)-analyzing the market 73 Watching Call and Put Activity 74 Understanding put-to-call ratios 75 Using the put volume indicator 77 Using Volatility to Measure Fear 78 Measuring volatility 78 Recognizing impact from changing volatility 79 Spelling fear the Wall Street way: V-I-X 79 Applying Breadth and Sentiment Tools 80 Locating neutral areas for indicators 81 Identifying indicator extremes 82 Chapter 6: Targeting Sectors with Technical Analysis . . . . . . . . . . . .85 Getting Technical with Charts 85 Chart basics 86 Adjusting your time horizon for the best view 87 Visualizing supply and demand 87 Identifying Relatively Strong Sectors 89 Relative ratios 90 Rate of change indicator 92 Using Sector Volatility Tools 94 Displaying volatility with indicators 94 Analyzing volatility with Bollinger bands 97 Projecting Prices for Trading 99 Support and resistance 99 Trends 101 Channels 102 Price retracements and extensions 105 Projections and probabilities 107 Chapter 7: Kicking the Wheels of a New Strategy . . . . . . . . . . . . . . .111 Monitoring Option Greek Changes 111 Tracking premium measures 112 Changing volatility and option prices 113 Paper Trading an Approach 114 Trading on paper: pluses and minuses 115 Implementing electronic paper trades 115 xiii Table of Contents 02_241769 ftoc.qxp 2/22/08 3:07 PM Page xiii Using Trading Systems 116 Knowing what you’re getting 116 Performing a backtest 117 Adding risk management to a backtest 121 Shifting from Knowledge to Mastery 122 Setting the right pace 122 Achieving mastery through longevity 124 Chapter 8: Mapping Out Your Plan of Attack . . . . . . . . . . . . . . . . . . . .127 Managing Your Costs 127 Optimizing Order Execution 129 Understanding option orders 130 Entering a new position 134 Executing a quality trade 136 Exiting an existing position 138 Part III: What Every Trader Needs to Know About Options 141 Chapter 9: Getting a Handle on Option Styles . . . . . . . . . . . . . . . . . . .143 Nailing Down Index Options 143 Getting to the nitty-gritty of indexes 143 Capitalizing on an index with options 146 Watching Out for Style Risk 148 American-style options 148 European-style options 149 Exercising Your Options American Style 151 Mechanically speaking 152 What you see is what you get 152 To exercise or not, that is the question 153 Exercising Your Options the Euro Way 154 Tracking index settlement (the “SET”) 154 Cashing in with exercise 155 Satisfying Option Obligations 156 American-style stock options 156 Expiring uninspiring options 158 European-style options 161 Breaking It Down: American-Style Index Options 161 Exercising rights 162 Meeting obligations 162 Trading Options For Dummies xiv 02_241769 ftoc.qxp 2/22/08 3:07 PM Page xiv [...]... for Your Results 327 Don’t Stop Learning 328 Do Love the Game 329 Glossary 331 Index 345 xvii xviii Trading Options For Dummies Introduction W elcome to Trading Options For Dummies This book brings you option strategies for managing risk and navigating a variety of market conditions I truly believe that by taking care of risk first, profits will follow With that... for option buyers and sellers It identifies how you trade these securities on exchanges, along with how your rights and obligations are satisfied As with any security, you must understand the risks and rewards associated with these contracts Part I provides foundational risk and reward information for you 3 4 Trading Options For Dummies Part II: Evaluating Markets, Sectors, and Strategies Trading options. .. foundational risk and reward information for you Chapter 1 Options Trading and Investing In This Chapter ᮣ Developing an appreciation for options ᮣ Using option analysis with any market approach ᮣ Focusing on limiting risk ᮣ Capitalizing on advanced techniques W hether you’re new to trading or an experienced investor, listed stock and index options are great vehicles for managing risk and growing your... Started Chapter 2 Introducing Options In This Chapter ᮣ Recognizing an option contract ᮣ Checking out an option’s value ᮣ Accessing option data ᮣ Gaining some tips on trading options O ptions come in many forms and sizes, but in this book I focus on two specific types of options: listed stock options and listed index options Both of these types of options are traded in the options market They provide... your trading career I use throughout the book, especially in Chapters 4 and 10 through 17 which are strategy oriented Incorporating Options into Your Routine Understanding options and what drives their prices gives you an alternate view of the stock market In addition to sentiment information provided by option trading, the conditions you more thoroughly understand as an options Chapter 1: Options Trading. .. true to the resource goal of this text, a nice glossary is provided that focuses on options to help you find the information you need quickly Icons Used in This Book To supplement the topics discussed in Trading Options For Dummies, I’ve also added different comments aimed at reiterating core ideas and giving you some trading insight I use the following icons to point out these insights: When encountering... 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 Tools and techniques focused on addressing these challenges are also provided throughout 2 Trading Options For Dummies This book allows you to move from topic to topic in any order or serves as a start to finish guide for option trading Use... characteristics associated with these contracts When applying for options trading with your broker, your 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,... option contract specifications, mechanics, and the risks associated with the security That publication, when coupled with Trading Options For Dummies, will give you the tools you need so you can understand your risks and use options effectively About This Book There are a ton of trading titles out there, including those focusing on option strategies This book focuses primarily on approaches aimed at... moment when reading the core content, check for one of these to keep you progressing smoothly Concepts that reiterate ways to manage potential risks appear with this icon It highlights important reminders in case you missed them in the text 5 6 Trading Options For Dummies Where to Go from Here Whether you’re seeking to improve longer term investing or shorter term trading results, strategies geared toward . written as well as show you how Trading Options For Dummies can be the resource you’ve been searching for. Here’s what I’ve assumed about you: 2 Trading Options For Dummies 03_241769 intro.qxp. by George Fontanills Trading Options FOR DUMmIES ‰ 01_241769 ffirs.qxp 2/22/08 3:06 PM Page iii Trading Options For Dummies ® Published by Wiley Publishing, Inc. 111. Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies. com and related trade dress