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Guide to

Options Strategies
TM

Guide to Options
Strategies
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Guide to Options Strategies

Table of Contents

Table of Contents
Introduction: The Options Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
History of Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
How Options Symbols are Assigned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Chapter 1: How Options Work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Basic Requirements to Trade Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Commissions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Basic Option Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Leverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Expiration Date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
In-the-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Out-of-the-Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Exercise. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Why Use Calls? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
The Good and Bad About Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Timing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Chapter 2: Options Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Elements of an Option and the Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Intrinsic Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Time Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Time Decay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Open Interest and Volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Theoretical Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Technical Analysis and Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Guide to Options Strategies

Trading Rules and Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46


Trading Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Chapter 3: Call Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Review What is a Call? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Why Trade Calls? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Fundamental Analysis and Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Technical Analysis and Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Duration of the Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Finding Stocks to Trade with Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Call Option Trading Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Choosing a Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Determining Your Time Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
Applying Reward-to-Risk Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Planning Your Exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Call Strategies and Setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Strategy I Swing Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Strategy II Trend Breakout and Reversal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Available Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Chapter 4: Put Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Review What is a Put ? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Why Trade Puts? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Fundamental Analysis and Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
Technical Analysis and Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
Deciding How Much Time to Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
Finding Stocks to Trade with Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Your Brokers Website . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
Your Watch List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
Seeker Scans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
Put Options Trading Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Choosing a Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Determining Your Time Objective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

Table of Contents

Planning Your Exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100


Put Strategies and Setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Stocks Beginning New Downward Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
Threshold Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Duration of the Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Stocks in Current Downtrends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Confirmation Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
Warning. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
Duration of the Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
Trendless Stocks at the High End of a Trading Range . . . . . . . . . . . . . . . . . . . . . . 112
Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
Chapter 5: Covered Calls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
What is a Covered Call? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
Downside Protection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Stocks to Use with Covered Calls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
Covered Calls Trading Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Direction of the Trend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
Selling Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
Choosing a Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Developing Your Exit Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
About Stop Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Income Strategies and Setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Growth Strategies and Setups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
Chapter 6: Option Strategies with LEAPS . . . . . . . . . . . . . . . . . . . . . . . . . . 139
LEAPS Defined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
Strategies for Using LEAPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Strategy I Using LEAPS as a Stock Alternative . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Strategy II Using LEAPS Options Instead of Short-Term Options . . . . . . . . . . . . 146
Measuring Time Decay. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Leverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
Strategy III LEAPS Puts on Stocks You Own . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

Guide to Options Strategies

Determining Which LEAPS Put to Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153


Important Conditions to Success . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
Using Calendar Spreads for Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Strategy IV Calendar Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
Calendar Spreads to Enhance Growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

The
Options Market

Options can be a terrific place to realize


potential profits from your winning trades
and should be considered in your
long-term trading system.

The purpose of this material is to help you


understand how the options market works
and how you, as an individual investor,
can take advantage of it. Many investors
look at the options market with a sense of
trepidation and fear, and this is unfortunate.
Options can be a terrific place to realize
potential profits from your winning trades
and should be considered in your longterm trading system. The objective of this
material is to help you understand how
you can use options to your benefit and to
familiarize you with how some of the most
powerful option strategies work. Here, we
will cover the following topics:
Option basics We will discuss the
basic principles behind any option
transaction and what they mean to both the
buyer and seller.
3

Guide to Options Strategies

Notes
Option dynamics There are significant differences between
stock trading and option trading that most investors who venture
into this arena arent aware of. Time decay, leverage, and implied
volatility are just a few factors that can dramatically impact the
success or failure of any option trade.
Buying call options We will cover the specific methods you
need to follow as you develop a trading system to take advantage of
the potential profits offered by call options.
Buying put options We will discuss why every trader should
understand how to trade the downside of the market.
Covered calls Generating income is a major objective of many
people that trade options. We will outline the different reasons a
covered call can work in your favor, how to identify stocks that
provide good call opportunities, and the specifics of how to
effectively manage each covered call trade you make.
Long-Term Equity Anticipation Securities (LEAPS) We will
discuss how to use long-term option contracts, or LEAPS, to take
advantage of extended stock trends and minimize risk on short-term
trades. We will also introduce the calendar spread, a powerful, yet
conservative type of spread trade.
It is important to note that this material is built on the assumption that
you already have some experience in stock trading and are familiar
with basic trading concepts, such as fundamental analysis and
technical analysis. Fundamental knowledge is needed to advance
to the options strategies discussed here. Specifically, make sure
you are comfortable with identifying the trend of any stock, drawing
trend lines, and finding support and resistance levels to identify
specific entry and exit points on a trade. You should also be familiar
with the basic types of orders you can place as you trade. And you
need to know when to use a market order or a limit order as well as
how to place a stop loss.

History of Options
Before we dive into what an option is, how a call or put option works,
or any of the specific strategies that apply to options trading, you
will find it interesting, and useful, to understand some of the history
behind options trading and how it has evolved over the years.
4

Chapter 1: The Options Market

Notes
Options have been used for literally hundreds, even thousands
of years. It is a well-known and established fact that the ancient
Greeks and Romans used contracts that were very similar in
concept and application to modern options in shipping. One of
the earliest known cases of options is that of a Greek philosopher
named Thales. Anticipating a plentiful olive harvest, Thales used
options during the off-season when demand for olive presses was
nearly nonexistent to secure rights for use of the presses at a very
low initial cost. When the harvest was in and the presses were
needed, he rented the equipment he had secured with his options
at a premium in relation to his original cost.
The Dutch used options in the 1600s to negotiate prices for tulips.
Initially, tulip dealers used call options to secure tulips at a rate that
would help them meet demand. Meanwhile, tulip growers used
put options to ensure an adequate selling price. Speculators saw
the opportunity to trade tulip call and put options for profit only
and joined the fray; however, when the tulip market crashed, these
speculators refused to meet the obligations they held, sending the
Dutch economy into a tailspin. The British economy saw similar
problems a hundred years later when they began using options.
These horrendous experiences led to a tainted view of options by
many people, and in many cases were even declared illegal.
Options came into existence in America around the same time
as stocks in the early 1800s, but they didnt exist in the ordered,
regulated manner they do today. The terms for each contractalso
called a privilegevaried according to the agreement between
the interested parties. Such variance meant that there wasnt much
of a secondary market, so options werent listed on any exchange.
Instead, buyers and sellers had to find each other, usually through
the newspaper when firms advertised specific call and put
offerings.
Options trading came under intense scrutiny after the Great
Depression. Options were legitimized by the Investment Act of
1934, which put option and stock trading under the careful scrutiny
of a new government agency, the Securities and Exchange
Commission (SEC). However, options trading continued to see
slow growth. By 1968, the volume of options trades was still less
than 300,000 contracts per year.

Guide to Options Strategies

Notes
One of the reasons investors and institutions didnt use options as
regular investment vehicles was because they were still trading
strictly as over-the-counter instruments. In addition, orders were
placed over the phone, and buyers and sellers alike had no notion
of what price they would actually get for their contract; the call-put
dealer simply matched buyers with sellers. Options investments
were very liquid because a dealer was under no obligation to
provide both the buy and sell side of a transaction, so if you had
an option contract you wanted to sell, you had no assurance of
finding a buyer. With no fixed commission percentage attached
to each transaction, the dealer kept the difference between the
buying and selling prices for each contract, with no restriction or
standard on what the spread should be. If you wanted to exercise
an option, it had to be done in person by 3:15 p.m. Eastern time.
If you missed the deadline, the option simply expired worthless
without regard to any intrinsic value it might have.
In the late 1960s, the commodities market was seeing a significant
decline in trading volume, so the Chicago Board of Trade (CBOT)
began looking for ways to diversify their market offerings. Joseph
W. Sullivan, who at the time was the Vice President of Planning
for the CBOT, studied the over-the-counter nature of the options
market and identified two key elements that a successful, robust,
and growing options market would need: a standardization
of terms relevant to options contracts and an intermediary
organization that would facilitate contract issuance and guarantee
contract settlement and performance. His solution to address
these needs was to standardize the strike price, expiration
date, and size of options contracts and to create the Options
Clearinghouse Corporation (OCC).
Under the old system, dealers acted only as intermediaries
between buyers and sellers, but these dealers were under no
obligation to provide a two-sided market. The dealer kept the
difference between the buying and selling prices, but there was
no system in place to prevent the dealer from widening this
spread beyond reasonable levels. The CBOT decided it would
be necessary to create a system where dealers became market
makers, providing for both the buy and sell side of any security
they dealt with. This requirement resulted in multiple market
makers for any given contract, creating a competitive pricing
environment in which buyers and sellers could both receive the
best possible price for their trade.
6

Chapter 1: The Options Market

Notes
In April of 1973, the CBOT put all of their research and planning
into effect by launching the Chicago Board Options Exchange
(CBOE). Initially, the CBOE offered options on only 16 stocks, and
then doubled the number to 32 approximately a year later. By the
end of 1974, daily volume on the CBOE reached an average of
200,000 contracts. Up to this point, the CBOE had been forced to
purchase ad space to list option prices in major publications such
as the Wall Street Journal. This newfound popularity attracted the
attention of newspapers, which began voluntarily listing option
prices.
For the first few years of the CBOEs operation, option trading was
restricted only to call options due to SEC concerns about the risk
of put option trading. In 1977, the SEC allowed the CBOE to list
put options for five stocks only; this narrow perspective has been
expanded since so that all optionable stocks offer both call and
put options. In the years since, volume on the CBOE has continued
to rise, with more than 1.3 billion contracts traded during 2009.
And as of February 2010, the CBOE offered more than 2,300 equity
options, which means many of the stocks you are already used to
looking at offer options as an additional means of investment.
Liquidity, or how quickly you can place a buy or sell order and get
to your money, is a critical issue in any financial market. With so
many publicly traded stocks on the American stock exchanges,
investors can find a huge variance between how frequently a
stock trades. Some large companies, such as Intel or General
Electric may trade several million shares per day. Other stocks,
usually smaller companies, may only trade a few thousand per day
at best. Smart stock traders pay attention to how much volume
a stock has because they know that if the stock only trades a
thousand shares per day and they want to buy in, their order could
shift the price of the stock in dramatic fashion, which probably
wont work in the traders favor.
The advantage options traders have over stock-only traders is
that this doesnt happen with options. Of the approximately 10,000
stocks that are publicly traded, there are just over 2,000 that
offer options trading. This means that just because a company is
publicly traded, you shouldnt assume options are available for it.
In fact, the CBOE typically wont offer options on a stock until it has
demonstrated a significantly active trading history with a high level
7

Guide to Options Strategies

Notes
of investor interest and demand. This is a large part of how the
liquidity of the options market is assured; by only offering options
on stocks that already have a high level of trading activity with high
volume, the CBOE can make sure that there will be a market for the
option contracts it offers. In addition, there are specific guidelines
in place that market makers are required to follow to assure an
organized and prompt order to how buyers are matched with
sellers, how much of a spread between the bid and ask price of a
single contract the market maker can take, and so on.

How Options Symbols Are Assigned


Have you ever looked at an options chain? The symbols for the
contracts any stock offers can look confusing and even convoluted
sometimes. Some symbols are clearly a variation on the symbol for
the underlying stock, while others just seem to have been pulled
at random from a bowl of alphabet soup. In reality, there is a logic
and order to how option symbols are assigned, and being familiar
with how this works can help you know what you are looking at.
The option root symbol consists of three letters and is derived
from the symbol of the underlying stock; however, it usually looks
at least slightly different from the underlying stocks ticker symbol.
This is done simply to maintain a clear delineation between the
stock and its options.
The expiration date symbol is a single letter and has specific
letters assigned to each month of the yearly calendar, as follows:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Calls A B C D E F G H I J K L
Puts M N O P Q R S T U V W X

The strike price symbol is also a single letter and is staggered in


$5 dollar increments; each letter used repeats itself at higher dollar
levels, as follows:
Suppose that you are looking to buy an option on XYZ stock while
the stock was priced at $52. If you wanted to purchase a May 50
call, the symbol for the option could be something like:
XRY EJ
8

Chapter 1: The Options Market

Notes
While a May 50 put could be something along these lines:
XRM QJ
You wont need to actually memorize the letters that correspond
to each month or strike price, since this information is displayed
in the options chain screen of any software or website you use for
price quotes. However, it is useful to understand the framework
that is used for the option contracts you will be looking at.
Now that you know some of the background and terminology of the
options market, youre ready to take the next step. In Chapter 1, we
will discuss some of the basic concepts behind options, and build
your knowledge from there. Lets get started!

Guide to Options Strategies

How
Options Work

The mapping process


is detailed and specific and it reads:
Make Money! And lots of it!
You can build on your knowledge of stock
trading by applying the common principles
of technical analysissupport, resistance,
and trendsto options trading. For many
people, options are an area of the stock
market theyve never heard of. Many others
have heard of options, but have heard more
about all of the money people have lost
trading options, so they are consequently
afraid of them. Still others have traded
options in the past and are familiar with
most of the basic concepts around them,
to one level of success or another.
Although the volume of trading in options
has been growing over the last several
years, the fact remains that options are
a strange, complex financial vehicle to
most people. Most options traders fall into
the category of reasonably experienced
investors who have been trading for many
years. Just because you may be new to
the options market, however, doesnt mean

13

Guide to Options Strategies

Notes
that you cant be successful in trading them. You simply need to
give yourself the proper education and knowledge of the various
techniques and strategies associated with trading options.
Options in general are an aggressive investment and trading
strategy. If you cannot afford to tolerate a high level of risk, you
shouldnt trade options. It is worthwhile to note, however, that if you
can accept a higher level of risk, there are a variety of methods and
strategies you can use to minimize and manage the risk you take.
There are also options strategies that in reality are very conservative.
Options can be an effective way to manage risk in stock trades. In
addition, covered calls give you a way to generate income on stocks
you already own.
In this material, we will outline several different strategies as they
apply to options and the risks associated with each. A common
mistake that many investors who are new to options make is to
attempt to master every strategy they learn. Indeed, there are many
strategies available to you, and you should make sure to spend
enough time on each one to become familiar with them all. However,
you dont have to master them all. As you work to learn each
strategy, you will identify strategies that appeal to your investment
style, tolerance for risk, and attitude more than others. That is
perfectly natural; in fact, the most effective options traders identify
only the strategies that work best for them and then use them again
and again over time.
You may decide that covered calls are the thing to do, while buying
calls and puts might be more risky than you are willing to deal with.
Thats fine! You can trade options and create profit potential with just
one or two strategies if that is all you are comfortable with.
This chapter will cover the following topics:
How to gain broker approval to trade options
The basic components that make up an option
The principles of leverage and risk as they relate
to options contracts

14

Chapter 1: How Options Work

Notes

Basic Requirements to Trade Options


Anybody can trade options, provided a few conditions are met.
First, in order to trade options, your broker needs to give you
permission. Just because you have a brokerage account doesnt
mean that you can trade options right away. In addition to setting
up your brokerage account, you also have to fill out an Options
Authorization application. You can call your broker to have this
mailed to you, visit their local branch office if they have one, or
you can likely download the application from their website. Some
brokerages will also allow you to fill out the application and submit
it online. This application will ask for similar information that you
provided when you established your brokerage account, such as
your investment experience and objectives, but the questions will be
options-specific.
Depending on your answers to those questions, your broker will
assign you a level of options permission. These levels are fairly
standardized as follows:
Level 1 Options trading is limited to writing (selling)
covered calls only
Level 2 Options trading is limited to level 1, along with
buying call or put options
Level 3 Options trading is limited to levels 1 and 2, along
with the use of options spread strategies
Level 4 Options trading is limited to levels 1, 2, and 3,
along with the selling of naked equity options
Level 5 Options trading is limited to levels 1, 2, 3, and 4,
along with the selling of naked index options
Levels one and two are the levels that most traders start with.
If you are only approved for level one, dont worry; you can still
create profit potential as an options investor using covered calls.
If you are approved for at least level two, however, you will be

15

Guide to Options Strategies

Notes
able to utilize every options strategy discussed here. Levels three,
four, and five all include much more sophisticated strategies
that are advantageous to those who can use them, but are best
suited to experienced traders who know how to manage a margin
account effectively. These types of trades are outside the scope
of this book; however, after you have established a familiarity and
confidence in the strategies discussed here, you may want to
examine these advanced strategies in greater detail.

Commissions
We assume that you have been trading stocks now for some time
and are used to the idea of paying a commission on your stock
trades. Commissions apply to options just as well as stocks, but
you will want to make sure to check with your broker, because
options commissions are usually slightly different than those
for stocks. They are typically charged at a rate of around $1.50
per contract, with a minimum commission fee for small contract
numbers. Your broker can give you their exact commission
structure. This commission will play a factor in evaluating your
break even and profit points in your options trades, so make sure
you understand it completely.

Basic Option Terms


An option gives the buyer the right, but not the obligation, to buy or
sell the stock that option is tied to at a specific price for a specific
period of time. It is an instrument that you can use to reserve the
right to buy or sell the stock at the price you want, if the stock
moves in the direction you thought it would in the time frame of the
contract.
Option securities are called contracts. Each contract controls 100
shares. Thus, you immediately have control of 100 shares of the
stock when you buy a single-option contract.
This may sound like a completely foreign concept to you at
first glance. Options and their structure are not readily known
or understood by the general investing public, so dont let any
confusion you may feel right now dissuade you from pushing into
this in more detail. Lets try to simplify the concept and relate it to
16

Chapter 1: How Options Work

Notes
something that may seem more logical. It is usually helpful to think
about the same concept as it applies to a different business. Lets
use real estate:
Suppose you have found a home you would like to buy, but you
dont have the cash to buy the home outright, your credit doesnt
qualify you for a mortgage to buy the home with, and interest rates
are high. So you sit down with the current owner and propose to
lease the property from the current owner for three years, after
which, you will purchase the house for $100,000. If the owner
agrees, you both win. You get to move into the house right away
while the lease contract gives you the time to rebuild your credit to
get a loan for the house. The owner keeps the rights to the house
and the title remains in his name. He will also receive income from
your lease payments, with a lump sum at the end of the contract
when you buy the house. To show him youre serious, you give him
a nonrefundable deposit of $5,000 up front.
As part of the lease contract, you stipulate that at any time during
the contract, you can purchase the house by giving him the lump
sum you have agreed to or sell your lease contract to someone else.
Two years later, you are ready to buy the house. But now the house
is worth $150,000. Now you are really excited to get the deal done
because your lease contract stipulates your purchase price is only
$100,000. Sounds like a great deal, right? Of course it is!
Before you jump on the opportunity to buy the house, think about
the terms of your lease contract. You also have the ability to sell
your lease contract to somebody else if you decide you dont want
to buy the house. Maybe you want to find somewhere else to live.
The house is now worth $150,000, so your lease contract should
also be worth more than the $5,000 deposit you paid to secure the
contract. To figure how much the contract is worth, subtract the
purchase price in the contract ($100,000) from the current value
of the house ($150,000), which gives you $50,000. Subtract the
deposit you paid of $5,000, and you could sell your lease option to
somebody else for a total net profit of $45,000.
You could either make $50,000 by purchasing the house and
selling it at the going market value or $45,000 by selling your lease

17

Guide to Options Strategies

Notes
option. In the first case, you would have to pay $100,000 to make
your $50,000 profit; in the second, your only cost is the $5,000 you
paid when you first entered into the contract.
Options on stocks work in essentially the same manner as our real
estate example. They allow you to make an investment based on
the direction you think the stock is likely to move in with a smaller
amount of money than it would take to buy the stock outright. If
you are right about the move, you can either exercise your option
to buy the stock or sell the option to another investor. Just as the
lease contract in our example increased in value proportionally
more than the house did, options also give investors the
opportunity to realize greater gains than if they bought the stock
outright provided the stock moves in their favor.
This is a powerful concept you should make sure to remember.
Options cost considerably less than would be required to buy the
stock outright. If the stock moves in the direction you want, the
amount of the move in your option will be greater as a percentage
of your initial investment than if you paid for the stock up front. This
is called leverage.
For any given stock move, options move more.
There are two types of options. Well describe them briefly here
and give a more detailed example of each later in this chapter.
Call The right to buy a stock at a set price for a set
period of time
Put The right to sell a stock at a set price for a set
period of time
The question is, when should you use a call and when should you
use a put?
When the market or stock you are interested in is going up, call
options will work for you, while put options give you the opportunity
to take advantage of pullbacks and downtrends. Each of these
types of options will be covered in more depth in Chapters Three
and Four.
18

Chapter 1: How Options Work

Notes
Just as stocks trade on a stock exchange, options trade on an
options exchange. For stocks, you have the New York Stock
Exchange (NYSE), the NYSE Amex, the NASDAQ, and so on.
Options are listed on the Chicago Board of Options Exchange
(CBOE). The CBOE operates on the same schedule as the
stock market.

Leverage
Leverage is the reason most people get excited about options,
but remember that leverage can work against you just as well as
for you. Remember that options decrease in value faster when
the stock moves opposite to the contract just as they increase
in value faster when it moves in favor of the contract. This is why
you should be very careful about taking large positions in any
given option trade. Although you stand to make superior gains
when you are right, you also could experience dramatically more
severe losses when you are wrong. The higher volatility associated
with options means that they dont fit every type of investor. If you
intend to invest in options, you need to understand this concept
thoroughly and make sure your trading system is structured
effectively around it.
Options are aggressive and risky, but that doesnt mean that you
cant create profit potential in them. You have learned how to use
threshold zones to identify possible failure points to get out of
a stock, as well as how stop losses can help you manage that
downside risk. These same principles apply in options. Your stop
loss ranges are generally wider for options than they would be
in stock, but you are still going to be using them. The point with
options is the same as it is for stocks: cut your losses short and let
your profits ride.
Before we go further, there are some very important terms to
understand about options. Lets look at them now.

Strike Price
Every option includes a strike price. This strike price is the price
at which you will buy or sell the stock. Strike prices are usually
listed in $5 increments, although more active options contracts will
sometimes be listed in $2.50 or even $1 increments.
19

Guide to Options Strategies

Notes
The strike price is always listed on any options quote. For example,
if you wanted a quote on a call option for General Electric, you
might see it listed by your broker in a manner similar to this:
GE HZ Aug 32.5 Call Bid 1.05 Ask 1.10
The strike price of this option is $32.50. That means that if you
bought this call, you would reserve the right to buy 100 shares of
GE stock for $32.50.
You will get a similar quote for put options:
GE TZ Aug 32.5 Put Bid .30 Ask .40
This put has the same strike price of $32.50. The difference with
this option is that since it is a put, buying it would give you the right
to sell 100 shares of GE stock for $32.50.

Expiration Date
Every option also includes an expiration date. All stock options
expire the third Friday of the month, each month. That month is
listed in your option quote as well, and can be easily seen from an
options pricing table. In our GE call example, its expiration is in
August, so we will have to make sure to take some type of action
on the option before the third Friday of August. If you take no
action prior to the expiration date, all the money you put into that
option will be lost.

Premium
An options premium is the amount you have to pay to buy it. Just
as with stocks, you will always buy at the ask price and sell at the
bid price. Looking at our GE call option again, we can see how
much we have to pay for it.
GE HZ Aug 32.5 Call Bid 1.05 Ask 1.10.
Our premium for this call is $1.10. Just as when you buy stock, you
have to multiply the ask price by 100 for the total dollar cost of the
trade, in this case $110 minus commissions.

20

Chapter 1: How Options Work

Notes
How about the put we looked at earlier? Remember that you
always buy at the ask, regardless of whether you are buying a call
or put option.
GE TZ Aug 32.5 Put Bid .30 Ask .40
Our premium for this put is $.40, so it would cost you $40 to
purchase one put contract.

In-the-Money
An option becomes in-the-money when the price of the stock
moves past the strike price of the option. If the price of GE went
to $35, for example, our call with a strike price of $32.50 would be
in-the-money since we can now buy GE much cheaper than its
current price.
Puts are a little different. Since you reserve the right to sell the
stock at the strike price, put options become in-the-money when
the stock drops past your strike price. Our GE put would be inthe-money if the price of GE dropped below $32.50 since we
could sell the stock at a higher price than it is at now. Figure 1.1
demonstrates the relationship between a stocks price and in-themoney call and put options.

Figure 1.1
The further the price of a stock moves above a given strike price,
the deeper in-the-money the call option with that strike price will

21

Guide to Options Strategies

Notes
be. By the same token, the further the price of a stock moves
below a given strike price, the deeper in-the-money the put option
with that strike price will be.

Out-of-the Money
An option becomes out-of-the money when the price of the stock
fails to move past the strike price of the option. If the price of GE
were below $32.50, for example, our call with a strike price of
$32.50 would be out-of-the money since the strike price we could
buy the stock at is higher than the current price.
The reverse is true for a put option. If the price of GE were higher
than $32.50, our GE put would be out-of-the money since the price
we could sell the stock is lower than the current price. Figure 1.2
gives an illustration.

Figure 1.2

Exercise
If you have bought an option and the stock has moved in the
direction you anticipated, you may decide to exercise your option.
Exercising your option means that you will buy or sell the stock
at the strike price of the option, depending on whether you have
bought a call or put option.

Call Options
22

A call option gives you the right, but not the obligation, to buy 100
shares of the stock you are interested in at the options strike price.

Chapter 1: How Options Work

Notes
This is a bullish trade.
If you have identified a stock in your analysis that you think is
poised to go up, you can find its options by adding the stock
symbol to your quote sheet, and right clicking on the stock symbol.
A drop-down menu appears. Click on option chain near the
bottom of the menu, as illustrated in Figure 1.3.

Figure 1.3
Your software will then populate the fields in the Options tab with
all of the currently available options. This list is shown in Figure 1.4.
Not all stocks have options; if the stock you are looking at doesnt
have options, you will simply get no results when you move to the
Options tab.

Figure 1.4
The available calls will be on the left side of the option table and
the puts are on the right.

23

Guide to Options Strategies

Notes
Lets look at your General Electric Options again.
GE HF Aug 30 Call Bid 2.90 Ask 3.00
Suppose that your analysis of GE leads you to believe that GE is
likely to increase in value in the near term. In fact, your analysis of
support and resistance zones indicates that it could move up by
several dollars. This would be a terrific reason to buy shares in
GEs stock, right? Of course! It is also a terrific reason to buy a
call option.

Why Use Calls?


Whether you buy the stock or the call option, you are placing the
same bet. The call option, however, gives you a wider range of
choices to make at a lower cost than buying the stock.
Suppose that GE was priced right now at $32. If you wanted to buy
100 shares of this stock, you would pay $3,200, plus commissions.
That is a significant amount of money for most investors. That
doesnt mean its a bad idea, but it does lock you in to a specific
course of action. You have plunked down $3,200 of your hardearned money to buy 100 shares of stock in GE. Your choices at
this point are limited and depend completely on which direction
the stock actually moves, but regardless of which direction the
stock moves in, you have $3,200 at risk.
Now suppose that GE drops in price to $28, a drop of $4 per
share. Your $3,200 purchase is now worth only $2,800; youve lost
$400 and now you have to decide if you are going to stay in the
stock, hoping that it comes back to your purchase price, or sell
and cut your loss short.
If the stock goes up to $36, of course, you are much happier since
now you have a $400 profit in the stock, which is a handsome
return of 12.5%. Now you need to decide whether to take the profit
by selling the stock or try to let the stock continue its upward run
and increase your profits even more.
Now lets use your GE FF Aug 30 call. At the point where GE is $32
and you think it is going to go higher, you could buy this call option
at $3, a total investment of $300 for a single contract (you could buy
more contracts if you wanted to, but we will work off of the idea of a
24

Chapter 1: How Options Work

Notes
single contract for the time being), plus commissions. You still want
the same thing as if you bought 100 shares of the stock, but you
have paid a dramatically lower price for your bullish bet. Rather
than placing $3,200 at risk, you risk only $300.
If GE drops to $28, you arent going to be very happy about the
trade since your option is probably not even worth the commission
you would pay to sell it, but how much have you really lost? $300.
This is a much smaller loss than the $400 you would have lost by
buying 100 shares of the stock. You still have most of your money
in your account and can keep trading.
Of course, if GE suddenly climbs to $36, your options trade will
look much better. Your option gives you the right to buy the stock
at $32, and since it is now at $36, you would immediately be in the
black on your trade if you decided to exercise this option. All you
had to do to give yourself this ability was to pay $3 per share up
front, rather than paying everything up front. Thats not a bad price
to pay to give you this kind of flexibility.
There is another choice, however, that may be even more
attractive. Since the stock has increased in value by $4 per share,
your option will likely have a comparable move in price. Suppose
that the bid price of your option is now $5.15 per share. You could
sell your option back to your broker and pocket $2.15 per share, a
total return of a little more than 120%.

Put Options
What if your analysis of GE led you to believe that the stock was
likely to drop significantly in the near term? Certainly youre not
going to buy the stock, but is that the end of the story? Not if you
buy a put option. Since a put option gives you the right to sell the
stock at the strike price, you want the stock to drop below the
strike price. This is a bearish trade, and a counterintuitive idea for
most investors, because human beings are naturally wired to think
optimistically in most respects. It makes all kinds of sense to make
money when a stock goes up: you buy low and sell high. Most
people trip on the idea of a put option because you actually want
the stock to go down, but in reality, the reason you want the stock
to go down is the same as the reason you want a stock to go up
when you buy it or a call option: you want to buy low and sell high.
25

Guide to Options Strategies

Notes
You will get price quotes for put options in the same table as call
options. The put options are listed on the right hand side of the
Equity Options page. Figure 1.5 shows a list of put options for GE,
shaded in blue:

Figure 1.5
Lets look at your GE put option again:
GERZ June 32.50 Put Bid 1.78 x 1.80
Hoping to make a profit on a downward move in a stock is the
most common reason people buy put options. This is a pretty
aggressive play, however, and if you arent accustomed to reading
negative patterns in a stock, you will want to ease into this kind of
trade gradually.
Lets walk through a trade on this option to establish the concept.
We will cover this in more detail in Chapter Four.
Our asking price for this put option is $1.80 per share, so it costs
you $1.80 total for a single put contract. Lets suppose that GE is at
$32 when you buy the option.

26

If the stock starts to climb, your put contract is going to be worth


less than what you paid for it, but since you only paid $180, you

Chapter 1: How Options Work

Notes
arent putting a major amount of money at risk. But if the stock
drops the way you forecast, your put option will increase in value.
Lets suppose GE falls to $28 per share, a drop of $4, or 12%. You
could exercise your right under the put contract to sell the stock
at $35. Since you dont own the stock, you make the sale possible
by simply first buying the stock at $28, and then selling the stock,
giving you a tidy profit of $7 per share right away, minus the $235
you paid to buy the contract.
Remember that exercising the option isnt the only choice you
have. Now your option, which only cost $1.80 per share, will be
worth considerably more. In this case, lets suppose the value has
increased to $8.50 per share, giving you a net profit, not counting
commissions of $6.70 per share, of $670.
Put options have the same element of leverage as call options,
making them an attractive way to play the downside of a stock or
the market and realize significant profits if you are right about a
breakdown in price. Again, remember that this is an aggressive
way to trade options; it has the potential to be a major drain
on your capital if you arent very familiar and comfortable with
identifying and trading negative trends.

The Good and the Bad about Leverage


In both of the examples from the previous section, we saw
significantly more price percentage movement from the option
contracts than we did from the stocks themselves. This phenomenon
is the primary reason investors trade options; they move faster,
percentage wise, than stocks. In other words, if you are right about
which way a stock is going to move, you will be able to make larger
profits as a percentage of your investment in a shorter amount of
time than you would by buying or selling the stock.
It is exciting to think about buying an option to control 100 shares
of stock for only a few hundred dollars rather than the thousands
of dollars it usually takes to buy or sell the stock itself. Many
beginning investors draw the natural conclusion from this that
they can use their investment capital to control more shares and
make even more money. If you bought the call option on GE we
used earlier, for example, buying three contracts would increase
your total profits from $310 to possibly $930. This is a correct
assumption, but it comes with a critical downside element that
must be recognized.

27

Guide to Options Strategies

Notes
As we mentioned earlier, leverage cuts both ways. Just as an
option will increase in value more quickly than the stock, it will
also drop faster if the stock doesnt move the way you wanted.
What if you bought the June 32.5 Put option on GE we discussed
earlier, and instead of dropping, GE increased in value to $35?
Will anybody be willing to pay you anything close to the $1.80 per
share you paid for that option? Not at all. In fact, in an example
such as this, that option will only be worth a small fraction of what
you paid for it originally.
Many investors, new to options, lose significant portions of their
investment capital because they dont correctly understand how
leverage can affect them, and they place too much money in
their first-options trades. Even if your first few options trades are
successful and you see significant profits from them, dont get
caught in the trap of thinking, If I had bought more contracts, I
would have made more money. Beginning traders who put large
portions of their capital into options trades will generally reduce
the value of their trading account significantly, even if they start
out with profitable trades. This is because they dont account for
the downside of leverage and fail to plan adequately to deal with
an option trade that has gone against them. They were so excited
when they made money; options trading seemed easy. Then when
a trade went against them, they stayed in it thinking they needed to
make the same kind of profit.
Frame the successful, profitable trades in the context of the money
you put into that trade to avoid trying to hit a home run every
time. Frame the losing trades in the same context so you can
identify the points in price when you need to get out of the trade
without being emotionally tied to it. Dont think, I only have a
couple hundred dollars in this trade. Its only a little bit of my total
capital. If I lose it, thats okay. The reason to avoid this mindset
is that if you start thinking in these terms, your winning trades
wont make up for your losing ones, and you will gradually deplete
your account. It is much more effective to think about a loss in
the context of the money you have in the trade: I put $200 in this
trade, and now Im down $80, or 40%. I should get out now so I
can use that $120 in a better trade.
Think of options trading as a gradual process. Not only are there
a lot of different strategies you can use, but there are also a lot
of dynamics you have to understand before you can correctly
28

Chapter 1: How Options Work

Notes
interpret how much risk you are taking. Understanding those
dynamics takes time and experience. Start your options trading
small; buy one or two contracts at a time at the most. As you build
experience, familiarity, and confidence, you can begin to use
larger allocations as you deem appropriate.

Timing
The leveraged aspect of options is part of what makes the
timing of an option so critical to the success or failure of your
trades. Remember, options have a finite life; in other words, they
disappear after their expiration date. If you bought an August
option and the stock didnt move the way you wanted before the
third Friday of the month, any money you had left in the option
would disappear as of the third Saturday. Because of this, your
success will depend more on your ability to be right on time than
on simply being right about the direction of a stock.
Lets think about this idea for a minute. You already have had some
experience in performing technical analysis, identifying reversal
points in a stock pattern, and determining support and resistance
thresholds before delving into options trading. This should mean
that you can often identify which direction a stock is likely to move
in the future. This is a critical skill for successful stock trading and
for options trading, but the time sensitive nature of options gives
you a much smaller window of opportunity. Maybe your analysis
leads you to conclude a stock is bouncing off of a support level
and should begin a new rally. Your analysis leads you to buy a
call option that is two months away from expiration. After a month,
however, the stock still hasnt rallied. In fact, suppose it has begun
to drift sideways as stocks sometimes do. Even though the price of
the stock may not have changed, your option is going to be worth
less because now you only have a month left before it expires.
Suppose that a week after the option expires, the stock does in
fact rally as you had originally predicted. Unfortunately, it doesnt
help you because your option has expired. You were right about
which way the stock would move, but you werent right about
when it would happen. As you gain experience and familiarity with
options, you will find that the timing of your trade, and how much
time you buy, will sometimes do more to dictate success or failure
than any other single factor. That doesnt change the fact that
you have to perform your normal analysis; it just underscores the
importance of learning how to handle the timing of a trade.

29

Guide to Options Strategies

Notes

Summary
Options are a powerful way to achieve aggressive growth in your
investments and to diversify your portfolio. However, options do
represent a higher level of risk depending on how they are used,
so it is still critical to make sure that you understand the dynamics
of options and the risks involved.
Options require smaller capital investments than are needed to buy
stocks. This leads many people to try to hit home runs on their
options trades; in other words, they often try to achieve maximum
results on every trade they make. This is a dangerous mindset and
should be avoided in your trades. Effective management of your
trades means cutting your losses on bad trades and maximizing
your profits on good ones. This can be a difficult skill to master,
but successful implementation of a trading system in options will
greatly impact your long-term investment results.
Timing is critical in options trades. Options expire on the third Friday
of each month, so it is critical to know when to take profit and when
to cut a loss. Holding an option contract through its expiration date
means losing all of the money you spent buying the contract.

30

Options Greeks

Cut your losses short


and let your profits ride.

Now that you have an understanding of


some of the basic components of options,
we will examine some critical elements that
impact how much an option will move, how
those moves can be measured, and how
options pricing is based on some of that
information. We will also discuss
how that information can be included to
develop a trading system specific to your
options trades.
As you know, it is critical to develop a
trading system that you can apply to
each stock trade you make, and that
can respond and adjust to the changes
that take place in the stock market. The
same holds true for options trading. Just
as you established trading rules for your
stock trades, you should take the time to
establish trading rules for your options
trades. Some of these rules will be similar
to the rules you set for your stock trades,
perhaps even exactly the same. There

33

Guide to Options Strategies

Notes
will be other issues that your rules will need to address in options
trading, which we will discuss in this section.
By now you have heard the maxim cut your losses short and let
your profits ride many times. This is because the principle this
statement emphasizes applies to every kind of trade you make,
regardless of whether you are trading stock or options. Your trading
system and trading rules must reflect your determination to do this
consistently. If they dont, your success rates in options trading will
be extremely haphazard and will ultimately take away significant
amounts of your trading capital.

Elements of an Option and the Greeks


There are various elements of options pricing and valuation that are
measured and tracked by investors, market makers, and institutions
alike. These elements are designed to reflect the volatile nature of
options and to underscore both their upside and downside risk.
Understanding these dynamics and how they are used will help
you identify the contracts in an options chain that give you the best
combination of reward and risk and increase the probability of
achieving success.

Intrinsic Value
Intrinsic value refers to the dollar amount the stock price has moved
beyond the strike price of a given options contract. For a call option,
intrinsic value is calculated by subtracting the current stock price
from the strike price of the option. For a put option, subtract the
strike price of the option from the current price of the stock. If your
result is a negative number, the intrinsic value is zero.
Intrinsic value is like equity in a home. If you bought a home for
$150,000 and it is now worth $200,000, you have $50,000 of equity,
or intrinsic value in the home. Intrinsic value is the difference
between the current value of an asset and its purchase price.
Intrinsic value is a quick way to determine whether a contract is in-themoney or out-of-the money. Simply put, an in-the-money option always
has intrinsic value, while an out-of-the-money option never has intrinsic
value. The moment an out-of-the-money option has intrinsic value, it is
in-the-money.
34

Chapter 2: Options Greeks

Notes
As you evaluate the different options contracts available for any given
stock, whether or not the stock has intrinsic value can tell you a lot
about the prospects for that contract. If an option has no intrinsic value,
the entire value of the option is tied to the term of the contract. If the
stock doesnt move past the strike price of the option before expiration,
it will never have any real value and will simply expire worthless. This
is why out-of-the-money options are so risky; when you buy out of the
money, you are betting that the stock is going to reach your strike price
and continue past it. If it doesnt, you will quickly lose most, if not all, of
the money you put into the trade.
The intrinsic value of inthe-money options provides a conservative
means to buy option contracts. Although the stock price can still
move quickly and change from being an in-the-money option to
an outof-the-money option in a short period of time, the intrinsic
value of the option provides a cushion, or buffer, that can help you
manage downside risk. If the stock moves against the direction of
your contract, the intrinsic value you bought at the beginning will
likely leave a larger portion of your money in the trade, so if you
need to get out, you have more money to walk away with.

Time Value
We alluded to time value in Chapter One. Every options contract
has a finite life. Options expire on the third Friday of the month they
specify. Options contracts can have durations of one month to a
couple of years in many cases; this duration translates into a realdollar value called time value.
Time value is calculated by simply subtracting the intrinsic value (if
there is any) from the price of the contract you are looking at. The number
that is left is how much time value that contract has. If a contract has no
intrinsic value, then the entire price of the option is time value.
You can also think about time value as possibility value; it is an
expression of the likelihood the stock will move in the direction
you want in the time the contract has. Lets put it into literal terms:
Suppose that in August, you bought a September call on IBM. In
addition to that, you decide to buy a December call on IBM with
the same strike price as the September call.

35

Guide to Options Strategies

Notes
Under which time frame does IBM have the greater likelihood of
going upone month or four? Since stocks tend to go up over
time, the December contract has better odds of increasing in value
than the September contract. Therefore, December calls will have
greater time value reflected in their price than September.
Lets look at an example.

Figure 2.1
Lets use the $20 strike price. The last trade for INTC was at
$20.85, giving us a total of $.85 in intrinsic value for any of the
call options with a $20 strike price. Look at the April 20.00 calls
(Figure 2.1). Its ask price is listed at $1.22. If we subtract the $.85
in intrinsic value from $1.22, we see that this contract has $.37 of
time value.

36

Figure 2.1a

Chapter 2: Options Greeks

Notes
How about May (Figure 2.1a)? The October 20 call has an ask
price of $1.48, which means that its time value is $.63. We have to
pay a higher price to add a month of time to our contract, but we
get almost twice as much time value.
The principle to remember about time value is that the closer to the
expiration date you are, the smaller the time value will be. If you
were to buy the April call, you would only have $.37 of time value
to work with. If the stock doesnt move up for you right away, you
will probably have a hard time making money in this trade because
you are going to have to do something before the option expires.
You have the intrinsic value acting as a buffer, which means you
probably wont take a huge loss, but the small time value equates
to a very small window of opportunity.
On the other hand, if you bought the May call, you would have $.63
of time value to work with on top of the $.85 in intrinsic value. This
gives you a larger window of opportunity to work with. If the stock
doesnt move in the next few weeks, the time value will be less, but
probably not to the point that it will hurt your trade. When you buy
options with longer expiration dates, you can usually afford to let
the stock run for a longer period of time.

Time Decay
Time value and time decay both are borne out of the fact that
options have a finite life. Time decay refers to the decline of an
options time value as it gets closer to its expiration date.
Time decay occurs in every option contract, regardless of whether
the option is in the money or out-of-the-money. The truth is that time
decay is less visible with in-the-money options because as they
become deeper in the money, they are more profitable. Remember,
though, that time decay is still there.
Time decay affects out-of-the-money options far more dramatically
than it does in-the-money options. Remember, if an option is outof-the money, it has no intrinsic value. In that case, the entire cost
of the option is tied to time value. As the contract gets closer to the
expiration date, time decay will accelerate, eating away at the time
value on an increasing basis every day until there is nothing left.

37

Guide to Options Strategies

Notes
An effective analogy when thinking about the concept of time
decay is an ice cube. If you hold an ice cube in your hand, the
heat from your hand and the air around it will cause the ice cube
to begin to melt and shrink in size. As it becomes smaller, the
heat being generated on the cube is working on less mass, which
forces the cube to melt even faster until eventually all youre left
with is water. This is precisely what happens to options as they
get closer to expiration and also why the option simply disappears
after the expiration date. If you bought an October call right now
and the stock didnt move for the next three weeks, the option
wouldnt be worth as much as you paid for it because of the
loss of three weeks of time value. By the same token, if the stock
continued to hover in the same range through October, time decay
would continue to erode the overall value of the option until after
the third Friday of October when there is no time value and the
option ceases to exist.
As you gain experience in your options trading, you will find that
keeping track of time value and monitoring the effect of time decay
will be a critical part of your risk management strategy. It will often
do more to differentiate between profitable and losing trades than
guessing correctly which way the stock is going to move.

Open Interest and Volume


Open interest refers to the net amount of outstanding open
positions on a given option contract. This number is displayed in
any options chain for each contract listed. This is an important
number; it gives traders a sense for how much interest there is in
a given option. As a minimum, you may want to look for at least 50
contracts in open interest for any options trade you consider. If the
contract you are looking at has less than 50 contracts available,
there may not be enough interest to maintain liquidity in the option,
which you will need to have when its time to get out.
The daily activity in that option is reflected by its volume. Just as
volume on a stock tells you how many shares were traded in a
given day, volume describes how many contracts have changed
hands on any given option during that day. You will rarely see
a correlation between open interest and volume; in terms of
measuring liquidity in a contract, open interest is a better indication
than volume.
38

Chapter 2: Options Greeks

Notes
This may sound counterintuitive, but the reasoning behind this
statement lies in the way options trades are processed. When
you place an options trade with your broker, that order is sent to a
market maker. The market makers role is to maintain and update
a list of buyers and sellers for any option contract throughout the
day, and find matches for each. If your option order specifies that
you want to buy 10 call contracts, the market maker will try to find
an order to sell 10 contracts to match you with. The market makers
job is to maintain liquidity for the options contracts he deals
with, and so in addition to matching buyers and sellers, he will
frequently assume some of those contracts as well. Market makers
make money by taking the difference between the bid and ask
prices of the contracts they deal with, which is why they are willing
to take on the occasional contract to maintain liquidity. This is
different than stock trading, where market makers primarily match
buyers and sellers, but rarely take any positions themselves.
The role the market maker fills makes the options market one of
the most liquid of all of the various financial marketseven more
so than the stock market! This is why, despite the fact that volume
describes how many contracts have been traded during the day,
it is more important to pay attention to open interest. If there is
adequate open interest, the market maker will be able to match
your order to buy or sell with another trader on the opposite side of
the coin quickly.

Volatility
If you have not already done so, be sure to learn how to evaluate the
volatility of a stock to determine whether a stock meets or exceeds
your risk tolerance. Options traders use measurements based on
volatility to identify contracts that are overvalued or undervalued.
It is important to remember that an overvalued options contract
isnt automatically bad and an undervalued options contract isnt
automatically good. Even fairly priced options arent always the
most desirable options to use. Depending on your approach and
what your objective is for a given options trade, any of these types
of options could work for you.
Implied volatility (IV) represents the expected volatility of a stock
over the life of the option. As expectations change, option premiums
reflect this change. Supply and demand of the underlying option
also influence the markets expectation of the direction of the price
of the underlying stock.

39

Guide to Options Strategies

Notes
IV is also used as a surrogate value of the option itself. More simply
put, if the implied volatility is above the midpoint of a volatility graph,
it is said to be overpriced. If IV is below the midpoint of a volatility
graph, it is said to be underpriced. Because there is no standard
value of implied volatility, both historical volatility and implied
volatility must be charted. The 90-day IV is a very valuable indicator
regarding the expected change in the price of the stock or option.
In Figure 2.2, implied volatility is the column highlighted in red.

Figure 2.2
However, it is of little worth unless it is applied to a volatility chart.
In Figure 2.2, the 90 IV is 42.25. On first glance, it would seem that
this is below the 50th percentile and therefore just underpriced.
When this is charted on a volatility chart the initial perception of
being underpriced is radically changed.

Figure 2.2a

40

Chapter 2: Options Greeks

Notes
In Figure 2.2a, we see that both the HV and the IV are at the
top of the volatility chart signifying that both of these values are
overpriced. Still, volatility, like all technical indicators is subjective,
meaning it is not absolute. The price of Google could continue to
go up, remain overpriced and people betting against it could lose.
Like all technical indicators, volatility should be used in conjunction
with other indicators and information.
The general rule of thumb states that stocks with high-implied
volatility numbers will have inflated option prices. This is a logical
conclusion, since options traders look for stocks that can make
significant price swings in short periods of time so as to maximize
their opportunity.
Experienced options traders will often use implied volatility values
as a way to identify potential reversal opportunities. An option with
high-implied volatility is overvalued and may well be at the top of
its increase; for option sellers, this could provide an opportunity to
generate significant income. By the same token, an option with low
implied volatility would be considered undervalued, which could
be an indication of an early opportunity. Dont rely on volatility
measurements alone as buying and selling indicators; the same
rules for buying and selling signals apply to options as to trading
stocks. Make sure that technical analysis of the underlying stock
confirms the opportunity you are looking at.

Delta
Delta is a percentage that describes how much the option will
change in value as its underlying stock price changes. Delta is not
constant. As the value of a stock price changes the value of delta
will change as well. The further out-of-the-money an option strike
price is, the lower the delta. Deep in-the-money strike prices have
a progressively higher delta.

41

Guide to Options Strategies

Notes

Figure 2.3
Delta is also described as the ratio comparing the change of the
price of a stock to the corresponding change in the price of the
option. It does not have values higher than 1.0
Lets use an example from Figure 2.3. The May 145 call option for
Apple (AAPL) has a delta value of $.58. If AAPL moves up or down
by one dollar in the near term, this option will likely experience a
$.58 move. This may not sound like much at first, but be careful to
take this information in its proper context. We are looking at a call
option, so lets suppose that AAPL goes up by $5, from $147.56 to
$152.56. This would equate to roughly a 3% return if you owned
the stock which isnt bad for a short-term trade. Remember that the
price of the May 145 call for AAPL is $11.25. With a delta of .58,
the price of the May 145 call would go up $5 x .58 = 2.90.* Seeing
this option suddenly increase in value to $14.15 on a $5 stock
move would certainly give you a greater return on investment than
if you bought the stock outright. The option returns 25%.
*Note: As the stock moves up, the delta on the options increases
as well. Therefore, the $.58 would not be the actual amount the
option increased. All other factors being equal, the delta would
have a sliding value. The actual rate of return on a $5 stock move
would be somewhere around $3.50.

42

Be careful about getting too excited about the information you get
from the delta. Many investors see the upside of leverage but fail
to consider the downside. Leverage cuts both ways: Just as delta
describes how much the May 145 call option would likely increase
if the stock goes up, it also describes how much this contract would

Chapter 2: Options Greeks

Notes
likely decrease if the stock goes down in the short term. If AAPL
dropped from $147.56 to $142.56, your option would also drop, to
around $8.35, an unrealized loss of more than 25%. This is a critical
part of the leveraged nature of options to remember: You can make
greater profits faster than is possible in ordinary stock trades, but
you can also experience dramatic, steeper losses. You have very
high-upside potential, but also increased-downside risk. This is why
we emphasize using options as just one component of an overall
investing strategy. It can be an effective means of diversification
and supplementing the growth side of that strategy, but using too
much of your investment capital in options will usually increase your
risk profile beyond reasonable levels. Anytime you look at making
an options trade, make sure you check the delta so you can gauge
both sides of the equation.
Also remember that delta is not a hard-and-fast number; it can and
usually does change daily. One of the biggest factors that impacts
the delta is whether a given options contract is in-the-money or
out-of-the-money. As an option goes deeper in-the-money, the delta
will increase as the premium (the ask price) increases. As an
option goes further out-of-the-money, the delta will decrease as
the premium decreases. So while the delta can help you evaluate
reward and risk, make sure you dont depend on delta too much.
It can give you a sense of potential upside or downside, but those
numbers arent fixed or guaranteed.
You can also use delta to sort through the various options that are
available based on potential reward for the amount of capital required.
Generally, there are three rules to follow which will increase the
probability of a winning trade. They are (1) buy an option one strike
price in-the-money; (2) buy more than one months period of time
and; (3) dont exercise the option. Buy the option to sell the option.
Options are a personal thing; however, each investor or trader
should pursue them with regard to their own comfort level. There
are no absolute rules. Many investors try to find the option contract
in a chain with a delta closest to $1, and if that is your preference,
thats fine. When it comes to sorting through an options chain,
use delta to evaluate potential reward versus cost and to begin to
assess overall risk. If you want to be aggressive, options that are
closer to at-the-money have lower deltas and greater total upside
potential that will probably suit you better, while if you prefer a
more conservative approach, you should look at deeper in-themoney options with a higher delta.

43

Guide to Options Strategies

Notes

Theoretical Value
As with the stock market or any other market in a supply-anddemand economy, options prices can be impacted not only by
buying and selling, but also how much demand for a given contract
there is. In other words, options prices can inflate or deflate
depending on how much interest there is in a contract. Lets use an
example we all deal with on a daily basis to illustrate: gas prices.
Gas prices fluctuate widely depending on a wide variety of factors.
One of the more interesting factors that can impact how much you
pay at the pump is where you fill your car. If you use a station on
a busy thoroughfare, it isnt unusual to pay five to ten cents more
per gallon than at stations on less busy roads. You also usually
pay higher prices for gas in large metropolitan areas than in rural
communities, again by around five to ten cents per gallon. In other
words, where interest (or demand) is high, gas prices are more
inflated than in other areas.
The options market works in a very similar manner. Where interest
in a specific option contract is high, the price of that option will
usually be inflated to higher levels than for contracts that arent
receiving much attention. Many professional traders use this
dynamic to gain an edge in their tradesthey will look to buy
options with deflated prices and sell those with inflated prices.
Theoretical value, also called t-val, gives options traders like you
the ability to look for the same kinds of opportunities.
On any table showing theoretical value, this value can be
compared with the actual buy-sell price of the option. If the option
price is less than the t-Val, the option is under priced. In such
cases, if the stock is trending upward, you may wish to buy a call.
If the stock is trending downward, a put may be a wise choice
Be careful about relying on t-val exclusively to identify good
opportunities; make sure you combine evaluation of t-val with
solid technical analysis of the short-term prospects for the stock.
Remember that if your technical analysis doesnt lead you to
believe the stock is going to move the way you want, it doesnt
matter what the t-val tells you.

44

Chapter 2: Options Greeks

Notes
Overvalued options are another dilemma that can be viewed from
different perspectives. The implication of an option contract with
a t-val that is less than the current trading price of the option is
that the option is overvalued; therefore, you would be paying a
higher than fair price for the option. Many traders stay away from
overvalued options on the assumption that the opportunity for
profit in the trade may be limitedit has already extended itself far
above its fair value. This is often true, but can also be viewed in
exactly the opposite light.
Think for a moment about a stock that is riding along a strong
upward trend and setting new high prices every couple of weeks.
Although these kinds of stocks will certainly run out of steam
at some point and begin to go down, these stocks often simply
continue their impressive upward run. This is because in order
for a stock to make a new high, it has to overcome a previous
high. The market often reads this action as a bullish indicator and
continues to push the stock even higher. Although call options for
this kind of stock will likely be significantly overvalued, there is
often still ample opportunity for significant profits in these types of
trades. This is just one more reason why you should use technical
analysis as the overriding indicator in your decision making about
whether or not to place a trade. The t-val is helpful in knowing
that the call option is overvalued because it essentially provides
confirmation that interest in the call option is high and market
sentiment may still be bullish.
The price movement, or volatility, of a stock has a dramatic
effect on an options price relative to its t-val. If you see highimplied volatility figures for an option contract, the trading price
of the option will usually also be significantly inflated above the
t-val. Stocks with high-historical volatility also tend to see more
inflated options premiums because volatile stocks generally give
aggressive traders more opportunities to make significant profits in
a short period of time than less-volatile, more conservative stocks.

Technical Analysis and Options


You have already become familiar with performing technical
analysis and identifying buying or selling opportunities in your
stock trading. One of the aspects of the stock market that makes

45

Guide to Options Strategies

Notes
options trading so attractive is the fact that the analysis skills you
have already learned have direct application to options. A breakout
above a support threshold on strong volume may be an indication
to buy a stock; the same signal could be used to buy a call option
on that stock since the call option requires the same movement to
be profitable. A breakout below support is usually a sign to sell a
stock if you havent done it already; the same indication could be
used to buy a put option since put options are profitable trades
when a stock is dropping.
In addition, remember that options trading is by and large a very
short-term strategy. If you are used to getting in and out of a
stock within days or even weeks, this mindset will lend naturally to
options trading. If you have previously held onto stock trades for a
month to a year, you will probably find that your options trading will
be much more active, which will require a mindset adjustment.
Although there are many similarities, there are a few differences
in options trading to be cognizant of. For example, there is
specific additional information you should check for to confirm
your signals with options. We will discuss this further in Chapters
Three and Four.

Trading Rules and Trading Systems


Many of the trading rules you have established for trading stocks
will apply in equal manner and importance to options trading.
One thing you should be absolutely certain to do if you havent
already is to make sure your rules include requirements for
planning your exit. Successful traders will plan their exit before
getting into a trade regardless of whether they are dealing with a
stock trade or options trade, but it is even more important to plan
this process out prior to an options trade.

46

The reason planning your exit is so critical to success in options


trading is due to the time-sensitive nature of options contracts.
When it comes to stocks, there is no expiration date to deal with,
so it is entirely possible that when you reach a point in a stock
trade that your rules dictate you should get out, you may decide
that the current strength in the trend would justify staying in the
trade longer. If your technical analysis supports such a decision,
this would be perfectly reasonable. But in options trading, this kind
of adjustment on the fly approach can have catastrophic results.

Chapter 2: Options Greeks

Notes
Suppose you have purchased a call options contract due to expire
on the third Friday of October. True to your analysis, the stock has
moved up nicely and you have built a tidy profit into your options
trade. By the end of September, the stock has reached a point
where you would normally say, Good enough, lets move on. But
as you look at the strength of the upward trend, you think, This
is going to keep moving upI dont want to sell yet. You would
be better off to go ahead and take your profit and buy a longer
option contract in the same stock if you think the upward trend is
going to last than trying to stay in the trade until the very last day.
Remember, if you havent taken action on your options contract
before the expiration date, all of your money in the trade will
disappear, regardless of profitability.
Make sure before you enter an options trade that you have
considered all of the current support and resistance levels and the
strength of the current trend. You should identify specifically when
you are going to get out of the trade on both sides of profitability.
In other words, know what you will do to cut your loss short if the
stock moves against your options trade, and make certain you
know at what level you will get out of a profitable trade.
Some options traders will identify a specific dollar or percentage
amount they want to make before they get out of a trade. The
reason they often do this is because options move so quickly.
When your analysis is correct, you will very quickly reach a highly
profitable level in your tradefar more so than in the stock alone.
This is a dangerous trap to fall into because it establishes an
expectation level the stock may not be able to meet.
Suppose you say to yourself, I will get out of the trade when I
double my money! The stock moves the way you want, and you
are quickly looking at a profit of 50%. This is already a handsome
trade, and you see that the stock is approaching resistance. But
since you are looking to double your money, you stay in the trade.
The stock hits resistance and drops quickly back to the levels it
was at when you first bought your options contract. Now you are
lucky to get out of the trade with as much money as you put into it
or with a small loss.
This example is illustrative of the kinds of issues traders run
into. We all love the high profit trades when we get them, but
expecting that level of performance trade after trade will often
47

Guide to Options Strategies

Notes
turn a profitable trade into a losing one very quickly. Clearly, in
our example you would have been better off seeing resistance for
what it was and selling the options contract back to the market,
happy with your 50% profit. This is the reason you dont set profit
expectations in your trade; instead, when you get into an options
trade, make sure that there is enough room between where the
stock currently sits and support or resistance to make the potential
reward worth the risk and establish your exit points at those
support or resistance levels.
Another critical part of planning your exit strategy at the beginning
of the trade is to use stop losses consistently. You should be
familiar with the process of evaluating stop loss prices in a
stock trade. In stock trades you will often use current support or
resistance levels as your stop loss prices. You can generally use
the same principle for options contracts, but remember that, as
a percentage of your investment, your stop loss on an options
contract will represent a wider gap than it would for a stock trade.
The leveraged nature of options contracts makes their price
swings more severe on a day-to-day or even intraday basis. To
simplify the issue, a good rule of thumb in options trades is to use
50% as a baseline for your stop loss. If your analysis of support or
resistance seems to indicate you could bring it in closer, fine, but
you will find that most options contracts will fluctuate by 30 to 40%
easily within a given day or period of time. You dont want to put
your stop loss so close to the current price of the contract that you
will get stopped out because of normal fluctuations.

Trading Systems
The consistent use of a disciplined trading system is one of the
most critical keys to long-term success in the stock market. This
is true both for straight stock trading as well as options trading. A
trading system is a complex set of rules, conditions, and criteria
that have to be met in order to place a trade; it also dictates what
actions will be taken in the event of positive or negative moves in
price. As much as possible, a successful trading system will also
factor in the effect of surprise announcements that can sometimes
take place.

48

Chapter 2: Options Greeks

Notes
Remember that a trading system doesnt guarantee that you will
win on every trade you make. There is no silver bullet for the
stock market. This is why you have to consider your trading system
in the context of long-term results. Your trading system should be
built to increase your odds of success, help you minimize loss
when you do have a losing trade, and to maximize profits when
you are right.
You have experience with building a trading system as it relates
to stock trading. When you first started building that system, you
likely spent a fair amount of time paper trading before you started
trading with your real investment dollars. This was so you could
begin to build experience and confidence in your trading abilities
and the techniques you were learning. Although many of the same
principles and techniques you already know will apply to options
trading, there are dynamics and aspects of options trading that
you will find to be very different from stock trades. For this reason,
you should take the same approach to developing your options
trading system. Paper trade first, and then begin going into real
money options trades with small dollar amounts until you have built
some confidence, experience, and history behind you.

Summary
Understanding the various elements of an option and the way
that Greeks try to measure these elements will help you identify
both the potential opportunity and the risk of any option trade.
Remember, when you trade options you are assuming the risk that
is inherent to the underlying stock as well as the risk associated
with the contract you choose to trade. Make sure that you take the
time to analyze and properly evaluate both types of risk in every
option trade you make. If you dont, you may be surprised when
the options price movement doesnt track exactly as you thought
it might, and you wont be as prepared to deal with unusual
circumstances when they arise.

49

Guide to Options Strategies

Call Options

Simply put, a call option is a bet that the stock


underlying the option will go up in value over a
given period of time..
Many traders who are new to options try
to oversimplify options trading by thinking,
If I think the stock is going to go up, I
buy a call. If I think it will go down, I buy
a put. Lets go; Im ready to get rich!
This is a common and often fatal mistake
that beginning traders make. Just as it is
necessary to establish a trading plan and
trading rules before you ever place a trade
in the stock market, you need to begin
establishing a trading plan that is specific
to options trading.
In order to be successful, you must first
understand all of the various factors
that can affect your options trading.
Understanding how options are issued,
when they expire, what price each contract
is associated with, and how to measure
the leverage, time decay, and potential
reward or risk are critical elements you
must understand before you begin trading
options. For example, time decay in options

53

Guide to Options Strategies

Notes
will often make a trader, who is correct about the direction a stock is
going to move, actually lose money because he or she didnt predict
correctly when it would happen. If you dont account for this risk up
front, you are far more likely to make a mistake and not purchase
enough time. More than just a few options traders have depleted
their trading accounts because they failed to account for time
decay.
This is the reason Chapters One and Two are presented before
any information about specific strategies has been outlined in this
manual. In this chapter, we will discuss using call options to take
advantage of short-term, upward moves in the stock market.
We will discuss the fundamental, technical, and logistical aspects of
trading calls, as well as the tools, such as Seeker, you can use to
find good options opportunities.

ReviewWhat Is a Call?
Simply put, a call option is a bet that the stock underlying the option
will go up in value over a given period of time. To be more specific,
when you purchase a call option, you pay for the right to buy the
stock at a specific price but at a later date. For example, you buy an
option that expires three months from now. Assume the current month
is April. You are looking at IBM. The current price of IBM is $100 a
share. You have reason to believe that IBM is going up in price to
$110. You do not know when exactly, but you reasonably expect it to
do so before the June option expires. You purchase an option to buy
IBM at $100. You buy an option that expires in June. It is called the
June 100 call option. Hypothetically, the June 100 call option costs
$10.00 a contract share or $1,000. Now 10 days have gone by, and
IBM is at $110. Congratulations! Your research on IBM was correct
and it happened sooner, not later. Do not feel bad that you expected
it to happen in three months instead of 10 days. You now have an
interesting choice. You can exercise your option and take delivery of
IBM at $100 a share and sell it at $110.00 a share. If you do, you will
break even on the trade because it cost you $10 to exercise. OR, you
can just sell your option. Remember delta? Assume delta was .70 on
the June 100 call options. That means that the option went up in value
to approximately $17.00 (bid price) a contract share. At this point,
you can simply sell your call for a $7.00 profit. REMEMBER, if you
exercise, it costs you the price of the option to buy the stock. If you
just sell your option, you sell it for its bid price.
54

Chapter 3: Call Options

Notes
If you exercise the option, you will first buy the underlying stock for
the options strike price, and then you can sell it at the going market
rate or hold it for as long as you wish. If you sell the option back
to the market, you will get back the money you originally paid for
the option, plus the amount the option has increased in value. The
appreciation in the option will be dictated by a variety of factors
besides the price increase in the stock, such as how much time
value the contract still has and how sensitive it is to an increase
or decrease in the stocks volatility. These factors can be roughly
measured by looking at the Greeks information of an option, such as
delta and implied volatility.

Why Trade Calls?


Buying shares of a stock can be an expensive proposition; if you
want to buy 100 shares of a $50 stock, for example, you would
have to spend $5,000 of your trading money. For many investors
who are starting with small accounts, this is a daunting reality.
They are often attracted to call options because call options on
the same $50 stock will be available for a small percentage of the
value of the stock. A call option with a $50 strike price and a twomonth expiration, for example, may only cost around $500.
One of the main reasons traders like to use call options comes
from the leverage that is associated with a call option. For
example, if the stock moves from $50 to $55 and you own 100
shares, you will make exactly $500, a total return of 10%. This is
pretty good! However, if you bought the two-month call referred to
earlier, you might get a move of around $4 per share, depending
on how much leverage the option has. This would equate to a $400
increase in the value of your option contract, a total return of 80%
on your money. This gives you the chance to get a much bigger
bang for your buck.
Big-percentage trades such as the one just described arent
uncommon in options trading; however, it is important to understand
that trading on the expectation or assumption that your profits will
be this big is dangerous. Look at Figure 3.1.

55

Guide to Options Strategies

Notes

Figure 3.1
Suppose that you made your first options trade in IBM at the
beginning of the new uptrend beginning in July. You bought four,
two-month, at-the-money call option contracts for a price of $2
per share, or a total cost of $800 excluding commissions. This first
trade was pretty conservative at the beginning; since you have a
trading account of $50,000, its less than 2% of the total value of
your account. The stock began its move at around $75; suppose
that when you placed your trade, it had gone up to $76. Since then,
we can see that the stock has made a most impressive run, with
only three down days. The stock is now hovering just below $84,
an increase of $8 per share from when you got into your call option
trade. Your contracts are now one month from expiration, but since
they are now nearly $9 in-the-money, suppose that they are worth
$10.50 per share. This gives your position a total value of $4,200.
Selling your contracts now will give you a total return in this single
trade of 525%. Wow! Isnt that exciting? You have probably called
your friends, neighbors, and even your mother to tell them about the
amazing results you got on your first options trade. You immediately
sell your position and take the profit.
Your profit in this first trade is so large, you feel like you are on top
of the world! You begin to think that it was so easy, you should
be able to do the same thing on every trade. You do a quick
calculation: A 500% return on the next five straight trades will make
you a multimillionaire and you can quit your job. You immediately
start scanning your watch list for the next big trade, anxious to get
back in the market as soon as possible. By now, you may even be
thinking about taking an even larger position next time; you figure
that if you increase your position size to 25% of your account, you
will make even bigger profits and will be able to retire even sooner.

56

Chapter 3: Call Options

Notes
Suppose now that in your next trade, the stock you trade makes
only a modest move initially, giving you a total profit about a
month before expiration of 25%, and then stalls. If you are paying
attention to your technical analysis, you may be getting signals
that the stock is done for the time being and you should take your
profit. The problem now is that since you have only made 25% on
the trade, you will probably be looking for reasons to hold onto the
trade. You will be so focused on getting a big profit again that you
will be able to find ways to misinterpret selling signals for bullish
indications. By now, though, you are one month from expiration. If
the stock begins to drop, you will find the value of your trade falling
quickly also. You will go from having a modest profit to none, or
even a loss, in a very short period of time.
Many options traders make exactly this mistake. By the time
they realize that the stock isnt going to come back, they are
so desperate to see the stock make a miraculous recovery they
will hold onto their option all the way to expiration. Even if that
next trade was a loser from the beginning, the fact that you saw
a ridiculously high profit on that first trade can still skew your
perception of reality such that you will hang onto the option through
expiration. Remember that when an option expires, its value
disappears altogether, and all of the money you put into the trade
will disappear as well.
This kind of emotion will have a ripple effect across every aspect of
your trading system. Now lets suppose that you followed through
on your thoughts of increasing your position size and put 25% of
your total capital into the next trade. Waiting for the stock to make
the big move you wanted forced you to hold the contract past
the point where your mind told you the stock wasnt working; you
were so intent on being right that you couldnt accept the fact that
you were wrong. As a result, you held onto the contract through
its expiration date, losing all the money you put in the trade
and immediately reducing the value of your $54,000 account to
$40,500. Now you are so upset by the large loss you have taken
that you become determined to make back the money you lost.
You realize that you might now get a 500% profit on the next trade,
so you decide that you would be willing to settle for a 50% move.
Since you now have an emotional need to make back the $13,500
you have lost, you put $26,000 into your next trade.

57

Guide to Options Strategies

Notes
Do you see the slippery slope that options traders often find
themselves on? What if youre wrong again? You may lose all
$26,000 you put into that trade, leaving only $14,000 of your original
$50,000 account. You may be so desperate now that you take one
final roll of the dice with everything thats left; surely you cant have
three bad trades in a row. Sure enough, though, this trade doesnt
work either. You have now burned all $50,000 you started with, and
are so despondent that you swear never to trade again.
This example underscores the problems that come from looking
for big profits on every options trade. When you get it, you will
be so excited that you wont be able to frame your next trade in
its proper context as part of your trading system. You will feel so
confident in your ability and mastery of the market that you may
decide the rules you initially set up dont apply anymore. The
emotion associated with your astounding success will skew your
perception of success so much that you wont be able to accept
modest profits, cut losing trades short, or think objectively about
how much risk you are taking. Trading on the anticipation of huge
profits creates an emotional vacuum that is extremely difficult
for anybody to force himself or herself out of. Many traders have
burned through their entire investment capital doing exactly what
has been described here. IBM, as illustrated in Figure 3.1, is proof
that stocks can and do make big moves that can yield incredibly
impressive profits in options trades; however, forecasting which
way a stock will move, how far it will move, and when it will
happen are very tricky and are the main reasons options trading
is so risky. The kind of big moves, such as that made by IBM, are
extraordinary exceptions to the rule, not the norm. Your trading
system should plan to take quick profits in options with short-term
expirations. If you develop the discipline and mindset to do this,
you will be a more effective trader. It doesnt mean you wont have
trades that produce huge profits, only that you wont trade on the
expectation of getting them every time. This way, when they do
happen, you will be able to react objectively to them and place
your next trade in its proper perspective.
You may be thinking, This isnt going to happen to me. If I get a
big move like this, I wont let my emotions carry me the way theyre
saying. I can be objective. This is the right mindset to have, but
you will only be able to pull it off if you make sure that your trading
system is geared around taking reasonable profits rather than
58

Chapter 3: Call Options

Notes
huge ones. In options trades, a good guideline is to be ready to
take profits once your profit reaches a total return of 25 to 50%.
This way, the occasional big move will be a terrific bonus to your
trading, but not the emotional crutch you use to define yourself as
a successful trader. Be careful to remember also that most traders
are wrong about the move a stock makes more often than they are
right. If you keep this in mind, you will be able to deal with losing
trades and streaks effectively and close them out before they
become large losses.
Now that we have examined the pitfalls of options trading and the
mindset you must apply, lets look at how you can identify stocks
that could work well in your favor in options trading. It isnt hard to
understand that before you can determine if a stock would work
well for an option trade, your technical analysis of the stock must
indicate that the stock is due for a significant move. We will discuss
the specific information your technical analysis should give you for
a good options trade later, but first we should consider an area of
analysis that many options traders ignore: fundamental analysis.

Fundamental Analysis and Call Options


Due to the short-term nature of most options trades, many traders
overlook fundamental analysis altogether as part of their options
trading system. There is real value in including fundamental
analysis in your system; even if you choose to trade options on
stocks with poor fundamentals. Fundamental analysis will help you
gain a broader, more complete picture of variables that are critical
to success in options trading, such as:
Volatility
Trading ranges
Motivation that drives a stock in one direction or another
Ability and probability of a stock to sustain
a significant trend
As you analyze a stocks volatility and trading ranges, completing
a thorough look at the fundamentals of a stock will give you a
good sense for why the stock moves as it does. Fundamentally
strong companies generally tend to be less volatile, with more
predictable swing and cycles. Lower volatility doesnt mean that

59

Guide to Options Strategies

Notes
the stock doesnt make large, profitable moves; in fact, when they
begin a move to the upside, it often becomes a long, sustained
upward trend. This is because the emotion and attitude of the
broad market is driven by information that indicates the company
in question is managing their business effectively and is good at
maximizing their profits. If you plan your trade correctly, you can
take advantage of these sustained trends with options just as you
would with the stock. Lower volatility also makes it easier to identify
your entry and exit prices since fundamentally strong stocks
typically dont experience wild day-to-day swings in price. They
also tend to be less volatile on the downside, which makes your
risk management easier to deal with. Identifying support thresholds
for stop losses, for example, is easier and more straightforward.
Fundamentally strong stocks tend to work best for call trades; their
lower downside volatility generally makes them tougher to trade
profitably on the downside.
Fundamentally weaker stocks, of course, tend to be more volatile,
with wider swings in price on a day-to-day basis as well as larger
ranges between support and resistance. Many options traders
prefer these kinds of stocks for their trades because the greater
volatility equates to a higher profit opportunity when they are right.
The value of performing a fundamental analysis in this case is that
it can give you a very clear picture of exactly why the stock has so
much volatility; the stock is fundamentally weak, so the principal
drivers of the stock are speculation and emotion. Although these
stocks can and often will make major moves to the upside, the
fundamental weakness they have is part of the reason these stocks
often experience steep, sustained moves to the downside. For this
reason, most options traders who trade call options on these stocks
look to take quick profits once the stock makes a move of around
two or three dollars. If you are comfortable identifying entry, exit,
and stop loss prices on volatile stocks and you are willing to take
quick profits, these stocks can work in your favor as an options
trader. If you are comfortable with a higher level of risk and more
complicated management of the trade, mixing fundamentally weak
stocks with strong ones can give you the opportunity to take larger
profits from time to time.

60

Chapter 3: Call Options

Notes

Technical Analysis and Call Options


To a great extent, technical analysis for call options trades is no
different than what you do when you are looking for a good stock
trade. Breakouts above or below support and resistance, trend
reversals, and bounces along a trend line are all opportunities
for good short-term stock trades. Likewise, these types of moves
generally have easy application to options trading. The analysis
you use for stocks applies to options because, for any options
trade to be successful you have to analyze the likelihood of the
stock making a move you can take advantage of.

Duration of the Trade


The biggest thing to remember about the technical analysis you
use to place an options trade is that you must be sensitive to the
amount of time it will take the stock to make the move you want.
When you trade a stock, there is no limit on the amount of time
it may take for the stock to move for you. As long as the stock
doesnt violate your stop loss, you can stay in the trade and wait
for it to move. This isnt true in options. If you buy an option that will
expire in two months, you generally only have about one month to
wait for the stock to move the way you want. If it doesnt make the
move in that time, it isnt likely to at all. Even if it does actually start
to move for you at that point, the time decay of the option will have
eroded the value of the option to such a point that the stock will be
unlikely to move enough to make up the difference in the time you
have. More options trades go bad because of traders not buying
enough time than perhaps any other element of options trading.
As you perform your analysis of support, resistance, and trend,
make sure to consider how long it usually takes the stock to
move by a certain amount. For example, suppose that you have
identified a trading signal on a stock that has broken above
resistance on strong volume. A check of support and resistance
levels gives you a likely $5 range between the current price of the
stock and the next probable resistance point. When you make this
conclusion, make sure to check the stocks volatility over the past
year. How long does it typically take the stock to make a $5 move?
Taking a few minutes for this check will give you an idea of how
much time you should purchase in the call option. A good rule of

61

Guide to Options Strategies

Notes
thumb most traders use in options trading is to consider buying
more time than you think you need. If the stock appears to need
about a month to make such a move, buy at least two months. The
more time you buy, the more conservative the trade is because
you minimize the effect of time decay and widen your window of
opportunity.
Many new traders in the options arena assume that trading options
means using short-term trading strategies exclusively. This isnt
true! Options contracts have a wide range of expiration dates. This
makes it possible for you to take advantage of nearly any range of
time that is available to you. This means that you really dont have
to change the technical analysis you are already used to; only that
you must account for the amount of time your trading strategies
generally require to make the moves you need. Since call options
are designed to take advantage of upward moves in the price of a
stock, you can profit nicely from short, intermediate, and primaryterm trends as long as you account for the time you need to let the
stock make the move you expect.

Finding Stocks to Trade with Call Options


If you have been using the software for any length of time, you
have probably identified scans that give you the kinds of potential
stock trades that fit your trading system. These same scans have
the same translation to options trades, so you dont necessarily
have to try to find new ways to find potential plays in order to find
successful options trades. But there are Seeker scans that are
particularly well suited to short-term call options trades based on
common short-term trading techniques. A few of these scans are
listed below; you can find others by experimenting with Seeker and
analyzing the results of the scans you try.

62

5/50 SMA Approaching Cross UpThis scan uses a


five- and 50-day moving average upward crossover as its
trigger. Stocks that will come up in this scan will often be
in current downtrends; the crossover will often come as
the stock reverses direction and begins a new uptrend.
Since the five-day moving average covers a very short-time
period, the point where its line crosses the 50-day moving
average gives a breakout signal at a very early stage of
the trend. This can get you into a good call trade if the
trend is confirmed and continues to move. It is important
to remember; however, that this early signal will fail to get

Chapter 3: Call Options

Notes
confirmation. Make sure that if you use this search that
you have very specific filtering rules set up to confirm
the existence of a breakout before you take a trade. This
scan can work well for short-term options trades as well as
longer ones.
Daily Swing BuyThis scan looks for stocks that have
been in sustained uptrends or begun new uptrends, then
retraced back down towards their trend lines. Short-term
traders look for opportunities to trade stocks that bounce
off their trend lines since these often prove to provide very
attractive return potential. This scan epitomizes the concept,
the trend is your friend. Not all of the stocks that come up
in this search will provide the bounce you are looking for, but
from any given search you run from this scan, you stand a
good chance of finding at least one or two stocks that will.
Daily Breakout Buy Watch ListThis search looks for stocks
that have broken above previous resistance levels. These
could be stocks in current uptrends that have retraced to
their trend line, then broken above the resistance defined
by the retracement; stocks that have broken 52-week high
price levels, or stocks that have broken the resistance
formed by a strong downtrend. A breakout in this scan
is defined simply as a price move above resistance; there
are no additional criteria such as volume used to confirm
the move. Your filtering rules will be critical in whether the
stocks you choose to follow actually give you the trade you
are looking for.

Call Options Trading Rules


The first, and perhaps the most critical component of any
successful trading system is a carefully thought-out and planned
set of trading rules. This is as true of options trading as it is of
any other trading market. One of the advantages of trading in any
market is that once you develop a successful trading system, you
can apply the most important aspects of that system to just about
any other trading market. That doesnt mean that once you learn
how to trade one market, you know them all. It simply means that
there are common elements that can be applied to any market. For
example, if you have learned how to effectively analyze the trend
as well as support and resistance of a stock over any given time
63

Guide to Options Strategies

Notes
period to identify entry, exit, and stop prices, you have a skill that
will apply equally well to commodities, bond, futures, or currencies
market trading. As you work to develop a system for your options
trading, think about your previous trading experience and write
down the skills that have made you successful in those areas that
will translate to options.
These could include areas such as the following:
Trend analysis
Support/resistance
Weekly/daily/intraday chart analysis
Fundamental analysis
Relative strength analysis
Money management
In any financial market, there are dynamics and intricacies that
cannot be learned in any other market. When it comes to your
options trading system, you must account for the variables that
make options different from any other financial market. Your trading
rules must reflect how you plan to deal with these dynamics to
minimize risk and maximize opportunity. These dynamics can be
encapsulated as a whole in the following:
Choosing a strike price
Identifying your time objective
Your reward-to-risk ratio
Planning your exit

Choosing a Strike Price


Once you have identified a stock that is poised for a strong
upside move, you must decide what strike price you intend to use.
For any given stock that offers options trading, you can purchase
call options with strike prices that range from deep in-the-money
64

Chapter 3: Call Options

Notes
to highly out-of-the-money. The strike price you pick will go a long
way to identifying whether your options trade is very aggressive
or more conservative. Because the strike price can have a large
impact on the profitability level of your trade, you should develop
trading rules that dictate your approach.
Purchasing in-the-money call options is a conservative approach
to options trading because of the intrinsic value of these contracts.
Intrinsic value, or the difference between the current price of the
stock and the strike price of your call option, can act as a buffer
to minimize some of the loss you will deal with if the stock moves
against you. Of course, in order to take advantage of this feature,
you have to pay more money. In-the-money options are more
expensive than out-of-the-money options. This higher cost also
means that if the stock moves the way you want, your profit will be
smaller as a percentage of your initial investment. In-the-money
call options are considered more conservative, then, because they
arent as volatile; the leverage they provide in a given trade is less
than what you can get from out-of-the-money options.
Out-of-the-money options provide a higher degree of leverage
than in-the-money contracts primarily because of the fact that they
are cheaper. An out-of-the-money call option has no intrinsic value
because the strike price is higher than the current price of the stock;
in order to have intrinsic value, the stock must rise in price past the
options strike price. The further away from the current stock price
the strike price is, the smaller the chance that the stock will rise past
it, which is why out-of-the-money call options are so cheap.
Your trading rules must reflect your attitude about risk and the
efforts you intend to make to minimize that risk. As they relate to an
options strike price, you need to find a balance between cost, risk,
and opportunity. There isnt a single best way to determine where
that balance lies. Some traders will always purchase the first inthe-money call option on any trade they make, while others might
prefer the at-the-money call, regardless of whether it is actually
in or out-of-the-money. Still others will stick to purchasing the first
out-of-the-money contract in an effort to maximize their opportunity.
Defining your approach will probably take some experimentation.
You will have to make a few options trades each with in, at, and
out-of-the-money contracts before you develop a sense for the
approach you prefer and that works best for you. Make sure you
65

Guide to Options Strategies

Notes
try a few trades with each type of strike price so that your attitude
isnt unduly influenced by the success or failure of a single trade.
Taking a losing trade with an out-of-the-money contract, for
example, probably wont be enough to determine if that approach
is wrong for you. You will have a better idea of what works best if
you have winning and losing trades in each approach so you can
make a proper comparison among them.
Using the delta value of an options chain is one way that you can
get a good sense for how much leverage an option has, as well
as the concurrent risk. This can be a good guide to follow for
identifying the type of strike price you prefer. Look at Figure 3.2.

Figure 3.2
Suppose you had a signal to buy AAPL today, which is why youre
considering buying a call option on the stock. The stock last traded
at $147.53, which means that every contract with a strike price
below that level would be considered in-the-money. The $140 strike
price, for example, is the closest in-the-money call to the current
price of the stock. Every strike price above $147.53 and higher is
out-of-the-money.

66

Many conservative options traders like to look for options that carry
a delta value as close to 1.00 as possible. In this event, the $100
call offers a delta value of .99, meaning that for every dollar AAPL
moves, the $100 call will also go up in value by nearly a dollar.
Does this mean that this is the option you should use? Maybe, but
first a little more evaluation is in order before you decide. Look at

Chapter 3: Call Options

Notes
the Last column in the table. This is the last trading price for the
option you are considering and will give you a good idea of how
much the option will cost you. The $100 strike price will cost you
approximately $48.15 per share, or $4,815 in total capital. A $1
increase in this option will give you a return of just over 2%.
By the same token, the $120 call option offers a delta value of .90,
which is about .9 short of the delta offered by the $100 call, yet it
last traded at $29.10. A $1 move in the stock would move the option
$.90, this option would yield a return of close to 3% on your $2,910
investment. In this case, the differences are not that dramatic.
However, this sometimes is a very valuable drill especially when
dealing with options one and two strike prices in-the-money.
Evaluating the out-of-the-money call options works the same way.
The $150 call option, which is the first out-of-the-money call option
available, carries a delta of .48 against a current price of around
$8.70, giving you a potential return of 5.5% if the stock moves
higher by $1. The $155 call is even cheaper, going for only $6.60,
while its delta of .4061 provides a return of 6.1% if the stock moves
up by $1. Of course, this option is much further out-of-the money
than the others.
Many traders new to options make the mistake of picking out-ofthe-money contracts because of the enticing combination of lower
cost with higher potential returns. Why is this a mistake? As a
society, we are used to trying to get the best possible deal we can
on any purchase we make. We want more features and benefits
for every dollar we spend, and when we can get them for a cheap
price, we pat ourselves on the back for finding a good deal. The
problem with this mentality in options trading is that cheaper
options mean higher risk. The contracts in Figure 3.2 expire in just
over one month. With the stock currently just below $148, what is
the likelihood the stock will rise above $150 in just over one month?
In the case of Apple, it could happen tomorrow but you also run
the risk that Apple will choose to rest the next two months and the
considerable money youve spent buying out-of-the-money options
will make a large flushing sound as it goes in the toilet. You will find
that it is usually worth the extra money required to buy options that
are closer to the current price of the stock.
The decision of whether you should go in-the-money or out-of-themoney lies solely with you. Using the delta can help you try to find
67

Guide to Options Strategies

Notes
the best mix of risk and reward for your temperament, needs, and
trading style, but you will still need to prove your decision out over
time by applying it to your trades and evaluating the results.

Determining Your Time Objective


Once you have developed rules around the strike price you will
use, you will need to determine how much time to buy. If you have
some experience trading options, you have probably already
developed a sense of the importance of buying enough time to
let the stock work for you because you have had trades that lost
money, not because you guessed wrong about the direction of
the stock, but rather because you didnt buy enough time to let
the move develop. Following the suggestions made in this section
can help you avoid making those same mistakes again. If you are
new to options trading, this section gives you the chance to learn
from the mistakes of others and avoid many of the most common
problems options traders face in making money. Incorporating
these suggestions into your trading rules, whether you are
experienced or not, can help you accelerate your learning curve
and develop a solid options trading system.
As noted before, one of the easiest mistakes to make in options
trading is to not buy enough time to let a stock make the move you
want. Your technical analysis should give you a good sense for
what the future direction of a stock is likely to be; identifying short,
intermediate, and primary-term trends is the most effective way
to forecast future price movement. However, the point that many
traders fail to learn without first making several bad options trades
is forecasting how long that move may take. Look at Figure 3.3.

68

Figure 3.3

Chapter 3: Call Options

Notes
In this chart, FSLR was in a trading range from roughly 175 at
support and 225 resistance. It has just broken resistance and
could be poised for a strong upside move. The next closest major
resistance is 275, meaning that it has shown the capacity to move
+/- 50 points in a 30-day period.
The next step to complete and to determine how much time you
should plan to buy for this trade, is to look at the stocks movement
over the past year. How long does it typically take for the stock to
move $50? In the last quarter of last year, FSLR moved about 75
points each 30-day period. This is a significant move to the upside.
After a very strong upward trend, it began a longer downtrend
with concurrent $10 or greater moves in a short period. However,
over the last couple of months, as demonstrated in the chart in
Figure 3.3, the stocks volatility has dropped off; the stock now
seems to make a $45 to $50 move in a months period of time. This
means that if you wanted to take advantage of the entire $50 range
between $225 and $275 if the stock breaks its current resistance,
you should plan for an options trade of at least two months. The
stock has a 30-day swing, its true, but the swing is not dependent
upon beginning of the month to end of the month dates. More time
for more insurance. Your analysis of FSLR has demonstrated that
it is a money maker but because its a huge money maker, it can
also be a huge money loser. If it suddenly swings down, history
illustrates it will do so for approximately 30 days. Buy enough time
to prevent yourself from getting whipped out of the trade if FSLR
decides to roll back a little. If volatility increases and it makes the
move in a shorter time period, then your profit will be even better,
but you should plan for at least as long as the stocks current
volatility indicates it should take.
Purchasing even more time, maybe four-to-six months, would make
the trade even more conservative and increase the likelihood that
you will be there for the move if it happens. However, buying more
time does not mean that good stop-loss curbs should not be in
place to prevent catastrophic losses.
The decision about whether you should buy more or less time
depends on you, your attitude about the stock you are considering,
and to what extent you are willing to let time decay affect your
trade. Many options traders fall into the trap of purchasing less
time than they need because options with closer expiration dates
69

Guide to Options Strategies

Notes
are cheaper. If the stock quickly moves the way you want it to, you
will make a large profit; however, if the stock doesnt move within
a couple of weeks, the time decay in the contract will degrade
the value of your option to the point that realizing a profit just
before expiration becomes highly unlikely. Your options trading
rules should reflect whether you intend to take an aggressive
approach by buying less time or conservative by buying more.
Most successful options traders adopt a philosophy of buying
more time than they think they need. For example, if the stock they
are considering appears to take a month to move within a specific
range, they will usually buy two to three months of time
as a minimum.

Applying Reward-to Risk Ratios to


Call Options
Many traders look for trades that provide at least twice as much
potential reward as the amount of risk they took. This 2:1 rewardto-risk ratio evaluation is an effective way to both look for attractive
profits as well as minimize your downside risk. This evaluation
applies to options trading as well as to stock trading. When you
are using call options as a way to leverage long opportunities in
a stock, your reward-to-risk analysis will be simplified if you use
the stock rather than the option. Looking for the 2:1 reward-to-risk
ratio works equally well in options trading. It can provide you with
opportunities to take significant profits while still limiting your loss
to a relatively low amount, even on an option trade.
Perhaps the best aspect of using reward-to-risk ratios in any kind of
trading is that it provides a thorough view of all of the possibilities
for what the stock could do. Identifying your potential reward usually
means evaluating the range between the most current support and
the closest resistance levels. If the stock goes up to the top of this
range, you will have an opportunity to take your profits. On the other
hand, if the trade simply doesnt work, it will probably drop below
the current support; if it does, your reward-to-risk analysis will have
identified the stop-loss point at which you will get out.
The one aspect of options trading that affects reward-to-risk ratios
differently than in stock trading is time decay. Since a stock wont
expire, you dont have to worry about whether the stock moves
the way you want quickly; you simply stay in the play until it goes
the way you want or you get stopped out. This isnt always true in
70

Chapter 3: Call Options

Notes
options trading. If you have purchased a relatively short period of
time, you will be facing a significant loss if the stock doesnt move
in your favor very quickly. Even if you buy what would ordinarily be
a sufficient amount of time, the stock may not move in your favor
in the time you have. Time decay alone can add up to a net loss in
an options trade if the stock moves against you or simply doesnt
move at all. For this reason, you should carefully consider the
effect of time decay in each of your option trades.
Measuring time decay can be a difficult proposition if we try to do
it ourselves.
The following is a binomial table showing the damage theta can
cause if a stock does not go in the direction of the trade. For this
example, well use a call play. As you can see from Figure 3.4,
holding a call option position when the stock is staying flat is not a
safe harbor.

Figure 3.4
If the stock stays at $30 a share and the option has 60 days prior
to expiration, the decay factor, theta, breaks down like this:
71

Guide to Options Strategies

Notes
1st day of purchase-no decay
In the first 15 days, the option value falls from $1.53 to
$1.30 for a decay of 15%
In the next 15 days, the option value falls to $1.028 for
cumulative decay of 33%
In the next 15 days, the option value falls to $.67 for a
cumulative decay of 56%
In the final 15 days, the option value falls to $.0 for a
cumulative decay of 100%
As you can see, theta accelerates as time passes.
With respect to theta, if the stock is staying relatively flat for a protracted period of time, get out. Staying in only makes matters worse.
The deeper in-the-money or out-of-the money an option is, the
smaller the effect time decay has on the contract. How much
higher or lower the theta will be tomorrow is something that we cant
evaluate with the information at hand since forecasting future price
movement is, ultimately, little more than a best guess venture. The
main point you need to take from looking at theta is to get a ballpark
sense for how time decay is likely to affect your option. Dont use it as
a precise measurement of exactly what time decay is going to do.
Think of theta as an added cost you will have to incur no matter
what contract you choose, and that the move made by the stock
underlying your option must offset. This added cost should be
considered as part of the risk portion of your reward-to-risk ratio in
any given option trade. When you analyze reward-to-risk ratios, you
should make sure that the target price your exit analysis gives you
is enough to offset your time decay risk as well as the downside
risk identified by your stop analysis. You should also combine your
evaluation of theta with your analysis of how long you think it will
take the stock to move the way you want. If you forecast a three-tofour month time period for your stock to move and plan to purchase
a five-month option, for example, make sure to evaluate the theta
value for that five-month option.

72

Chapter 3: Call Options

Notes

Planning Your Exit


One of the essential components of any trading system is making
sure to plan your exit strategy. Most traders tend to think about
trading primarily in terms of when they get in to a trade. This rationale
is logical since the idea of any trading system is to buy low and
sell high. The only problem with putting so much emphasis on the
entry portion of a trade is that traders often try to split hairs on the
price they buy atThe option is priced right now at $2.35, but I
only want to pay $2.30. This mindset, then, can lead to traders to
trip over dollars to make pennies. In the example just mentioned,
if the stock moves the way you want and the option increases from
$2.35 to $5, does it really make a difference whether you bought at
$2.30 or $2.35? This is not to say that you dont have to wait for a
stock to begin the move you want; all of the trading rules you have
developed for identifying when the opportunity is ripe still apply.
Just remember that if you are confident the stock is going to move
in your favor, it is more important to get into the trade than it is to
try to get the best price possible.
The more effective traders, in any market, understand the
importance of identifying exit prices. Make sure you perform a
complete analysis of the trend as well as support and resistance
thresholds before you enter into any call option trade. You need
to identify an entry threshold as well as an exit threshold; neither
one should be ignored. Just as with analyzing reward-to-risk ratios,
it is more effective to do this using the stock itself rather than the
option. Use resistance levels to identify points at which you will
either close out your call trade or, if you have purchased enough
time, stay in the trade and maximize the trend. If you want to
forecast where the options price could be if the stock moves
to the level you have identified, you can use the delta to calculate
the options potential increase.

Examples - Call Strategies & Setups


Now that we have covered the specific information that you
should make sure to account for when you are looking at a call
option trade, lets look at some examples of how to apply some
of the stock trading strategies you use to options. We will outline
each step of the trade and walk through an evaluation of the
options information we need to plan the trade before we place
it. Remember, these are only examples of one way to apply the
73

Guide to Options Strategies

Notes
concepts discussed in this chapter. You can and should use these
examples to get your own thoughts started in how your trading
rules and system will use options, but make sure that your trading
system reflects your personality, trading style, and risk tolerance.
Strategy I
Swing Buy (also called a Bull Pullback)
The software has a number of excellent searches which find
setups with a high potential of being a winning trade. Remember,
there is no such thing as a perfect search. One individual trader
can make money on a search while another one finds it to be a
losing proposition. The swing buy or bull pullback pattern is a
favorite among a large number of traders which is indicative of the
successful predictability of the pattern. In Figure 3.5, you can see
how to set this search up.

Figure 3.5

Technical Analysis
The search finds AAPL. Note from Figure 3.6 that AAPL has been
on an impressive upward trend over the last month. In the last few
days it has been pulling back to the intermediate trend line (red
line). Today, on positive earnings projections and new product
announcement, the stock has made a classic bull pull back pattern.

74

Chapter 3: Call Options

Notes

Figure 3.6
Short-term pullbacks in upward trending stocks provide good
opportunities for options traders to make relatively low-risk trades
with very attractive profit potential.
Based on previous peaks and valleys, we can identify support
for the stock at around $138 and rock hard support at $120.
The support provided by the intermediate trend is around $148.
The high peak for the intermediate uptrend is around $160 with
a secondary higher resistance at $180. Well use our first resistance
level of $160. Also, the 52-week high is about $200.
Of critical note is the fact that AAPL is declaring earnings on April 23.
AAPL is currently trading at $153. On this bull pullback, some
traders will buy the May 150c and exit the trade before earnings
declaration on April 23rd. The current date is April 16th.
The stock is poised to give a good trading opportunity. In addition,
the market has been open for three hours and there have been
almost 16-million shares traded so far today. This is not remarkable
volume for Apple, but its also not wimpy.
Available Call Options
Exploring the opportunity further, we pull up an option table on
AAPL to price the May 150 calls.

75

Guide to Options Strategies

Notes

Figure 3.7
Swing trades typically last no more than one-to-two weeks at most,
so many options traders will look to take advantage of the higher
leverage and lower costs associated with very short-term options.
The current available month, April, offers the highest leverage, but
also a very short window of time. Also, April options expire prior
to the earnings announcement coming out on April 23rd. We dont
need more time than May. The May 150 strike price is 11.15 x
11.20 with a delta of 59.23. The May 155 strike price is 8.55 x 8.60
with a delta of 50.75. Lets concentrate on these two options and
determine which option provides the most leverage for the money.
1st Calculation: Buy the May 150c.
Pay $11.20 at the Ask
Stock goes up $1 (delta = 59.23)
Option goes up $.5923
Percent return: .5923/11.20 = 5.2% return on the cost of the May 150c
2nd Calculation: Buy the May 155c
Pay $8.60 at the Ask
Stock goes up $1 (delta = 50.75)
Option goes up $.5075
Percent return: .5075/8.60 = 6.7% return on the cost of the May 155c

76

Earlier we stated that you should always buy one strike price inthe-money. However, when the delta is above .50 for any option,
it pays to do the math to determine what the highest rate of return
is, based on your cost. Options with a value of less than .50 have

Chapter 3: Call Options

Notes
a difficult time making money given a short investment period.
This is definitely a short investment period. Since the May 155s
have a delta above .50, theyre worth considering.

Reward-to-Risk Ratio
Is there enough upside potential in AAPL to justify taking the risk
of putting money into the trade? At the end of the day AAPL was
trading at 153. The following morning, it opened at $153.65. The
low of the prior day was $150. Setting a stop loss at just below
yesterdays low of $150 (down approximately $3) and a profit
target of $160 (up approximately $7) gives us greater than a 2:1
reward risk ratio in the stock, which is quite encouraging.
Strategy II
Trend Breakout and Reversal

Figure 3.9

Technical Analysis
In the chart in Figure 3.9, AEE has been on a steady downtrend
over the past few months, and then reversed its direction over the
last and made a move to the upside. Four days ago it pulled back
and today, corrected. If it continues tomorrow it could provide
a good opportunity for a call option trade if the short-term trend
continues its upward move.

77

Guide to Options Strategies

Notes
We can use the short-term trend line that has formed since the
beginning of this upward move as a likely immediate short-term
support level at around $45.99, since if the stock breaks down
below this level, we could call this move a fakeout move rather
than a breakout. We see additional support at around $45. The
stock has recently broken above short-term resistance of about
$47 and the next likely resistance level is near $53.
If this is a legitimate trend reversal, and the stock runs past $47.50
the stock is likely to continue its upward trend to $53.

Available Options
See Figure 3.10.

Figure 3.10
With AEE currently just above $45 per share, the first in-the-money
strike price for all the contracts listed in Figure 3.10 is $45. If we
wanted to be aggressive and increase our leverage, we could
purchase one strike price out-of-the-money at $50. For this play,
lets stay conservative and buy the $45 calls just in-the-money.
We are forecasting a move from its current price around $45 to
$53 in a stock that typically only moves about $2.50 over the
course of a normal month. Buying the June contract would give
us roughly five to six weeks of time for the stock to make its $4
moveprobably not enough time. The next options available are
the September calls.

78

The September 45 calls are priced at $2.75 per contract share.


The delta value is 70.93. That means if the stock goes up $1, the
option should increase to about $3.10. Dividing .70 (the delta
value) by the value of the contract gives a return of 25%. This

Chapter 3: Call Options

Notes
does not take into account the spread between the bid and the
ask. Please remember that delta, theta, volatility, interest rate,
and a number of other factors play into the calculation of the
options price. Delta is just a guideline for a small period of time.
It changes very quickly. Also delta and theta are not the only
factors used in the calculation of the options value. Spending
an inordinate amount of time estimating the effect of delta on the
price of an option can sometimes be an exercise in futility. Many
traders believe that it is more important to make a trade with a high
probability of reaching a projected profit than structuring a trade
favoring the highest leverage value.

Summary
Call options provide excellent opportunities to combine the same
kinds of short-term stock moves you have already learned to
use with the leverage and profit potential of options trading. It
is important to make sure that your rules for trading call options
reflect the elements of time, leverage, and time decay that exist
in all options contracts. Following the process of evaluating the
viability of a potential call option trade should begin in the same
way as any stock trade: by analyzing the strength of the current
trend. Basing your entry, exit, and stop prices on the stocks
movement is also a straightforward, logical way to approach
money management in your options trades. In addition to the
stocks trend and support and resistance thresholds, use the delta
and theta values of a given option contract to realistically gauge
the profit or loss potential of that option trade. This will become
an important part of your options trading system as you learn to
manage the risk of any given options trade and minimize loss.
Maximizing the profit of a call option trade must be contrasted
against the amount of time remaining in the contract you have
purchased. If you are dealing with a short-term option that expires
in two months or less, you will have less opportunity to maximize
profit and should look to take quick profits. Buying contracts that
extend across a time period of several months can give you better
opportunities to maximize profits by staying in a trade while an
upward trend is strong.

79

Guide to Options Strategies

Put Options

Put options provide an excellent profit


opportunity for long trading strategies in stocks
making downward moves and trends.
In Chapter Three, you learned one of the
simplest, yet most powerful ways to trade
options: using calls. One of the things about
trading calls that makes them so attractive is
the fact that you can use many of the same
long trading strategies you have already
become familiar with as a stock trader. Put
options provide a similar opportunity on the
opposite side of the market, with excellent
profit potential in stocks making downward
moves and trends.
Playing the downside (usually referred to
as the short side) of any market or stock
can be part of any established, long-term
trading system. Most traders who are
new to the market begin by making long
tradesbuying and then sellingin stocks
first. After establishing some confidence
and experience in the long side of the
market, they next begin to learn about
shorting the market using the margin in their
brokerage accounts. The same principle

83

Guide to Options Strategies

Notes
applies to learning about trading options. For most traders, learning
to manage the dynamics of options trades works best by practicing
bullish options strategies first. This is the reason the call options
chapter precedes this chapter. Put option strategies, however, are
just as powerful and can provide, in many ways, even better profit
potential. For this reason, any smart options trader will take the time
to learn how to incorporate put strategies into his or her trading
system.

Review - What is a Put?


Chapter One introduced you to some of the basic concepts behind
a put option. If you have never tried to profit from the bearish side of
a market, the simplest way for most new traders to think about put
options is to contrast them against bullish trades. If you think a stock
or market is going to go down in the immediate future, put options
give you the best opportunity to make a profit. Put options give you
the ability to reserve a selling price for the underlying stock ahead
of time. If the stock drops below the price you have reserved for
yourself, you can buy the stock at the current price and then sell
it back to the market at the price you reserved.
The concept of shorting actually applies in more areas than just the
financial markets. Grocery stores are just one common example.
A grocery manager may know that he needs to stock up on hot dogs,
hamburgers, and other barbecue fixings in advance of the Fourth
of July. He knows he will be able to mark these items at a higher
price than he normally might because demand for them is going to
be particularly high going into the holiday. Because he might not
have the cash flow to pay for the entire order up front, suppose the
grocery manager uses a line of credit to buy the items he needs and
stocks up his shelves. After the holiday has passed, he can use the
money hes made by marking the items higher to pay off the line of
credit and pocket the difference. A very similar process happens
when you short a stock.
The advantage of a put is that, unlike shorting, you dont have to
use margin in your brokerage account to reserve the right to profit
when the stock goes down. You only need to pay the cost of the
put option, which will be a fraction of the cost of 100 shares of the
stock. The strike price of the option is the price you have reserved
the right to sell the stock at. If the stock drops, you can exercise
84

Chapter 4: Put Options

Notes
the put by buying the stock at the current price, and then sell the
stock back to the market at your strike price. You can also choose
not to exercise the option and simply sell it back to the market.
Since the stock is below the strike price of your put option, you will
be able to get a higher price for the option than what you paid for
it. Simply closing out a profitable put trade is the course of action
most options traders take.

Why Trade Puts?


A common adage states, What goes up must come down. Its
physics, right? You cant jump up into the air without coming
down. The same is true of the stock market. Everybody loves
to see stocks going up, but smart traders understand that bull
markets only last so long. Every upward run comes to an end at
some point, and when it does, it usually leads to a downward turn.
Downward trends in stocks are sometimes very short-lived, but
they can also turn into long, extended pullbacks. Both situations
offer opportunities for astute options traders to make money with
puts. Look at Figure 4.1.

Figure 4.1
In March, Intuitive Surgical (ISRG) ran from $250 to $350.
However, we can see that the stock began to hit resistance at its

85

Guide to Options Strategies

Notes
high price of $350 per share. Finally, after the third sloppy bounce
off of $350, the stock fell through the support offered by the upward
trend, as indicated by the green line in Figure 4.1. This precipitated
the consolidation the stock now finds itself in. This appears to
be a good opportunity for a put play. The short-term trend to the
downside established the first of May might continue. It appears that
the cycles for this stock last approximately 15 days. Since ISRG is
in the middle of a cycle, there are about 7-10 days left in the current
cycle. The stock price is about $287.57. Support is at $275. That is
a potential dollar move of $12. If ISRG breaks through resistance at
$275.00, its next resting place (support) is around $250.
One of the most powerful tools in the software is its dynamic risk
graph module. Lets use it now to illustrate the projected profit of
buying a put on ISRG.
Figure 4.2

Figure 4.2 shows that we can buy a July 290 put for $24.65. Thats
100 x $24.65 for a total of $246.60 + commissions to make the
trade. Since there are so many different commission structures, we
will leave those out of the equation. Just know that they exist. We
also set up the risk graph to show the profit curve with a 30-day
time frame. That means all calculations are done at the end of 30
days. If the stock goes down, it considers it to have happened at
the 30-day mark. Remember that we projected that the stock would
fall from $287.57 to $275. History shows that it could happen in 15
days. Weve given it an additional 15 days to hit that mark.
86

Chapter 4: Put Options

Notes
If the stock performs as expected and is at $275 on day 30,
we will have made about $915 on our investment of $246.60.
Of course if the stock goes nowhere, the option expires worthless.
We dont want that to happen of course ,so we set a stop loss of
roughly 30% below the purchase price of the put. Also, ISRG might
fall but not to the level we expected. If it suddenly shows strength
and starts back the other way, exit your trade and take your profits.
One of the things about downtrending stocks that makes them so
attractive to options traders is the rate at which stocks decline in
value. Think of a rollercoaster at an amusement park. Most start
with a long, gradual ascent to the highest point of the ride. This
can be favorably compared to the long, extended uptrends stocks
often experience. What happens after all of the cars have crested
the top? The entire coaster careens at insane (or exhilarating,
depending on your perspective) speeds to the bottom. The same
thing often happens to stocks at the end of an upward trendafter
everybody has realized the upward run is over, they all try to get
out at the same time, sending the stock crashing, often to amazing
lows. Smart traders learn to identify, through technical analysis,
when these drops are likely to occur and take corresponding
short positions. Then, just like the enthusiastic rollercoaster riders
hanging at the edge of that first steep descent, all they have to do
is hang on and wait for the drop. Once it happens, they take their
profit and look for another trade. Of course, this isnt a foolproof
strategy; sometimes a stock simply pauses in an upward trend for
a period of time, and then continues its run. This is why the same
approach to stop losses and money management is necessary
when you trade puts as you would use in any other type of trade.
The purpose for this chapter is to help you learn to identify when a
stock is about to begin or continue a downward trend and how to
construct a put options trade that you can use to take advantage
of it. We will also discuss methods to minimize and manage risk in
put options trades.
Because stocks in downward trends often drop very quickly,
trading put options is a strategy that generally doesnt lend itself
well to extended periods of time. A common mistake option
traders make with puts is to try to squeeze every last bit of profit
in a downward trend. Most downward trends dont last as long as
a stocks upward trend, although they may be just as severe as

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Notes
or even more dramatic in price decline than the increase in price
experienced in an upward trend. This means that you should
typically plan to take quick profits when you have them. We will
examine this fact in more detail later.
Many traders who first begin learning and trading options tend to
gravitate towards the options trades that most closely approximate
the approach they use to stock trading. In other words, if you have
become familiar with buying a stock and selling later at a higher
price, you will naturally lean towards trading calls. If you are already
familiar and comfortable with shorting stocks, then trading puts
will be an easy fit for your style. This is a good thing; the more you
can replicate what you have already done successfully in the stock
market, the better your chances of making money in the options
market are. Even if you arent already familiar or comfortable with
shorting stocks, however, you should still take the time to learn how
to use put options to take advantage of downward trends.
Successful traders make sure they know how to trade in as many
markets and environments as possible. Were you in the market
in April of 2000? If so, like most people, you probably didnt think
the bull run would ever end. But the people who made money that
year, and the next, were the ones who knew how to adjust when
the market adjusted. Learning how to trade puts is just one way
to make sure you can do exactly that. If the market in general is
dropping, which does happen more frequently than many people
think, the worst thing you can do with your money is to place
bullish trades. Many traders in this situation simply put all of the
money in cash and wait for the market to begin to go up again.
Couldnt you do better than earn 1 to 2% interest in a money
market or cash account while youre waiting for the market to
go back up? Trading put options will allow you to respond to the
market and keep your money in the types of trades that market
conditions dictate will be the most likely to make money.
This section only discusses trading puts as a growth strategy to take
advantage of downward movements and trends. There are other
approaches to put trading, such as selling puts, which emphasize
income. These strategies are outside the scope of this material, but
are available to explore.

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Chapter 4: Put Options

Notes

Fundamental Analysis and Put Options


Fundamental analysis provides an effective way to make sure that
the stocks you are considering have strong business reasons for
moving up; thus, looking for fundamentally strong stocks generally
applies to bullish strategies. Fundamental analysis does have a
place on the short side of the market; just as in bullish trades, this
is an area that many traders neglect to pay attention to.
If fundamental strength provides a reason to look for bullish trades
in a stock, it stands to reason that fundamental weakness gives
you a reason to look for bearish moves; however, be careful about
making this assumption too much. Fundamentally weak companies
often go up and experience dramatic bullish moves just as
fundamentally strong ones do, so fundamental weakness doesnt
always equate to the expectation a stock will go down.
To put fundamental analysis in its proper context in put options
trading, think about some of the characteristics that fundamentally
poor stocks often have:
They tend to be more volatile, providing larger swings and
trading ranges between support and resistance levels.
Bounces off resistance provide opportunities for put
trades with good reward-to-risk ratios. The higher volatility
associated with weak stocks means that when they begin
a downtrend, they would be more likely to break existing
support levels than stronger stocks, which often show
resilience around support.
The factors that drive these stocks up tend to be based
primarily around the news. Speculation, favorable rumors,
and hot buzz often lead to the dramatic price increases you
will see in fundamentally weak stocks. By the same token,
any kind of negative news or speculation will send the stock
spiraling downward very quickly. These kinds of events often
lead to extended downtrends in fundamentally weak stocks.
These downtrends may provide multiple opportunities for
profitable put trades.
Fundamentally weak stocks generally have a more difficult
time sustaining upward trends than strong stocks. If you
see a fundamentally weak stock in an upward trend, check
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Guide to Options Strategies

Notes
the news to see if you can determine what is driving the
upward move. If you find that improving fundamental
information such as increasing sales and earnings are
the driver, the stock may continue its upward trend for a
while. On the other hand, if the news driving the stock is
speculative in nature, then you may want to watch for the
stock to become overvalued and drop below its trend lines.
These might give you early opportunities to make a good
put trade.

Technical Analysis and Put Options


You should already be familiar with identifying and drawing
downward trend lines. The Threshold Trading Method is equally
well equipped for dealing with bearish trades as it is with bullish
ones. Remember the basic rules of threshold trading:
1) Trade in the direction of the next longer trend.
2) Identify three levels of support.
3) Identify three levels of resistance.
Most bearish trades are very short-term in nature; therefore, your
highest-probability put trades will generally come in stocks in
intermediate downtrends. Identifying three levels of support will help
you identify likely exit thresholds, while identifying three levels of
resistance will give you an indication of where your entry thresholds
are likely to be. The range between current support and resistance
levels in relation to the current price of the stock will also give you
a way to determine if the time is right for the trade or whether you
should wait for a specific event first.

Deciding How Much Time to Buy


The question of how much time you should buy is an important part
of a successful options trading system. The way you answer the
question will be dictated, as with most questions related to risk, in
large part by your personal aggressiveness and tolerance for risk.
There are a few different ways to apply a put options trade, which
are outlined later in this section. Each of these strategies and setups
has a slightly different perspective associated with time decay risk.

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Notes
Go through each strategy thoroughly and practice them on paper so
you can be well associated with the impact time decay will have.
To simplify their system, many traders will simply apply the same
logic about time decay in put options as in call options; they look
to buy more time than they think they need. This can be a good
guideline to follow in put trading, but you should remember that put
options with longer expiration dates tend to be even more expensive
than equivalent call options. Dont fall into the trap of buying several
months away from expiration in put options. This can make a call
trade more conservative and increase the chances of a successful
trade, but in the case of put options, the extended time in the
contract tends to detract even more sharply from the effectiveness
of the trade than in call options.
The reason buying more time in a call contract is a good strategy
to apply lies in the fact that stocks tend to go up more than they
go down over time. This is also the reason that buying more time
when you trade puts is more dangerous. If your short-term forecast
leads you to believe a stock is going to drop significantly enough to
warrant a put trade, you should generally look to buy no more than
one month longer than you believe the drop will take. If the stock is
going to drop, it will generally happen sooner rather than later. The
longer you hold onto a put trade in a stock that is showing resilience
at a support level, the less likely the stock is to actually drop for you.
In the meantime, the put option will continue to decay throughout the
period you hold it. If you do eventually happen to get the drop you
had previously anticipated, the stock will have to drop more than
your original analysis predicted in order to yield a respectable profit.
At this stage, time decay will likely have eroded the value of your
option to such a point that you wont be profitable. You will usually
be better served by keeping a short-term perspective on put trades
and getting out of them quickly if the stock doesnt drop the way you
thought in a short period of timeeven if the stock hasnt violated
your stop loss price.

Finding Stocks to Trade with Put Options


There are a number of methods you can use to find stocks that
provide good trading opportunities with put options. Some of the
tools available to you include:

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Guide to Options Strategies

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Your brokers website
Your watch list
Seeker scans

Your Brokers Website


Most online brokers provide several tools to help their account
holders find trading opportunities. Many of these tools, if used
properly, can give you timely information about stocks that are
ready to make downside moves. Familiarize yourself with any
searching tools your broker offers, and contact them with any
questions you have.

Your Watch List


A broad, sufficiently large watch list will help you keep track of
stocks you are already familiar with and identify opportune times
to place tradeson both the long-and-short side of the market. By
now, you should have already created a watch list with numerous
stocks in it. A broad watch list is one that includes stocks from a
wide range of sectors and industries. Many traders tend to focus
on one sector or industrytechnology or pharmaceuticals, for
examplebut in doing so they actually limit the opportunities
they get to take advantage of. The broader the list is, the more
opportunities you will have to place trades in any kind of market.
This is because when one sector is down, you can almost always
find another that is moving up. At any given moment in time,
in any particular market or economic setting, there are always
sectors that move up or down in contrast to each other, while still
others move sideways, without any particular direction. Each of
these situations can be taken advantage of by smart traders, and
your watch list is the tool that will allow you to make sure you can
respond to whatever condition a given sector or industry is in.
Central to the operation and execution of an effective watch list is
the amount of time it takes you to analyze stock movements on a
day-to-day basis. Although any watch list can be effective, dont
forget that you have access to powerful, easy-to-use charting
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Chapter 4: Put Options

Notes
and analysis tools that will greatly simplify this aspect of your
trading system. With these tools, you can quickly analyze the
current market action on any stock and identify optimal trading
opportunities as they arise.

Seeker Scans
Seeker has a variety of scans that can help you identify stocks at
several different stages of a downward trend. Seeker scans are
based on specific types of stock movements over varying time
periods. These time periods can be as long as one week at a time
or as short as five minutes. In this section, the scans we describe
are specific to one-day periods and are just a few examples of
some of the bearish scans that you might find helpful. Experiment
with the scans yourself to identify the ones that you specifically find
applicable to your trading style.
Daily Swing Sell Watch list This scan identifies stocks in
current downtrends. Just as in an uptrend, a stock wont
always track close to its trend line. It will often extend away
from it, then retrace back towards it. A stock may do this
several times in a given trend. This is as true of stocks in a
downtrend as in an uptrend. This scan looks for stocks that
have dropped well below their downward trend lines, but
are now retracing back up to it. Stocks in this environment
are likely to bounce off the resistance found at the trend
and move lower again; this scan attempts to identify stocks
with good chances of bouncing lower before it actually
happens.
Daily Breakdown Short Watch list The stocks that this
scan identifies are typically at the extended top of an
upward trend, with a repeated failure to create new highs,
or are in already established downtrends. In both cases, the
stock will have entered a consolidation phase during the
most recent few days, meaning that the stock has begun
to trade sideways. In addition, their daily trading range
during this consolidation phase will usually be significantly
lower than in the time periods previous to the consolidation.
This lower volatility combined with a failure to create new
highs is usually seen as a bearish indication, which makes
many of the stocks this scan highlights worth watching for a
bearish move to confirm the downward forecast.
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Bear Area Stocks This scan identifies stocks in similar
situations to those that come from the daily swing sell watch
list, but provides more specific information. The bull area
or bear area on a stock chart can be seen by applying
multiple moving averages to a stock chart. The bear area
is identified as the space between downtrending 20-day
and 50-day moving averages. When a downtrending stock
rises above its 20-day moving average, the likelihood that
the stock will bounce off the 50-day moving average and
continue its downtrend is significantly increased. Since
this scan identifies stocks that have entered this bear area
within the most recent few days, you will be looking at
stocks that are likely to drop but havent done so as of yet.
You should make sure to wait until you get confirmation the
drop has occurred before taking a trade.

Put Options Trading Rules


Just as with trading calls or stocks, you will be more effective as a
trader with put options by following specific rules you have outlined
for yourself about the types of information you will look for. The
types of technical signals you should look for in put trades vary
according to where a stock is in its trend and trading range. These
signals are outlined more specifically late in this chapter in the Put
Strategies and Setups section. The use of trading rules doesnt
apply only to the technical signals you have decided you will wait
for. In options trading, it also applies to the information about the
contract itself: the strike price you want to buy at, how much time
you want your contract to carry, the risk you are taking contrasted
against the opportunity you have, and what you will do in the event
of either a profitable result or a loss.

Choosing a Strike Price


Choosing the strike price you will use in your put trade is a critical
question you must answer. Just as with call options, buying in-themoney puts is more conservative the deeper in-the-money you go,
while buying out-of-the-money contracts is more aggressive the
further out-of-the money you are. Whether you decide to go in-themoney or out-of-the money, a good general guideline to apply to
put trading is to not go further out of the money than the nearest
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Chapter 4: Put Options

Notes
out-of-the-money strike price to the underlying stocks current
price. Going deep in-the-money simply makes a trade more
conservative, but remember that by doing so you will have to place
a significantly greater amount of your money into the trade. Making
an options trade more conservative by going deep in-the-money
doesnt increase the odds that you will place a winning trade; it
only improves the likelihood that if the stock moves against you
and you need to get out, you will be able to do it without incurring
a large loss. Being able to minimize loss is critical to the success
of your options trading system, and this can be effective. Just
remember that you will be using larger amounts of your capital to
do so. The more money you put into a trade, the smaller your profit
will be if you are right, because your leverage is lower than with a
strike price that is closer to the current stock price.
Many traders prefer to defer the decision of whether to buy inthe-money or out-of-the-money contracts until they are ready to
place a trade. This means that before they place the trade, they
must complete another step in their analysis. In the last chapter,
we discussed using delta as a way to identify which contracts are
likely to provide the best value for the given opportunity you are
looking at. This analysis can be applied with equal effectiveness
to put options once you have considered how much time you want
to buy. Lets apply this analysis to an example.
To find a viable put, lets give ourselves as much advantage as
is possible. Lets look for stock that is losing price on increased
volume. Seeker has an excellent search engine under its basic
scan Top Losers on Increased Volume.

Figure 4.2

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Guide to Options Strategies

Notes
The results are in alphabetic order. We will select VLO because it
has a negative five-star rating and its price is above $20. At the
risk of sounding predatory, it has room to fall.
Figure 4.3 is a side-by-side chart comparison of VLO using a
60-minute chart and a daily chart.
In both time frames, the stock is headed toward the basement.
Notice in the daily chart, VLO has just broken through a triplebottom resistance at about $45. Further, the 14, 5, 3 stochastic
shows no sign of reversal.

Figure 4.3
VLO is currently trading at $44.56. We need to check news and
find why VLO is in this downward trend.

Figure 4.4
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Chapter 4: Put Options

Notes
Earnings is the culprit. Usually when a stock falls as a result of bad
earnings there is an initial opportunity created to take advantage of
the market shock and awe. Perhaps a five-point play. It is, in any
case, a short-term play. An initial trade with June Options may be
prudent. VLO is an energy stock. Going into summer is usually not a
wise time to bet against energy for a long period of time. Checking
for put options we obtain the option chart seen in Figure 4.5.

Figure 4.5
The June 45.00p are going for $2.82 at the ask. There is a
substantial volume on these puts and the delta is -48.46.
The June 42.50p (one strike price out-of-the money) are going for
$1.62 at the ask. There is respectable volume and the delta is -33.60.
If we compare the two respective positions to determine maximum
leverage we get the following results:
June 42.50p
June 45.00p

.3360/1.62 = .20
.4846/2.82 = .17

Said differently, for every dollar we invest in the June 42.50p we


will receive $.20. For every dollar we invest in the June 45.00p we
will receive $.17. That assumes, of course, that the stock goes the
direction we have anticipated.

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From this perspective, it appears the June 42.50p options are
the better play. They are not, however, the safer play. The laws of
probability always favor the plays that are just in-the-money as
opposed to those which are just out-of-the money.
Which option to buy is left to the discretion of the individual
investor. If there were a best solution, there would be no other
options sold at a different strike price.

Determining Your Time Objective


When using call options, a common principle many options traders
follow carefully is to buy more time than they think they need. This
approach minimizes the effect of time decay and allows a trader
the choice of staying in a trade longer if a stock shows strength in
its trend so as to maximize its profit.
It may sound logical to take the same approach with put options
trading, but be careful. Put options with longer expiration dates
tend to be more expensive than the call options with the same
expiration. This means that even though you can minimize time
decay in your put trade by buying more time, you will usually do
so at a much higher cost; the cost may be such that if the stock
moves in the direction you forecast, you wont get enough profit in
the trade to justify the amount you risked. This is simply because
of the fact that stocks tend to drop more quickly than they rise in
price. Corrections and downward trend reversals are harder to
maintain in most stocks than are rallies and upward trends. You
can generally assume that if the stock is going to drop, it will do so
in a short period of time; if you dont get the drop you anticipated
within a week to two weeks, it is unlikely the stock will give it to
you, and you would be best served to close out the trade and look
for something else. For this reason, a good guideline for choosing
your expiration dates on put options trades is to buy no more than
a month of time more than you expect it will take the stock to make
the drop you forecast.
Identifying how quickly a stock will likely drop to a support level
or to your target price is not an exact science and will vary
depending on the type of put trade you are placing.

98

It is important to note that there is an inherent danger of projecting


an option price based on the delta and theta. Because there are
actually six elements in an option formula, using just two of them to

Chapter 4: Put Options

Notes
determine the advantage of a one option position or that of another
by just using two of the six elements is overly simplistic. The
elements in the formula are:
n s = the price of the underlying stock
n x = the strike price
n r = the continuously compounded risk free interest rate
n t = the time in years until the expiration of the option
n

= the implied volatility for the underlying stock

n = the standard normal cumulative distribution function


Taking the time to gather all the data required by the Black-Sholes
formula to make an accurate projection is an exhaustive process.
An Excel spread sheet calculating all the elements in the BlackSholes formula and making two additional assumptions necessary
for a valid projection is illustrated in Figure 4.6. The two additional
assumptions are the predicted future price of the stock and the
date on which that price will occur. In this example, the future
date is arbitrarily set at June 10 and the price of the stock is
projected to drop an additional $5 on that date. Now, taking into
consideration all the dynamic formula elements, you can see from
the spread sheet that the 1st strike price in-the-money has a greater
rate of return. That option would be the June 45 puts.

Figure 4.6
In doing projected calculations without the benefit of a sophisticated
spread sheet, do not fall into the trap of using a static delta value
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Guide to Options Strategies

Notes
for movements greater than $1. As the price of the stock changes
so does the delta value. Assuming it will stay the same over a $5
movement of the stock is not a safe assumption.
When trying to figure out which expiration month you should use,
remember that if all other information is equal, buying adequate
time to let the stock move while minimizing the effect of time decay
is generally the best strategy. Again, remember that buying as
much time as possible may not be the most effective approach
January may or may not be more profitable or effective at managing
loss than November, for exampleso you have to find a reasonable
balance. Experiment in your first several put options trades with
different expiration months to develop a feel for how much time
works best in the application of your trading system.

Planning Your Exit


You are probably used to identifying a specific target price on
any stock trade you make. This target price is a level at which you
need to re-evaluate the stocks move and its current strength, and
determine whether it is time to get out of the trade or stay in it and
let the trend continue to work for you. Planning your exit helps you
to rationally and objectively manage the decision you have to make
once the stock has reached your target price; you have already
thought about what you will do when the stock gets there, so you
dont have to deal with indecision or what if questions. This is an
important element of a successful stock trading system, and it is
no less important to successful options trading.

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Notes

Figure 4.7
In Figure 4.7, we see that VLO stock has just broken through a
double bottom at approximately $45. Prior to that it broke through a
triple bottom at about $47.50. In the last seven trading days, it has
fallen six points. We are going to assume, given the trend, the news
and the time frame of the previous seven days, that the stock will
fall another $5 on or before June 10. There is nothing magic about
June 10. But if it has not moved to that point by that date, its time to
take your money off the table and look for another opportunity. If the
stock falls $5 three days from now, take a serious look at exiting the
trade. Once again, the only thing predictable about the market is its
lack thereof. The stop loss should be set at about 30% less than the
purchase price of the option. There are no hard and fast rules about
stop losses. All traders wishing to maintain a friendship with one
another agree to disagree on where to establish a stop loss. Set it at
your own comfort zone. If youre getting stopped out of your trades
too quickly, then make it more generous. If youre losing too much
before you get out of the trade, make it tighter.
Remember that when you are trading a put option, trying to
maximize a trend is usually more dangerous than advantageous.
Unless you see clear indications of continued weakness in the
stockhigh-selling volume along with an increasing number of
short positions, for examplethe best general guideline to use
is to sell your put and close the trade once you reach your target
price. If the stock does continue its downtrend, you will likely get
another trading signal before too much longer.

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Notes
The next section will demonstrate specific applications of planning
your exit following the principles discussed here.

Put Strategies and Setups


In general, there are three specific strategies you can apply to
put options:
1) Stocks beginning new downward trends
2) Stocks in current downtrends
3) Trendless stocks trading at the upper end of
a trading range

Stocks Beginning New Downward Trends


Stocks that have just begun or are about to begin new downward
trends provide the earliest opportunities to place a put options
trade. Just as we like to buy calls for a stock at the earliest
confirmed indication of an upward trend breakout that we can find,
buying puts on a stock at the earliest confirmed indication of a
downward trend breakout that we can find provides the greatest
overall opportunity to reap a significant profit. Look at Figure 4.8.

Figure 4.8
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Chapter 4: Put Options

Notes
The stock in Figure 4.8 has begun to make a significant move to
the downside and just started a downward trend. It moved below
its 50 sma three days ago.
The 50-day moving average is often a critical support point for a
stock in an upward trend; professional investors and institutions will
often watch for a break below this level as an indication of a genuine
trend reversal. Lets apply our threshold analysis to this stock.

Threshold Analysis
Look at Figure 4.9

Figure 4.9
The stocks primary and intermediate trend lines are clearly moving
up; however, the stock has found significant resistance at the
$67.50 level. An attempted breakout at the middle of April and
again near the end of the month failed very quickly, which lends
even more strength to the resistance at this level. In addition, at
todays close, the stock closed below the support provided by the
primary trend line. Even though todays price action was positive, it
failed to rise above the intermediate trend line, suggesting that the
stock may now be finding resistance in that price area. The volume
three days ago as the stock broke below the 50 sma was quite a
bit stronger than the volume of the last week, while the volume for
todays attempted rally was measurably lower than yesterday. All of
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Notes
these readings point to an overall bearish current view of this stock.
The factors just described can all be taken as early indications of a
bearish trend reversal, at least for a short-term trend time frame.
The stock is presently around $65.71; its most immediate level of
support is now around $65. Lets assume that if the stock closes
tomorrow or the day after below the current support at $65, we
would want to initiate a put options trade. This would apply a simple
price filter to our threshold analysis; we could also stipulate that
selling volume continue to be at least as large as the volume shown
in todays upward move to add an extra filter and make the trade
even more conservative. We will place our entry price at around
$64.75; if the stock reaches this area, we will buy a put option.
Additional support can be seen around $63 and $60, as
demonstrated by the upward trending primary trend line. Since
our entry point is quite close to the secondary support, justification
for the trade can only be made if there is strong evidence that the
stock will fall to at least $60.
Looking at a risk-reward graph on AFL in Figure 4.10 and
projecting 15 days into the future with a predicted stock price
falling to $60.00, we buy 10 contracts of the June 65p at $1.85.
According to the risk graph (which considers all the Black-Scholes
elements) our puts will be worth $3.37 per share or $3,373.
Our purchase price was $1,850. That is a net profit of $1,523.

104

Figure 4.10

Chapter 4: Put Options

Notes
Trying to jump into a put trade on a stock that appears to be on the
verge of starting a new downtrend can be tricky and somewhat
hazardous. Naturally, you have to be wary that the downside
breakout you are looking at isnt actually a fakeout; this is why
you need to be careful to apply filtering rules to the signals your
threshold analysis gives you just as you normally do on bullish
trades. The other aspect of downward trending stocks that often
makes this a difficult trade to actually place lies in the increased
volatility stocks often experience as they initiate a new downtrend.
Look at Figure 4.11.

Figure 4.11
Early in May CCOI began a strong uptrend. However, in the face of
disappointing earnings, it gapped down almost five points.
This type of action is fairly common in stocks as they begin a new
downward trend. Extreme sell-offs that trigger downward trends
often force the stock to exceed its normal daily trading range by a
large amount, which produces the gap we see in Figure 4.11. If the
gap is large enough, the stock can often find support very quickly
at the bottom of the gap space, meaning that if you didnt get into
the put trade before the gap occurred, there isnt likely to be much
downside left in the stock.
One of the mistakes traders will make when they see a move such
as this is to chase the stockthey will be afraid that if they dont
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Notes
get in as soon as possible, they will miss whatever opportunity
might be left. Dont let an extreme move to the downside ruin
your objectivity; a simple way around the problem is to ignore the
stock for the rest of the day and see what its movement is like the
next day. Be careful to identify the current support and resistance
thresholds that apply to the stock now; if it continues to move lower,
for example, closing just below todays low price on higher than
average volume, there may still be enough downside room left to
afford you an opportunity to trade.
In these situations, you should also remember that although a
stock may be poised to experience a significant drop, any positive
catalysta favorable guidance report, a bullish analyst upgrade,
etc.could also cause the stock to move to the upside and begin
a new uptrend. This is why you should make sure to wait until the
stock actually does break below support and begin the downtrend.
If it breaks, it could gap lower, which means that you should expect
to miss many of these moves. The gaps often mean that your
reward-to-risk ratios in the trade no longer work in your favor. Since
your objective is to identify trades with the highest possible odds
of success, understand that many of these moves will happen so
fast that you wont be able to take advantage of them, and that
is all right. There is always another opportunity. In fact, when you
miss moves in stocks that gap lower, your next approach should
be to watch for the next setup: stocks that have already begun a
downward trend.

Duration of the Trade


Trying to take advantage of the drops a stock makes as it begins
a new downtrend can provide opportunities to take greater
advantage of the price range of a downtrend than many of the
other strategies that can be applied to put options trading.
However, remember that downtrends typically arent as easy to
sustain for extended periods of time as strong uptrends. Because
of this, few downtrends actually last longer than a couple of
months. In general, one of the most effective strategies to use
when planning a put options trade in a stock that is about to begin
a new downtrend is to purchase sufficient time to allow the stock
to begin the downtrend and make a large enough move to give
you a good profit. But planning to stay in a put trade throughout
a downtrend is a risky and expensive trade. Once you have
identified the most immediate support thresholds for the stock you
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Chapter 4: Put Options

Notes
are about to trade, you should be prepared to exit your trade and
lock in your profits at these levels.
Look back at Figure 4.11.

Figure 4.11
CCOI dropped from $32.50 to $30.97 and broke its 50 dma. If you
entered the trade here and purchased 10 put contracts, you would
be in a favorable position two days later as the stock fell to $28.42
as seen in Figure 4.12.

Figure 4.12
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The eternal question do you take your profit or let the play run?
Assume the put option cost $1 per share. The stock fell in price about
$2.50. The option probably increased in value $1.25. Youve made
over 100% on your investment. You may seriously wish to consider
taking the money and running. Frankly theres not time to perform
additional analysis. The stock can stabilize or run the other direction
just as quickly as it fell. Reconsider the trade and if the indicators
signal re-entry you can get back in, but protect your profit first.
It is common for a stock initiating a new downtrend to breakdown
and then find support. However, when it does finally find support,
the stock typically will attempt to fill the space between support
and those previous highs. Fighting against a new downtrend, the
stock will require a greater amount of time to fill a portion of the
space before any further action occurs that could continue the
downtrend. This rally attempt, and the time it takes, will erode your
profits at rates that you may not be able to recover from if the stock
does continue its downtrend. The moral of the story is simple: If
you are fortunate enough to get into a put trade at the beginning
of a new downtrend, be prepared to take your profits as soon as
the stock finds support. Thus, you should plan to purchase only
enough time to allow the downtrend to continue. Purchasing more
than two to three months time in this type of put trade is usually
more costly than it is effective.

Stocks in Current Downtrends


Look at Figure 4.13.

108

Figure 4.13

Chapter 4: Put Options

Notes
HMC began a new downtrend near the first of May and continued
by breaking below its 20 sma shown in Figure 4.13. It dropped
from $33 to $31 in five days. While this is not a substantial amount
it promises a $3 stock play or perhaps a $2 option play in the
next five to eight days if it holds pattern. Assuming the $30 puts
initially cost around $2, that approaches 100% return in a very
short period of time. Stocks in these situations can provide good
trading opportunities if you can apply a little patience and wait for
the proper signals. These are generally considered to be the types
of put options trades that carry the least risk since the stock has
already begun a downtrend.
Just as a stock in an upward trend will experience occasional
retracements to its trend lines before bouncing and continuing
upward, a stock in a downward trend will experience occasional
short rallies to its downward trend lines, then bounce and move
lower. These bounces are the put options trading opportunities you
should look for in these situations. Lets discuss how to identify the
signals that you can use to take advantage of these opportunities.

Threshold Analysis
Look at Figure 4.14.
Figure 4.14

Figure 4.14

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SGR has been trending downward since the last part of February.
Over the past 10 days, the stock has consolidated. It appears to
be finding substantial support at the $50. It hit this bottom three
times since April (strong triple bottom signal). That can be a basis
for a return to the $55 level. However, if it breaks through the $50
support, it may be an excellent put play. Stochastic and MACD,
while not conclusive, do not show positive direction.

Confirmation Indicators
In this type of put trade scenario, paying attention to the direction
of the MACD histogram and stochastic lines can be helpful. The
MACD histogram in particular can aid in the timing of your put
trade. Look at Figure 4.15.

Figure 4.15
As a stock in a downward trend attempts to rally above its
downward trend lines, watch the MACD histogram carefully.
The end of the rally can often be found when the histogram
makes a peak, then drops off of the peak. It isnt necessary for the
histogram to cross the zero line; if you wait for this to happen, the
drop you are looking for will have already occurred and you will
miss your opportunity.
Although stochastic doesnt necessarily provide a trading signal in
this kind of trade, it can be used to provide additional confirmation
of the analysis that has led you to consider this type of trade. In
Figure 4.15, we can see that stochastic has moved strongly to the
downside. This is an indication of the lack of bullish momentum in
the stock, and lends credence to the trade we are considering.

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Notes

Warning!
Be careful about trying to maximize the downward trend in this
type of trade. Remember that downward trends are generally
harder to maintain than upward trends. This means that the
bounce you identify may be the only bounce the stock will see in
a downward trend. This is usually truer if the underlying stock has
strong fundamentals behind it. Some traders will purchase more
time for their put option trade to attempt to stay in the downward
trend for as long as possible. This is risky since longer-term
put options tend to become quite expensive and staying in a
downward trend hoping for an additional bounce lower increases
your exposure to time decay in the put option. Generally, the best
approach is to buy enough time to allow the stock to make the
short-term drop you forecast, and be ready to take profits once it
reaches your target price. If the stock does continue its downward
trend or stage another rally to its trend lines, you may have an
opportunity to place another low-risk put trade by applying the
same method again, but since you would be waiting for the
bounce lower to begin, you dont expose yourself to the same
risk you would if you were already in the play and the stock broke
resistance to begin a new upward trend.

Duration of the Trade


One of the advantages of using put options on stocks that are
bouncing lower off of trend-driven resistance is that this bounce
will usually lead to a continuation of the downtrend. Stocks that
bounce off their downward trend lines will often bounce more
than once, providing multiple opportunities to use this strategy.
However, you should plan to use a separate put trade for each
bounce rather than purchasing a single put option with enough
time for any bounces lower the stock could make.
A bounce off resistance in a downward trend will usually only last
a few days to a couple of weeks at the most; planning to be in a
put trade for a longer period will place you at risk of eroding your
profits when the stock moves in your favor. Thus, this type of move
usually works well with put options that have an expiration of no
longer than one to two months. Using these shorter expiration
periods will also reinforce the need to take quick profits when you
have them rather than trying to stay in the trade hoping the stock
doesnt find resistance. Look at Figure 4.16.
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Figure 4.16
Notice that WB has been in a downtrend since mid-October.
After reaching $30 in mid January, it rebounded to around a
consolidation point of $37. The news about the financial sector has
been unkind, even in its positive moments. Assume you believe WB
is going to continue to fall. Because of your belief, you bought a
March $40 put for $2. On March 14, the stock closed at $26.54.
You have a $10.50 move on the stock and probably a $7 increase
in the value of your put now showing a value of $9.

Trendless Stocks at the Hig End


of a Trading Range
Lets look back at Figure 4.13.

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Chapter 4: Put Options

Notes

Figure 4.13
From late 2004 until May, SYMC began a strong downtrend that
provided several good put trading opportunities. Since then,
through the time represented in the chart, the stock has been
trading largely within a fairly specific trading range. These trading
ranges, or channels as they are often referred to, can provide
reasonably good put option trading opportunities as long as
your analysis of the stock, from a fundamental and technical
perspective, doesnt lead to a bullish attitude for the near future.
Assuming that factors such as news, earnings announcements
and supply and demand continue to confirm the current trendless
environment, this is considered to be a relatively low-risk, shortterm put trade.

Summary
Put options provide abundant opportunities to take advantage of
the downward price swings all stocks make. Smart traders make
sure that they understand how to use both the bullish and bearish
sides of the market to their benefit, because it gives them the
ability to potentially profit no matter what direction the market is
actually moving.
Doing technical analysis on a stock for put option opportunities is
no different than the analysis you would do for any stock; applying
the Threshold Trading Method to your analysis will help you identify
clear put option opportunities and what the stock must do to give
you a high-probability put trade.
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Although stocks do occasionally experience long, extended
downtrends, trying to maximize profit by buying more time in put
options generally increases your risk in the trade. An effective
guideline for understanding how much time to buy in a put trade
is to buy no more than one to two months longer than you think it
will take the stock to drop to your target price. Once the stock has
dropped to your target price, get out and take your profit.

114

Covered Calls

One of the most conservative


options strategies for any investor is selling
covered calls.

Many investors shy away from trading


options because of the perception that
options trading involves an extremely high
level of risk. While there most certainly are
options trades that represent that extreme
high side of the risk equation, there are
also very conservative strategies that
options can be used for. One of the most
conservative options strategies for any
investor is selling covered calls. Many
investors use covered calls as an incomegenerating strategy. It can also be used to
enhance an overall growth strategy. This
section will discuss both approaches and
ways to identify stocks that address each
type of strategy.

What Is a Covered Call?


Why Should I Sell Them?
A covered call is simply a call option that
you sell on a stock you own. Remember, a
call option gives the option buyer the right to

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Notes
buy the stock at a specific pricea lower price than where the stock
will be if it goes up and the buyer chooses to exercise the option. This
is a right, not an obligation. They can exercise the option and buy the
stock, sell it to somebody else, or do nothing. As the seller, you take
on the obligation to sell the stock to the
buyer at the options strike price if they do exercise the option.
Most investors buy a stock because they like the company, right? So
why would you want to sell a call option on a stock you own when you
run the risk of having to sell the stock at a cheaper price?
The first answer to this question is to remember that successful
investors dont buy stocks just because they like the company;
they do it because they think it is going to go up or because there
is some other benefit owning the stock gives them at the time.
Successful investors will buy and sell stocks as quickly as their
analysis tells them it is necessary; selling covered calls gives them
a way to take in extra income on a stock while they own it that they
wouldnt have seen if they relied only on price appreciation.
The second answer is to remember that the covered call strategy is
generally a bullish strategy; you should only buy stocks you would
be willing to own, and selling covered calls means you have to
own the stock. The statement, The trend is your friend applies to
covered calls just as to trading stocks. You shouldnt sell covered
calls on a downward trending stock, because you shouldnt be
in the stock in the first place. If you plan your covered call trade
correctly, a worst case scenario where you have to sell the stock at
a lower price than you bought it at should be a rare occurrence and
should translate to only a small loss.
The third answer to Why would you want to sell covered calls? is
that selling a covered call on a stock you own (also called writing
a covered call) accomplishes two things: It provides a measure
of downside protection and can add income to your investment
portfolio.

Downside Protection
When you sell an option on a stock you own, you receive a premium
for that option. You recall that when you buy an option, you pay the
ask price, and when you sell it back to the market, you receive the
bid price. This is also true when you sell a call using the covered call
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Notes
strategy. You will receive the bid price for that option. This premium
is immediately credited to your brokerage account and can act as a
buffer against loss if the stock begins to drop.
Suppose you own 100 shares of a $30 stock. You sell a call option
and receive $2 from the premium, or $200. After you sell the call, the
stock begins to drop. The advantage you have over other investors
is that your covered call has given you a $2 buffer. Unless the stock
drops below $28, you havent lost anything. The downside protection
afforded by covered calls is a reason many long-term investors
make regular use of this strategy.
It is important to remember that you dont have complete downside
protection with covered calls. In our example, if the stock suddenly
dropped to $25 per share, you would quickly be in a net negative
situation and would have to take some kind of action to protect
yourself. Nevertheless, for stocks that you might take a longer-term
view of, covered calls can be a way to even out the volatility of the
stock and weather minor drops in price.

Income
Most investors who use covered calls do so primarily for the
income they provide. If you are in a situation where you need to
live on your investments, covered calls can be a perfect fit. It is
not unrealistic to potentially earn 2 to 5% per month on a monthly
basis when using covered calls. That works out to a much better
return on your money than you would see from a bank, CD, or
Treasury note! Each time you sell a call option, the premium you
receive is deposited immediately in your trading account. You can
then use the money as you wishpay living expenses, reinvest the
proceeds, and so on.
Many investors who are seeking long-term growth of their portfolio
will read the last paragraph and say, That isnt me. I dont think
covered calls would help me out at all. Not true! Although covered
calls are considered an income source, they can also be a valuable
component of an aggressive growth strategy. Suppose you have
purchased 100 shares of a stock at $30 and it has increased to
$40, and your technical analysis indicates the stock is approaching
resistance. Congratulationsyou have a 30% or more profit in your

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Notes
trade. So its time to get out, right? Maybe, but before you make that
decision, you might want to look at the current prices for the call
options on that stock. Many stocks at the top of an upward trend
dont start downtrends right away. Instead, they will often hover at
or around their high price for a period of time before they begin
to go down. This period of time can last anywhere from days to
months, but it isnt uncommon to see this kind of pattern last at least
a few weeks. Suppose you could add an additional $2 per share to
your account by selling a call that will expire in one month. Would
you? Why not, if your analysis leads you to think the stock might be
topping out but isnt likely to drop quickly? Instead of a $10 profit,
you give yourself a handsome $12 potential profitand $2 of that
comes to you immediately! If the stock continues to go up, you will
get called out and lock in your profit and move on to another trade;
if you dont get called out and the stock hasnt dropped, you can
decide whether to move on or try it again.
Now suppose you repeated this process at the end of each
profitable stock trade you made. An extra $2 per share on a single
trade may not sound like much, but what if you were to repeat
this process again and again over a period of time? Your trading
account would grow exponentially over time. This is one of the
secrets of the market that not everybody knowscovered calls
can be a major component of a successful, long-term wealth
building strategy.

Stocks to Use with Covered Calls


An important consideration in implementing a strategy for using
covered calls is to identify what kind of stocks you intend to use.
Specifically, you need to determine what level of volatility you want
to deal with in the stocks you will sell covered calls on. Volatility
has a dramatic effect not only on the potential downside risk of
a stock, but also in the valuation of its options.
In Chapter Two we stated that the options for highly volatile stocks
are typically overvalued. This is because the greater relative
volatility in those stocks makes them more attractive to speculative
options traders. The reverse of this mindset is that for the options
seller, overvalued options offer more attractive yields. It isnt
uncommon to find call stocks that offer options premiums in excess
of 10% under these conditions. The fact that the stock is volatile,
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Notes
however, means that you have to make sure the stock is one that
you would want to own in the first place.
This consideration follows hand in hand with whether you are using
covered calls to generate income or as part of a growth strategy.
If you are trying to generate income, highly volatile stocks may not
be appropriate to your needs, despite the higher premiums you
would collect. If you are trying to live off your investments, you likely
dont want to put your capital at great risk. Highly volatile stocks
make capital preservation more difficult, so the higher potential
reward may not be worth the risk. In these cases, looking for
covered call premiums of 1 to 2% per month is usually
a better idea. You will find less volatile, more conservative stocks
this way, and you could still be earning around 12% per year!
If you are an aggressive investor seeking long-term growth, you
will probably be trading more volatile stocks anyway, so you will
be in a good position to take advantage of the overvalued nature of
the options associated with these stocks. Remember to conduct a
thorough analysis of the stock first so you can completely evaluate
the risk associated with the stock.
Fundamental analysis is a key part of determining what stocks
you should use for covered calls. Its a simple concept: You have
to own the stock in order to write a covered call, and you have to
conduct fundamental analysis before you buy a stock anyway,
so it makes sense to conduct a complete fundamental check
before selling covered calls on any stock. Make sure that the
fundamentals of the stock are such that you would be willing to
accept the level of risk associated with it.

Covered Call Trading Rules


Any investment strategy, no matter how conservative or speculative,
must follow specific trading rules. You have learned about setting
and establishing trading rules already. This section discusses
how to expand the trading rules you have already established for
buying stocks to include an effective covered calls strategy. There
are several decisions you will have to make before you can sell a
covered call on any stock. These decisions are the additions to your
trading rules you will make.

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The assumption is made here that you have already determined
the stock fits your fundamental requirements and risk profile. Your
covered calls rules apply specifically to the direction of the stocks
short-term trend, which call to write, how much time to sell, analyzing
the potential downside, and how you will exit your covered call play.

Direction of the Trend


As stated earlier in this section, it is important to make sure that
the covered call trade you are about to make is consistent with the
direction of the trend of the stock. Make sure that you use the shortterm trend as your barometer; the primary reason for not using a
longer trend is that most covered call trades only last one month.
Using a longer trend than the trade would cover will likely result in
incurring unnecessary losses since longer trends such as the primary
or intermediate trends generally take longer to change direction.
Remember that to write a covered call, you have to own the stock.
In order to own a stock, it has to satisfy the original trading rules
you established. If a stock you may be considering for covered
calls wouldnt pass those trading rules, it doesnt matter how
attractive the premium might be; you should avoid the stock.
The direction the short-term trend should be going depends
on whether you are using covered calls to generate income or
enhance growth. Lets look at the graph in Figure 5.1.

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Figure 5.1
Although BRY pulled back in late April, it now continues a very
impressive trend to the upside. This is a fairly volatile stock.
An appropriate play might be to buy a long call.
Now look at the graph in Figure 5.2.

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Notes

Figure 5.2
Over the last six weeks, this stock has become range-bound,
meaning that it has found consistent support at around the $23
mark while resistance appears to be at $27 per share. Rangebound stocks are also considered to have a flat short-term trend.
Stocks in flat trends are generally the types of stocks that offer
the most reliable and attractive income-producing opportunities
through covered calls.
The trading rule that applies to using the short-term trend to
identify covered call opportunities is very simple: The short-term
trend of the stock should be moving upward or flat.

Selling Time
124

What expiration month should you use? This is an important


consideration you should account for as soon as you have
determined that the trend of the stock works for a covered call trade.

Chapter 5: Covered Calls

Notes
In Chapter Two, you learned that the more time an options contract
has built into it, the more it is worth. As an options seller, you can
garner larger premiums by selling more time. However, as a general
rule, you should focus on selling short-term call contracts. This is
because selling short-term, monthly contracts on a consistent basis
can give you a greater percentage return over time than selling a
single long-term contract. Selling long-term contracts also
increases the amount of time you are exposing yourself to being
exercised by the individual that bought your call contract.
Lets use some examples to illustrate the benefit of selling shortterm call contracts. Look at the options chain in Figure 5.3.

Figure 5.3
These contracts on CCU are about 37 days from expiration. The
current price for CCU is $30, meaning that the June 30c is at-themoney. If you own the stock, you can sell this contract for $3.30
at the bid. Thats an immediate return of 11%. For every $3,000
invested, you receive $330; 11% for 37 days is equivalent to
approximately 130% annualized.
If the stock doesnt move higher than $30, the contract will expire
worthless, and youll still have the stock and be able to sell another
contract for another month. 11% on a covered call contract is
uncommonly high; 2 to 3% is more typical. Suppose you get 2.25%
every month for 12 monthsthats 33.8% return on your money, not
counting commissions, just from writing covered calls!
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Notes
One wrinkle you should be careful not to forget is the effect of
commission costs on your returns. Remember that when you sell
a covered call, you will be charged a commission on that trade.
Your covered call premium needs to be high enough to give you
an attractive return after commissions. If your commission costs
are eating at a significant portion of your premiums$20 to $30 or
more per tradethen you should probably try to find a broker with
lower commissions.
Now lets compare our 11% return from short-term June call to a
longer period of time. Look at Figure 5.4.

Figure 5.4
This option chain is for the October 30c contracts, four additional
months of time. They are going $4.20 at the bid. Thats 14% rate of
return but it ties up our stock clear through the month of October.
As a general rule, we buy a stock and sell the next or current
months option contracts one strike price out-of-the money. Since
the 30 strike price is at-the-money, it is usually where we receive
the highest rate of return on our premiums. Also selling one short
month after another is almost always more profitable than selling a
long-term option with four to six months of time. Also, selling a call
with an expiration date four months into the future implies that you
are convinced you want to own that stock for that much time. That
may or may not be the case.

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The stock could experience a significant, extended downtrend.
This is the greatest danger associated with selling long-term
contracts. When you sell a covered call, you are required by your
broker to hold on to the stock for as long as you are liable for the
call contract. If the stock takes a sudden downturn, you cannot
sell the stock until you eliminate the obligation for the call contract.
You can remove this obligation by buying a call at the same strike
price (this is called buying the call back), but in the meantime,
you are sitting in a declining stock. This risk is greater because,
over time, any stock will experience declines. Concentrating on
short-term contracts lessens this risk since you are committing
yourself to a smaller amount of time.
Remember that the closer to expiration an options contract is, the
more time decay erodes the value of the option. This is another
reason selling short-term contracts is valuabletime decay
erodes the value of the option faster. As the seller, time works for
you rather than against you, as we are used to with the normal
buying mentality. If the stock stagnates or hovers relatively close
to the price it was when you sold the call, you wont lose any value
in your principal, but the likelihood of the call expiring worthless
increases, which lessens the value of the option. Suppose you
sold the June 30 calls and one week before expiration, the stock
price was still at $30. You could buy the call back for a very small
amount, say $.25, keep the difference of $3.25 and remove your
obligation to sell should the stock suddenly move past $30 before
the expiration date. This is a money management technique that
you wont always have occasion nor need to use, but you will find
situations where it will be in your best interest to do so.

Choosing a Strike Price


Next, you must decide at what strike price you want to sell. Just
as when you buy an option, you have to decide whether you want
to sell an in-the-money or out-of-the-money call. Many investors
look at this question primarily from the viewpoint of how much
money they will get in their premium. This is a limited perspective;
however, it only addresses the immediate benefit of the trade and
not the potential risk or downside of the covered call itself.
Remember that in-the-money options are more expensive than outof-the-money contracts. This means that selling an in-the-money
covered call would translate to a higher immediate payment to
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Notes
your account. It also means that the person who buys your option
could immediately exercise the option and buy the stock for a
lower price than it is at right now; this is the rare exception because
most traders wont exercise an options contract until or close to
the expiration date. However, if you sell in-the-money options,
remember that if the stock is still in-the-money as you approach
the expiration date, you probably will be exercised.
Most buy-and-hold, long-term investors avoid selling in-the-money
options, while traders who are simply trying to supplement and
enhance growth use them actively. If you do decide that selling an
in-the-money option might work for you, make sure that the strike price
you sell the option at isnt so low that it completely offsets the premium
you receive if you are exercised. You want your covered call trades
to produce a net profit, not result in a zero-sum transaction.
Out-of-the-money options dont produce higher premiums like inthe-money contracts, but in order to be exercised, the stock will
have to increase in value above the strike price you have sold at.
This is the approach used by most traders who use covered calls
for income purposes because if they do get exercised, they will
be selling the stock at a higher price than where it was previously,
and they keep the premium they were paid at the beginning of the
trade. Although the premiums arent as high as for in-the-money
options, outof-the-money premiums can still be very attractive and
produce a win-win scenario for the astute covered calls trader.
We dont favor selling one type of covered call over another.
The simple fact is that each approach has its advantages and
drawbacks. Sophisticated covered calls traders dont limit
themselves to only selling one type of contract; they evaluate each
potential covered call on a case-by-case basis to determine which
approach would work better. Later in this section, we will examine
scenarios in which selling in-the-money options provides the
greatest overall benefit in using covered calls as well as those
in which staying out-of-the money works best.
After you have identified a stock you would like to sell a covered
call on, based on the movement of its short-term trend, and
determined how much time to sell, identify the at-the-money
strike price. If it is in-the-money, identify the first out-of-the-money
contract. If it is out-of-the money, identify the first in-the-money
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Notes
contract. Write down the strike price and the bid price for each
contract so you can begin to analyze each one.

Developing Your Exit Strategy


Before you sell a covered call, you should always make sure to
develop a specific exit strategy for that specific trade. This isnt
a new concept. Planning how you will end a trade is something
that you do for any trade, be it buying stock or options. It is just
as important to do the same thing when you are selling options; in
fact, covered calls have an added layer of complexity to deal with,
which make planning your exit absolutely critical.
This may sound counterintuitive in relation to the concepts of
selling time that were covered earlier. After all, when you sell a
covered call, you want the option to expire worthless, right? So all
you have to do is be patient and wait until the third Friday of the
month. This is only one way a covered call trade could end. There
are actually three possible scenarios, each of which requires a
different course of action, as listed in the following table:

Scenario
Stock stays below the
calls strike price.
Stock moves above the
calls strike price; buyer
exercises option to buy
the stock.
Stock drops below
its price when the call
was sold.

Action Required
None, the option expires
worthless.
None. The stock is
purchased at contracts
strike price.
Buy the call back and sell
the stock.

The first scenario is straightforward and easy to deal with; the


option expires worthless, you do nothing but keep the premium
that was credited to your account when you sold the call.
Realistically speaking, this is the most common scenario for
covered call sellers. It is also the least expensive, since you only
pay a commission to your broker when you sell the call contract.

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Notes
The second scenario can be straightforward if you dont mind
being exercised and selling out of your stock. You need to
remember, though, that you will have two commissions to pay: one
when you sell the contract and another when you sell the stock.
What can complicate this situation is if the stock has made a
significant upward run well above the strike price of the option
you sold. Being exercised would mean selling the stock at a
dramatically reduced price compared to where it has risen; many
traders in this situation will buy the call back before expiration to
remove their obligation and allow them to ride the stocks upward
run. It is important in this situation; however, to compare the
increase in the stocks price to the cost of buying the call back. If the
stock has increased in value, the call option you sold will also have
gone up; often, the net result is the same as if you sold the stock at
the options strike price. The counterbalance to this problem is your
analysis of the stocks upward momentum. If you think the stock has
reached the peak of its run, it may not be worthwhile to buy the call
back; on the other hand, if your analysis leads you to conclude the
stock may still have room to continue increasing in price, you will
find it easier to justify buying the call back.
The third scenario is the most urgent of all, particularly if the stock
has begun a downward trend. Remember that as long as your
covered call position is open, your broker will not let you sell your
stock. The downward trend mandates action before your loss
becomes more severe, so you will need to buy the call back and
then sell the stock. In some cases, it is possible to sell the stock
before buying the call back, but since this would place you in a
naked position, meaning that you dont own the stock on a call you
have sold, you should pay particular attention to the sequence of
your orders.
In this scenario, you will lose money and incur your highest
commission costs because you have three transactionssell
the call, buy it back, and sell the stock. However, there is a silver
lining: buying the call option back will cost you less than you took
in when you sold it, and the difference will give you some cushion
against your loss. This situation is one of the principle reasons
the direction of the trend is so importantif you focus on stocks
in upward or flat trends, this extreme scenario will be the rare
exception to your covered call experience.
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Notes
When it comes to planning your exit, make sure that you account
for all three of these possibilities. If your analysis of the stock
leads you to believe that it wont rise above the strike price of the
option, be content to sit through the play and enjoy your premium
when the option expires. If there is a good chance you could be
exercised, be prepared to evaluate whether to buy the call back or
allow the exercise to happen. Analyze the downside of the stock as
well so you can identify specific price points at which you need to
take action.
This analysis is simpler than most traders think. If you paid $36 per
share for the stock, for example, and sold a call option for $1.50,
your actual cost for the stock is only $34.50. Technically, you could
allow the stock to drop to that price and you would still break even,
not including commissions. The point at which you would need to
determine whether to get out of the stock, to avoid a downtrend in
this case, would be when the stock dips below $34.50.

About Stop Losses


One thing about using covered calls you should always remember
is that when you write a covered call contract, your broker will
generally not allow you to place a stop loss on the stock. This is
because if you were to get stopped out of a stock you have written
a covered call on, you would still be liable for the contract even
after selling out of the stock. You would be in a naked call position,
which you might not have permission for. Most brokers prefer to
avoid this added complexity and simply dont allow it. This means
that when you write a covered call, any stop losses you might use
are mental stop losses only; identify a price level where you would
simply have to move on, but be very careful about watching the
stock every day to see if that circumstance comes to pass. Daily
vigilance is very important to a successful covered call strategy.

Income Strategies and Setups


The purpose for this section is to take the information we have
covered to this point and apply it to specific trades that would be
effective in generating covered call income.
Lets start by assuming you purchased SOL stock around the
middle of May at $15. The current price is now around $19.47 after
trading around the $17.50 mark for the last 15 days. You check the
MACD and stochastic indicators to assist in the decision-making
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Guide to Options Strategies

Notes
process of identifying the trend. You see they are in the upper part
of their buy-sell signals and indicate that the stock is on course to
maintain its upward trend.
Checking the profile on SOL you see that it is engaged in the
manufacture and sale of solar wafers in the Republic of China. Its
last consensus earnings estimate was $.27. SOL made $.34. This
is a very positive sign. Finally their guidance is positive for the next
quarter. It would appear that the stock will not decline in value in
the foreseeable future.
Another factor that could make this stock attractive for generating
income with covered calls is the fact that over the past four months,
the stock has maintained a steady upward growth but has not had
serious gaps up or down. This is the type of steady-growth stock
that investors seeking income like to look for with covered calls.
The table in Figure 5.5 gives us the call option chain for SOL. Since
there is very little time left in May, we will look at June.

Figure 5.5
Although we only paid $15 for the stock, we look at the next strike
price out-of-the-money. The stock is currently at $19.47. That
means we look at the June 20c.
They are going for $2.50 x $2.70. Because we sell at the bid and
buy at the ask (remember we are the retail side of the market), we
can sell this option for $2.50.
The returns are impressive.

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Chapter 5: Covered Calls

Notes
Date

Day of
Expiration

Days to
Expire

Stock
Symbol

Stock
Price

Option

Bid
Premium

Static %
Rate of
Return

Annualized
% Return

11-May-08

20-June-08

40

SOL

$ 19.49

June 20c

2.5

13%

117%

Figure 5.6
Although the original purchase price was $15, it is prudent to
use the next strike price out-of-the-money from the current stock
price of $19.49. We do not want to sell the stock for a strike price
of $17.50 because it is a growth stock. There is a high probability
that the stock will be above $20 on the day the option expires. The
math is simple. If we sold the $17.50 strike price we would receive
$3.60. If the stock closes anywhere above that price on the day
of expiration we would receive an additional $2.50 (the difference
between our purchase price and the $17.50 stock price). Net
received: $2.50 + $3.60 = $6.10. If we sell the June $20c and the
stock closes above $20 when the option expires, we receive $5.00
+ $2.50 = $7.50.
Note: Stocks change personalities. A growth stock can reach an
unexpected maturation price and stay in a trading range for five
years (Microsoft). Other stocks can break out of their flat-trading
range and double their price unexpectedly (CBI). If you play every
stock as though it were not going to break out of its trading range
in the foreseeable future, and it does, youll have the pleasant
surprise of making more money. You make more when the stock
is called away than you do just selling the premium. If you make
a covered call play on a stock with a strong uptrend, you are
probably using the wrong strategy. To capitalize on a stock in a
strong uptrend, you may wish to consider a pure call play.
Usually the best approach to a covered call play is to stick with
stocks that are basing sideways or trending slightly upward. If you
wish to build a long-term investment portfolio, then play blue chip
stocks with moderate covered call returns and good dividends.
You can receive a sustained revenue stream from the calls. Usually
mature stocks have very small monthly covered call returns. Longterm investors sell three to four months of time in their covered call
positions. They also benefit from dividend payments.

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Notes

Growth Strategies & Setups


Although most covered call sellers do so for the purpose of
generating income, even aggressive traders seeking growth to
build wealth over time can and should look for opportunities to use
covered calls. Aggressive traders actively look for opportunities to
exit profitable trades. Proper application of covered calls gives you a
way to set up your exit strategy beforehand at a specific price, while
adding to your total return in the trade with the covered call income.
Using covered calls to supplement growth as suggested in this
section is counterintuitive to many traders. Those traders who buy
and sell stocks on an active basis tend to focus on the simple
appreciation of the stockthe difference between the price they
bought the stock at and where it is now. In order for an active trader
to want to stay in a stock, it must demonstrate strength in its current
trend. Writing a covered call on a stock in a strong upward trend
increases the likelihood that you will have to sell the stock at the
strike pricewhich would be a lower price than the stock will be at
when you are called out. Why count yourself out of potential profit?
The appropriate strategy lies in your attitude and approach to
trading. Think of it this way: You can take a known amount of return
early in a stock trade or you can try to take an unknown amount of
return later on. If a stock is in a strong upward trend, its call options
are likely to be priced at a higher premium than they would under
normal circumstances. These premiums represent that known
amount of return. Although you take the chance of getting called
out if the stock continues its upward run, if you plan the trade
correctly, you can combine the covered call premium with price
appreciation to realize an attractive overall profit. The strength of
the upward trend makes the downside risk of writing a covered
call less than it might normally be due to the support the stock will
usually see at the price level of the current trend line.
This is a conservative approach to selling stocks because you bring
in extra return at an earlier stage of the trend than you might by
selling at the end of an upward trend. The known return dynamic
means that the returns you realize this way generally wont be as
high as they could be if you extend your trade throughout an upward
trend. The alternative, of course, for a stock in a strong upward trend
is to stay in it, adjust your stop loss upward or scale more money into
the stock, and ride the upward trend for as long as possible. If you
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Chapter 5: Covered Calls

Notes
are an aggressive investor and arent willing to sacrifice the potentially
greater appreciation prospects of a stock for covered call income,
dont use this strategy. Determining whether this strategy works for
you lies in whether you would prefer to take what known profit you can
get for a relatively small amount of risk, or take the chance of greater
profit further down the road. One approach is not better than another;
it depends completely on you and your attitude about taking profits.
However, many smart, aggressive investors do look for opportunities to
supplement growth through covered calls when the time is right, so it is
worth your time to become familiar with how it works.
Earlier, we discussed strategies for using covered calls to generate
income on stocks you own. This is a regularly recurring strategy
that in many cases is repeated on a monthly basis. Supplementing
growth with covered calls is a strategy that is used less frequently;
you might write a covered call only once every two or three
months, depending on how often you trade and what your time
frame is for cycling in to and out of a stock. This is an important
distinction; as a growth investor, you are still going to be looking
for appreciation first. The covered call income you can generate
doesnt come until you have already gotten into the stock and
realized a positive return in it.
Lets look at a stock that may be a good candidate for this strategy.
Look at Figure 5.7.

Figure 5.8

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Notes
In the in Figure 5.7 chart, AA is cycling with several days of strong
rallies. It has increased in value from $35 to $39.
Assume you purchased the stock at $27.50 last January. At this
point youve recognized an $11.50 profit on a stock that is a DOW
component.
Since March it has bounced off $39 three to four times. Youd
like to take profit, but wouldnt mind holding onto the stock if it
falls back to the $35 level as well. Stochastic and MACD are also
indicating a retracement might be in the near future.
Look at the option price for the June40c.

Figure 5.8
As you can see, the premiums are $2.41 x $2.51. You can sell
the June 40c for $2.41. If on the day of expiration the stock is
trading above $40, it will be purchased from you. Said differently,
your position will be assigned. You will recognize the difference
between your purchase price of $27.50 and $40. That is a $12.50
profit as well as the $2.41 you received on the June premiums.
Essentially, you sold your stock for $42.41. and made $13.91 on
the trade. If, however, the stock pulls back and is at a number
lower than $40 on the day the options expire, you still have a $2.41
profit, you still own a strong stock and you can wait until the stock
reaches resistance again and sell another call. Buying and holding
can be a very profitable strategy, when combined with a covered
call at the apex of the stocks trend.

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Chapter 5: Covered Calls

Notes
Successful traders will always make sure to evaluate support and
resistance thresholds before they get into a stock trade. They use
resistance to identify price levels at which they should be ready to
sell the stock. These resistance levels will often have call option
strike prices that match or closely approximate them, so anytime
you get into a stock trade it could be a good idea to evaluate the
value of selling an out-of-the money covered call. This is why wise
growth investors make sure to consider including a covered call
in any stock trade they make. The numbers wont always bear
themselves out to give returns as attractive as those shown here,
but when they do, be ready to take advantage of them!

Summary
The covered call approach is a conservative strategy that can be
used both to generate income as well as enhance long-term growth.
Properly used, this can provide income or be a major component of
a long-term, wealth-building plan.
Selling options places you on the opposite end of the time/risk
equation; time works for you rather than against you. Make sure
that when you are thinking about covered calls to consider both
in-the-money and out-of-the-money contracts, and that you carefully
analyze the current trend of the stock. Be vigilant when you are in a
covered call trade to make sure you can react properly to extreme
changes in the stock. Think beforehand about how you will get out
of the covered call tradedecide ahead of time if you will allow
yourself to be exercised if the stock moves above your strike price,
and how far you will let the stock drop before you buy the call back
and sell out of the stock.
One final word of caution: Making annual projections based on a
monthly return is a very disappointing game to play. You might get
15% in one month on a specific stock and see returns of only 3%
the next month. A stock generating respectable option returns will
not continue to do so throughout the year. As stated earlier, stocks
change their personalities. It is incumbent on the wise investor to
learn to recognize when a stock moves into a trading range that is
no longer dynamic in terms of generating high-option returns. Also
be careful not to play stocks that have high rates of returns, but are
in a flat-trading range. It is usually a sign that the stock is going to

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Guide to Options Strategies

Notes
drop in value. Picking stocks is an art as well as a science. Learn
to judge the personality of a stock as well as its current returns. The
market suffers fools poorly. Those believing they have an unfailing
knowledge of its undercurrents are destined for hard and abrupt
reality checks.

138

Options
Strategies
with Leaps

You can use options on longer trades


intended to take advantage of intermediate
and primary-term trends.

Up to this point you have learned about


using options to take advantage of shortterm moves, both on the upside and
downside, using call and put options.
You have also learned about using covered
calls to generate income and enhance
overall returns in your stock trades. All of
these strategies are intended as relatively
short-term strategies; however, option
trading isnt limited only to short-term
trading. You can also use options on longer
trades intended to take advantage of
intermediate and primary-term trends.
This closing chapter will discuss how to
use LEAPS to do this.

LEAPS Defined
Put simply, LEAPS (long-term equity
anticipation securities) are options contracts
with a duration of six months or longer.
LEAPS contracts all carry a uniform January
expiration date; the only difference from one

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Guide to Options Strategies

Notes
contract to another is the year of expiration. LEAPS contracts in many
cases will be available for a given stock for a period of anywhere
between one and three years.
Just as not all stocks offer options, not all stocks that offer options
include LEAPS. Options contracts are offered and listed by the
Chicago Board of Options Exchange, not the company underlying
a stock. In order to offer options on a company, the CBOE usually
waits to see the stock establish a fairly consistent level of interest so
as to ensure the liquidity of that particular options market. The list of
stocks that offer LEAPS in addition to shorter-term options contracts
is considerably smaller than that of stocks that offer options;
however, the list is growing regularly as LEAPS become more and
more popular. LEAPS offerings include calls and puts just as any
short-term options offering.

Strategies for Using LEAPS Options


There are several ways that LEAPS options can be used; these
strategies make LEAPS options attractive for virtually any trading
system. This section will outline each strategy and the generally
accepted best way they can be used. You may not necessarily use all
of these strategies or find them applicable to your goals and trading
style. Thats okay! Go through each one carefully and think about how
it may apply to your trading system. Odds are that at least one of the
following strategies will be a good fit for your trading style and goals.
You may even find that they are all attractive for your needs.
Note: The strategies listed here are not comprehensive. There are other,
very advanced strategies for using LEAPS options that are beyond the
scope of this material.
Strategy I
Using LEAPS as an Alternative to Owning Stock

142

For many traders, one of the challenges of stock trading lies in the
considerable capital required to purchase shares of a company. If
a stock that trades at $50 gives a good buying signal, for example,
it would cost you $5,000 to purchase 100 shares. If you are starting
your stock trading with a small amount of capital, this could represent
a large chunk of your trading account. Although you can purchase
stock shares in any quantity you desire, the sizable amount of money
required to take advantage of significant moves in stock price
represent a significant stumbling block for many traders.

Chapter 6: Options Stragegies With Leaps

Notes
One of the things that makes options trading attractive is the
smaller capital outlay required to purchase a single contract. A call
option on the $50 stock in our example may only cost $5 per share,
requiring only $500. If the stock moves up, the leverage associated
with your option will cause the price of the option to increase in
value faster than a proportionate stock position. The downside
risk of short-term options, of course, is that if the stock doesnt
move the way you need before the contract expires, you can lose
a significant chunk of that $500, or even all of it. LEAPS options
provide a wonderful alternative to owning shares of a stock, with
two added benefits: They also take advantage of leverage when
the stock moves in your favor and they are affected to a much
smaller degree by time decay than shorter-term options.
Since LEAPS contracts last for a period of six months to three
years, buying a LEAPS contract gives you the opportunity to take
advantage of the longer-term intermediate and primary trends
without having to invest the larger sums of money it would take to
buy the stock outright. Look at the stock chart in Figure 6.1.

Figure 6.1
In this example, lets assume its May 2008 and this is the chart we
have before us. AAPL has experienced a significant upward trend
since March. The 30 sma and 50 sma are well below the price
indicating continual strength of the trend. We make the assumption
that AAPL will reach its 52-week high of $202 and then Steve Jobs

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Notes
will do a three for one split sometime in December. You could buy
a two to three call option or, in anticipation of AAPLs continued
dynamic behavior, purchase a LEAP that expires in January of
2009. Lets look at the two alternatives. The rules for short-term
options are fairly explicit in that, unless you are a seasoned options
player, you should stay conservative and buy one strike price inthe-money.

Figure 6.2
From Figure 6.2 you can see that the July 180 calls have a bid
of $14.55 x $14.75. Those are expensive optionsbut not when
compared to the price of AAPL at $183.16. That is probably a
good trade and given the current trend should return a profit on the
position. Unfortunately, it does not last through the opening of school
season, when many computers are purchased and it expires prior
to our anticipated split in Decemberagain a month where a lot of
computers are purchased. A LEAP may be a better alternative.

Figure 6.3

144

In addition to costing less than a stock, LEAPS have two other


attractive attributes. The delta on a LEAP is more generous than a
regular option and theta is less severe. That means all other things
being equal, a LEAP goes up in value faster than a two to three
month option and decays more slowly.

Chapter 6: Options Stragegies With Leaps

Notes
Further, if we follow the rule, except in special circumstances, to
only buy options that have a delta greater than .50, the Jan 10 230
LEAP calls have a delta of 50.42. They are actually five strikes outof-the-money. Still, every time AAPL goes up in price $1, the LEAPS
go up $.50. If we buy one strike price in-the-money on the LEAP, the
delta is 68.13. Using delta alone to calculate leverage presents a
distorted future price calculation. It does not take into account the
amount of time contained in the option contract.
Knowing the stock, and being aware of business cycles throughout
the year can be extremely helpful in determining if a LEAP is more
advantageous than a regular call.
Just as with short-term options, LEAPS provide leverage that
increases your profit opportunity as a percentage of the capital
invested when the underlying stock moves in the direction you
forecast. This leverage isnt quite as high as it would be on a
short-term contract because the time remaining on the contract
improves your odds of getting the move you want. This translates
directly to the premium you pay for the LEAPS contract; it is also
reflected in the delta value of the contract.
Clearly an option has greater leverage than a LEAP or the stock
itself. The great unknown is what will the stock do between now
and December? If the stock continues to trend upward as it has
for the last two months, then pure calls are the better selection. If
the stock maintains its annoying habit of pulling back radically as it
did in August of 2007 and again in November of 2007 (see Figure
6.4), then a LEAP is clearly the safer and better choice.

Figure 6.4

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Notes
The number of variables in the stock market, the economy, related
costs of goods sold and other factors is almost unlimited. Making a
decision based on leverage or rate of return between two options
with largely different time frames is probably extremely short sighted.
The best basis for making a decision on any investment is to
consider your overall objectives and tailor your strategies accordingly.
Remember also that LEAPS have two disadvantages when compared
to owning a stock. LEAPS decay with time and should a company
declare a dividend, the holder of a LEAP does not participate.
One approach to maximizing profit in a good trade that professional
traders use frequently is scaling in to a trade. This refers to placing
a smaller amount of the total capital you would be willing to risk in
the trade at the beginning, when the risk of failure is the highest.
If the stock begins to move the way you want, you can add to your
position until the entire amount you were originally willing to risk is
in the trade. This is a way to reduce risk and still take advantage
of a long trend. LEAPS options offer the same opportunity to scale
into a trade as if you had purchased the stock itself.
Consider the AAPL example. If an investor is willing to spend $183
for 100 shares of AAPL and the LEAPS at the $230 strike price
were $29.50, thats roughly 16% of the cost of the stock. Suppose
the stock reached its initial profit target and your technical
indicators signaled that the upward trend was likely to continue.
You could easily add another contract and achieve the same
scaling in effect keeping the LEAP leverage in place.
Strategy II
Using LEAPS Options in Place of Short-Term Options

146

Most traders who use LEAPS think of them primarily as vehicles


for longer-term investments. In this case, traders use LEAPS to
take advantage of option leverage, while approximating the nearly
infinite period of time a stock can be held, while still positioning
themselves for attractive short-term profits. However, conservative
traders can also use LEAPS as an alternative for short-term options
contracts. This approach applies a logic that is the reverse of
using LEAPS in long-term plays; it sacrifices some of the leverage
associated with the option in favor of the ability to minimize the
time decay associated with short-term options. Look at Figure 6.5.

Chapter 6: Options Stragegies With Leaps

Notes

Figure 6.5
AAPL made a strong move over the past two months moving up
some $60 per share. In the past three days it has pulled back.
If the stock reverses and continues its upward trend it may reach
the $200 mark achieved in late December
A simple options trade here would be to buy a call contract with
a duration of one to two months so as to maximize the potential
reward if the stock makes the $18 move between the current
resistance to its next resistance. The downside risk on such a trade,
of course, is that if the stock doesnt move up quickly, time decay
will erode the value of your contract to the point that you would
have to absorb a large loss. Many traders understand and accept
this risk, but dont think about ways to manage the trade beyond
using a stop loss or to make sure the trade is only a small portion of
their capital. Using a LEAPS option in place of the short-term option
is a good way to add yet another layer of risk management to your
trade; it minimizes the effect of time decay while still putting yourself
in position to reap a handsome profit if the stock moves the way you
want. Lets compare using a LEAPS option versus a traditional call
option using an example. Look at Figure 6.6.

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Guide to Options Strategies

Notes

Figure 6.6
If you were to purchase the July 180 call, you would pay $14.75
per share.
The January 230 LEAPS (delta > .50) are more than double the
call price at $29.50 because of the additional time. If we are
looking for the stock to go up by December, you could hold onto
the LEAPS without experiencing hardly any negative effect from
time decay.

Measuring Time Decay


Since the contract we are referring to in our example doesnt expire
until January 2010, you could hold on to this option for nearly
that entire period without experiencing the kind of severe price
degradation due to time decay that is so common to short-term
options. That doesnt mean that time decay doesnt exist in LEAPS
options; only that it doesnt begin to have a significant impact on
your trade until the contract is within three to four months of its
expiration. The effect of time decay on an option is reflected in its
theta value. Theta is a dollar value that indicates how much time
value an option will lose in a single day.
As an option gets closer to expiration, the theta value will increase in
the negative, reflecting the increase in time decay. This means that
every day the stock doesnt make a significant change in price from
its current level, your loss will increase on an accelerated basis.
You can minimize the effect of time decay by either buying more
time or by using an option that is deeper in-the-money.
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Chapter 6: Options Stragegies With Leaps

Notes
Since stocks, in general, tend to go up over time, the LEAPS option
gives you a greater window of opportunity to let the stock move in
the direction you need. With a longer time frame to work with, you
can usually afford to loosen your stop loss prices to give the stock
room to extend itself along the intermediate and primary trends
more than you can do with short-term contracts. This way, if the
stock moves the way you want in a short period of time, you have
given yourself the choice of either taking your profit, which will still
be attractive, or staying in the trade to maximize your opportunity
in the upward trend. These are both good choices to have, and the
more you can put yourself in this type of position, the more you will
be able to realize attractive profits in your options trading.

Leverage
At this point, you may be thinking, Minimizing time decay is
good, but if Im aggressive about the stock anyway and think
its going to move, why do I want to pay that much? Remember
that successful traders do everything they can to put the odds of
a successful trade in their favor. This is true whether they trade
stock or options. Putting the odds of success in your favor means
finding as many ways to minimize downside riskwhether it
comes in the form of price volatility or time decayas you can
possibly take advantage of. Using LEAPS options is a conservative
approach to taking advantage of short-term stock swings. AAPLs
price currently stands at $183.45, meaning that to purchase 100
shares of the stock outright for a short-term swing trade would
require $18,345. If the stock makes the $18 you would make just
under 10% on the trade. While that is a respectable profit, you are
risking $18,345 on 100 shares. Buying the LEAP risks $2,950 on
effectively the same position. If we assume an average delta value
of .70, all other things being equal, the value of the call would
increase $1,260 (.70 x 18 x 100). $1,260 / $2,950 = 42.7% return.
Quite a bit better return than the 9.8% received by buying the
stock. A LEAP also allows time for the trade to develop if it stalls
out in the first month or two.
This is the downfall of many options traders: They correctly
forecast the direction of a move, but guess incorrectly about how
soon it will happen. If you dont buy enough time to allow a stock
to move the way you want, you stand a much greater chance of
losing money on the trade.
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Notes
Another aspect of this kind of short-term options trade that is
often ignored is how quickly a stock is capable of making the kind
of move you forecast. Buying too little time puts you in danger
of losing money even if the stock does move the way you want.
Time decay begins to erode very quickly in the month leading
to expiration; if the stock isnt volatile enough to make up for that
decay, you have no chance of success. The chart clearly indicates
that AAPL can, and often does, move by $18 or more in a month. It
is also capable of falling that amount or more. While it is making up
its mind, it also does something that causes pain to all short-term
option players. It can base for upwards of two months.
Suppose the stock reaches $200 shortly after you purchase the
January 2010 $230 LEAPS call. You are now looking at a very
handsome profit, but the longer expiration of the contract means
that you can take the time to re-evaluate the stock and its trend.
There may be an opportunity to take advantage of a new extended
upward trend. Purchasing a short-term option automatically
precludes you from maximizing the trend on this trade unless you
repurchase another short-term contract, which generates higher
commission costs; by comparison, a LEAPS option gives you the
choice of bringing up your stop loss and staying in the trade with
commissions attached only to the buy and sell side of that option.
Strategy III
LEAPS Puts on Stocks You Own
Smart investors who hold long-term positions in stocks look for
ways to minimize their downside risk whenever possible. Another
strategy in addition to using trailing stop losses and position sizing
techniques is to buy LEAPS on the stock you own. This technique
is commonly known as hedging. A stock position is considered
completely hedged when the number of put contracts is directly
proportional to the number of shares. For example, if you own 500
shares of XYZ Company, you would need to purchase five LEAPS
put contracts on XYZ to be fully hedged.
This strategy may sound counterintuitive at first blush. Why would
you want to buy a put on a stock you already own? A put is, in
essence, a bet that the stock will go down. Who would want to bet
against a stock they already own? If you think it could go down,
shouldnt you simply sell the stock? The answer to that question
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Notes
depends on the situation under which you bought the stock and
your overall investment objectives. If you are a short-term trader
looking to take advantage of quick reversals and short-term trends,
this strategy wont help you. On the other hand, if you are a longterm investor who prefers to buy fundamentally strong companies
and ride their long-term trends, buying a LEAPS put can be a
useful, if somewhat expensive, way to minimize risk. Besides
simply wanting to take advantage of long-term strength, one of the
most common reasons investors might want to hold onto a stock
for a long-term basis is to receive dividends. If you own a dividendpaying stock and sell the stock when it begins a downtrend and
the stock pays a dividend during the downtrend, you will miss out
on receiving that dividend. Many long-term, buy-and-hold investors
rely on dividend income to help pay their living expenses. In this
case, buying LEAPS puts is a practical way to guard against
dramatic loss while still receiving your dividend income as a
shareholder of record.
Another reason investors often hold onto stocks is because of the
tax implications associated with selling a stock that has increased
in value over a long period of time. Suppose, for example, that you
have inherited stock from a recently deceased grandparent. Your
grandparent purchased the stock 30 years ago when the stock was
at a much lower price before stock splits, dividends, and so on.
Seeing the stock begin a downtrend is usually a compelling reason
to sell the stock, but in this case it could result in a massive tax
liability due to long-term capital gains. It may not even be a stock
you inheritedmaybe you purchased a stock 10 years ago that
has since split several times and increased dramatically in price.
Anytime you are in a situation such as this and you dont want to
incur the immediate tax consequence associated with selling out
of the stock, buying a LEAPS put could be an attractive approach
to take. Lets consider an example of a situation where a LEAPS
put might be a good strategy. Look at Figure 6.8.

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Figure 6.8
In the above example RIMM has experienced an extremely
attractive upward trend over the last 4 months. With very strong
fundamentals, this is a stock that many long-term investors would
consider as a good position to hold onto. Suppose that you had
purchased 500 shares of this stock in early February of this year and
had been enjoying this run, but you are beginning to be concerned
about the overbought state of the stock. You dont want to sell it
because of its strength and you believe that the stock will continue
to show overall strength for the long-term. Buying a LEAPS puts is
a strategy that could help you minimize any downside risk you may
encounter in the short-term and stay in the stock to take advantage
of its long-term strength. Look at Figure 6.9.

Figure 6.9
This table shows the LEAPS puts that are available for RIMM. The
stock is currently just below $143 per share. You could purchase
the January 2009 145 put for $24.85 per share, or a total of
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Notes
$2,485.00 x 5 = $12,425 expense for five contracts to completely
cover your 500 shares of RIMM valued at 71,225.00. If the stock
experiences a short-or-intermediate downtrend, which is likely at
some point in the next year and a half, and drops below $47.50 per
share, the value of your LEAPS puts will increase in value; it should
offset a portion of the decline in value of your 500 shares during that
time. If the stock begins a new uptrend after this decline, you can
sell the puts back to the market, pocket your gains, and purchase
more shares of the stock to take further advantage of the uptrend.

Determining Which LEAPS Put to Buy


There are a couple of points to keep in mind if you intend to use
this strategy. First, deep in-the-money LEAPS puts are the most
effective at offsetting any decline in the value of the stock. The
reason for this is that the deeper in-the-money an option is, the
higher its delta value is. Finding an option with a delta at or close
to 1.0, which means you get a dollar-for-dollar move in your option
usually requires going deep in-the-money, which is particularly true
for LEAPS options. Finding a LEAPS put with a delta around 1.0
also means that you will pay a higher premium for the option, as
we can see from our example. This is the reason that this strategy
can be expensive.
An effective way to think of this strategy is to equate it to purchasing
insurance. Whether it is for your life, car, home, health, or some
other purpose, the point in buying insurance is to protect yourself
against unforeseen expenses due to mishap, accident, or disaster.
You purchase insurance not because you think something bad
is going to happen, but because you need to guard against the
high sudden costs that are usually associated with that event. You
accept that the cost of your premiums is the price you have to pay
for the peace of mind of knowing that if something happens to
you or your familysudden death, traffic accident, fire, or serious
illnessthe costs that will come from it will be covered.
Buying LEAPS puts against stocks you already own is very much
like buying insurance for your stock. It doesnt mean that you
expect the stock to suddenly experience a serious downturn in
price, only that you want to protect yourself against loss in the
event it does happen. Although the $12,425 premium paid in our
example seems high, it is the cost associated with giving yourself
the peace of mind of knowing that if the stock does suddenly
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Notes
drop in price, you wont have to absorb a massive loss. This is a
very conservative strategy that fits well into a long-term trading
system. If perchance the stock doesnt experience a significant
downtrend, then your LEAPS put option will simply decline in
value and expire worthless and you will still have your increase in
the value of the stock.
Think of the premium you pay for the LEAPS put not only in
context of the total initial cost; think about it also in terms of the
value of that stock position as well as the total gain you have
already seen in the stock. In our example, you own 500 shares
of RIMM; rounding up to $143 per share, your position is worth
a total of $71,500. The $4,050 required to purchase five LEAPS
puts contracts is only about 17% of that total value. If you have
experienced a long-term gain of more than 17% in the stock, you
should consider the LEAPS put as a bargain in terms of its ability
to help you minimize loss and protect your profit.

Important Conditions to Success


There are some important points to remember when you are
thinking about using this strategy. It can take up a significant
amount of your investment capital, so you should consider these
conditions carefully as you plan this trade.
1. AttitudeThis strategy is only practical so long as you
use it on stocks you have a long-term bullish outlook on. If
the fundamentals of a stock begin to degrade or you find
information that changes your outlook, it probably wont
help you. The purpose for using this strategy is to stay in a
stock because you think it will continue to be strong in the
long-term future. If you dont believe this to be the case,
you will likely be better off selling the stock and dealing with
any tax consequence that may come.

154

2. Strike PriceThe deeper in-the-money you go, the more


conservative the trade will be, and the better your LEAPS
put will offset any loss your stock experiences. Check the
Greeks for each LEAPS put available to make sure you get a
delta value as close to 1.0 as possible. Going deeper in-themoney also gives you better protection over time. Buying the
at-the-money LEAPS put at the time you place the trade can
be dangerous because if the stock increases significantly
in value before beginning a downtrend, it may not drop

Chapter 6: Options Stragegies With Leaps

Notes
enough in value to give you any appreciation in the option.
From our RIMM example, if you bought the $47.5 LEAPS
put and the stock quickly increases to $55 before it begins
a downtrend, it will have to drop below $47.50 per share
before your LEAPS put does you any good.
3. Potential Future RewardIf you want to use this strategy
on stocks you have recently purchased but intend to hold
long-term, you should make sure that the potential longterm gain in the stock is greater than the cost of the LEAPS
put. Otherwise, you increase the chances of playing a zerosum game in the stock, which accomplishes nothing in the
long-term. Consider the effect of dividends, if they are paid,
as well your forecasted price appreciation.
4. RepetitionThis strategy is not likely to work if you buy a
LEAPS put and intend to hold the same contract through its
expiration. If your stock is in a significant uptrend, you will
probably need to repeat this strategy multiple times. Think
about the situation described in the second condition. If the
stock is in a dramatic uptrend, your LEAPS put will likely
only be worth a fraction of its original cost, which it may
be unlikely to recover if the stock does begin to decline. In
terms of providing protection against a future downtrend,
you would be better selling the contract back to the market
for whatever price you can get and purchasing another
deep in-the-money contract with a higher strike price.
Strategy IV
Calendar Spreads
You learned about using covered calls to generate income off of
the stocks you own in Chapter Five. Selling calls in this situation
can be an extremely attractive way to take advantage of sideways
trends in stocks you have held for a long period of time. Successful
traders, whether they are trading to generate income or to simply
build wealth, make sure to incorporate options selling strategies
such as covered calls in their trading systems.
LEAPS options provide another way to achieve the same result as
covered calls, but with a lower capital outlay required on your part
using a strategy referred to as a calendar spread.
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A calendar spread is applied by first buying one or more LEAPS
contracts, then selling an identical number of short-term contracts.
The principal advantage of using calendar spreads is that rather
than having to allocate thousands of dollars of your capital to
purchase a stock in 100-share lots, you can use smaller amounts
to control the same number of shares with your LEAPS contracts.
If the stock rises above the strike price of the call option you sold
and you are called out, your LEAPS option will be exercised to
cover the trade. If you plan the trade properly, this should yield a
net profitable result.
There are a couple of caveats associated with calendar spread
trading you need to be aware of:
Trading AuthorityA calendar spread is considered to be
a covered position. You are long an option and then selling
a call against it. It is not considered to be a risky trade
since the amount of risk you take is protected by the LEAP
you own. Most brokers consider this a level-two trade.
Since most LEAPs are not marginable, you do not have to
maintain a margin in your account to make this trade.
CapitalLiterally speaking, the only capital required for a
calendar spread is the cost of the LEAPS option.
You can use this strategy to generate income on sideways-trending
stocks, or you can incorporate it as part of an overall growth
strategy. The rules for applying this strategy in these scenarios are
the same as they would be for covered calls. Lets look at some
examples of each application and compare the benefit of writing
a covered call versus applying a calendar spread.

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Notes

Using Calendar Spreads for Income


The first, most common use of calendar spread trading is to
generate income. In Chapter Five, we discussed the general
characteristics a stock should have to make a covered call an
attractive option. These criteria are the same if you intend to apply
a calendar spread:
Flat trend (usually produced by a channeling stock trading
between narrow support and resistance levels)
Low volatility
Good fundamentals
Technical indicators such as stochastics can also be useful in
determining the timing of a covered call trade in an incomegenerating situation. If the stock you are considering is trading in
a narrow range between support and resistance, stochastics will
help you identify if the stock is likely to bounce off resistance and
move lower by turning down in the upper band. The signal is even
more important if it crosses below the 80 line.
Look at Figure 6.10.

Figure 6.10
Again, for the sake of our example, lets assume it is May 2008 and
we have pulled this information on MSFT. In the last three months,
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Notes
and for that matter, with few exceptions, MSFT has been range
bound between $25 and $29 for the previous three to four years.
This epitomizes the definition of a flat trend. Rarely MSFT breaks
out and runs bravely to the $30s but then dutifully returns to the
high $20 range. There is not a great deal of volatility in the stock.
Since it is the largest software company in the world and has cash
reserves in excess of $55 billion, we will assume for our purposes
that the fundamental strength of the stock is adequate. The fact
that last January, MSFT rose to the mid-$30 range gives evidence
that it might go that high in the next six months.
Since a calendar spread includes purchasing a LEAPS call
contract, an overall, primary-term uptrend works in our favor.
With our basic criteria for the stock satisfied, lets consider the
premiums involved in this trade. Look at Figure 6.11.

Figure 6.11
With the stock at $29.99, you could purchase 100 shares of the
stock for $2,999, then sell the June 30 call for $.95 per share
(remember, you will always sell at the bid price). Assuming the
stock stayed below $30 through expiration, you would keep the
stock and realize a very nice 3.2% return on investment for a
months worth of time. You would then be able to decide whether
to sell another call, sell the stock, or hold onto it if it begins a new
upward trend.
This is a very attractive trade for a covered call, but even more
interesting for a calendar spread. The LEAP January 25 strike
price is currently priced at $6.10 share (see Figure 6.12), meaning
that you would need to spend $610 to purchase it. You could then
sell the June 30 call for $.95. If the stock stayed below $30 at
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Chapter 6: Options Stragegies With Leaps

Notes
expiration, you would realize a total profit of 15.5% on the money
you have investedfor doing nothing more than selling the call
and sitting on the stock for a month.

Figure 6.12
Suppose the stock rises above $30 at expiration. Some traders fall
into the trap of exercising their LEAP in order to take delivery on
the stock to sell at $30. DO NOT DO THIS.
Heres why. If you exercise your LEAP, you sacrifice the price you
paid for it. Said differently, it costs you the price of the LEAP to
exercise the LEAP. So although you buy the stock for $25 and
sell it for $30 with an anticipated profit of $5, youre $1.10 in the
hole. Remember, you paid $6.10 for the LEAP. Subtract the price
you sold the June options for ($.95) and youre still down $.15 +
commissions. If, on the day of expiration, the stock price is above
the strike price of the short call (the one you sold), buy it back.
Then sell your LEAP. Because your LEAP has a very small theta
compared to the call you sold and the LEAP is in-the-money while
the call you sold was out-of-the-money, the LEAP will always go
up faster in value than the call. Therefore any loss you sustain in
buying back the call will be more than compensated for in the
selling of the LEAP.
Why sell the LEAP? Look at MSFT. If it goes above $30 you are
profitable with your LEAP. If you hold onto your LEAP thinking it will
go higher, youre betting against the odds. Take your profits off the
table and wait for MSFT to drop back down into the mid $20s.

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Notes
Of course, the stock could drop below the $32.5 strike price of the
LEAPS contract. Subtracting $1.10 from $32.5 gives a breakeven
price of $31.40. If the stock drops below this level at expiration,
you should re-evaluate the technical strength of the stock. If the
primary upward trend is still intact, you can consider keeping the
LEAPS contract and writing another call for the next available
month. If it has been violated, then you should consider selling the
LEAPS contract, taking a small loss, and moving on. In this event,
the $110 premium received will minimize the total loss you absorb.
Although writing a covered call provides an attractive return that
cannot be dismissed, if you can use the calendar spread, it gives
you a way to take advantage of the leverage associated with
options, on both sides of the trade. Time decay works in your favor
in the short call, and the delta of the LEAPS contract improves your
total returns if you are assigned. This enhances your returns well
above the level associated with covered calls.

Calendar Spreads to Enhance Growth


Just as using calendar spreads for income looks for the same
stock characteristics as using covered calls for income, calendar
spreads to enhance growth returns use the same criteria as
covered calls to enhance growth. The criteria are as follows:
You already own the LEAPS contract. This approach
assumes that you are using one of the LEAPS strategies
described earlier in this chapter, either as a replacement
for owning the stock or as an alternative to owning a shortterm option.
The upward trend has begun to stall or even retrace back
to its primary trend line.
The fundamental strength is driving the stock upward.
You can sell an out-of-the-money short-term call at the next
closest strike price.

160

In this scenario, the fundamental strength may not be as important


as it would be when you are trying to generate income in a sideways
trend. In fact, higher volatility in an upward trend should increase
the premium you receive as well as the likelihood you will be
assigned. If you set up the trade correctly, you should lock in

Chapter 6: Options Stragegies With Leaps

Notes
an attractive profit in the LEAPS contract, with the short call premium
adding to that overall return. Look at Figure 6.13.

Figure 6.13
SOHU has experienced an attractive upward trend since late March. In
the last month there was a pullback and then a continuation. This could
be a signal of a trend-continuation. Suppose you purchased a Jan 2009
$70 LEAP for $19.80 as shown in Figure 6.14.

Figure 6.14
The stock seems to move about $9 a month and might provide an
attractive return over a short period of time. It also may consolidate
around the $80 level for 30 to 60 days before continuing its upward trend.

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Notes
Assume you feel comfortable buying the LEAP and selling the
June calls one strike price out-of-the-money. Currently the June
$85 calls are going for $5.30 at the bid. See Figure 6.15 below.

Figure 6.15
Remember the LEAPS you bought cost $19.80. Selling the June
$85 calls and receiving $5.30 is a staggering rate of return. It is
26%. It is also somewhat risky. Would you be happy selling the
$90 calls for $3.60? It is still 18% return for 37 days? The chance
of SOHU going above $85 and forcing you to buy back the call is
fairly high. The chance of SOHU going to $90 and forcing you to
buy back the call is much less. Also, the $90 call will not go up in
value as fast as the $85 because of the differences in their delta.
Notice that the delta on the LEAP is .69. The delta values on the 85
and 90 calls are .48 and .36 respectively. Remember that the theta
value for the LEAP is much less than for either of the calls. These
factors alone make the trade attractive. Even if you are forced to
buy the calls back at a higher price on expiration because the
stock price is higher than the strike price, the LEAP will have gone
up considerably more.
The net effect of this trade is that if the stock stays flat, you win.
If the stock goes up, you win. If the stock goes down such that the
LEAP decreases in value, as long as the LEAP does not fall more
than $3.60, you still have a winning trade. There are not many
strategies that provide this type of directional advantage.
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Notes

Summary
LEAPS options provide a variety of ways to minimize time decay
and downside risk while being in position to take maximum possible
advantage of an upward trend. Although your trading system may not
benefit from all of the strategies covered in this section, analyze the
merits of each one. You will likely find at least one or two of them to
be applicable to the type of trading you are interested in. Successful
traders make sure to add as many layers of risk management as they
can to each trade they make. LEAPS options provide an additional
layer of risk management beyond stop losses, position sizing, and
analyzing reward-to-risk ratios.
Buying LEAPS calls gives you the ability to take advantage of a long,
upward-trending stock while adding the benefit of leverage to your
potential profits. It also minimizes the risk associated with purchasing
shorter-term options since time decay in LEAPS options is much less.
Buying LEAPS puts gives you a way to protect yourself from dramatic
losses in stocks you have held for long periods of time.
Calendar spreads provide all of the same advantages of covered
calls, while adding the benefit of leverage and time decay working
for you. You can significantly improve your returns over covered
calls by buying a LEAPS call, then selling a call at-the-money or
just out-of-the-money. This gives you a way to benefit from calendar
spreads irrespective of whether you seek to generate income or to
simply enhance growth.

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Glossary

Glossary

A
AGI (Adjusted Gross Income) A key number used by many different sections of the tax code
to determine the eligibility of the taxpayer for deductions and credits. As a general rule, you want
above the line expenses, such as business expenses, which are used to reduce your AGI.
Active Account Refers to a brokerage account in which many transactions occur. Brokerage
firms may charge a fee for an account that does not generate an adequate level of activity.
Analyst An employee of a brokerage, fund management house, or other financial institution who
studies companies and makes buy-and-sell recommendations on stocks of these companies. Most
analysts specialize in a specific industry.
Announcement Date The date on which news concerning a given company is announced to
the public. It is used in event studies to evaluate the economic impact of events of interest.
Ask Price This is the lowest price a market maker will accept to sell a stock. The quoted offer at
which an investor can buy shares of stock; also called the offer price.
Asset Any possession that has value in an exchange.
Authorized Shares Number of shares authorized for issuance by a firms corporate charter.

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Notes

Basis In simple terms, your cost of the asset. If you paid $10/share
for stock and $1/share commission, your basis would be $11/share.
Bear An investor who believes a stock or the overall market will
decline.
Bearish Refers to the attitude of an investor as being pessimistic;
a pessimistic outlook.
Bear Market Any market in which prices exhibit a declining trend
for a prolonged period, usually falling by 20% or more.
Benchmark High The most recent zone of resistance above the
current price of the stock on an upward trend.
Benchmark Low The most recent zone of support below the
current price of the stock on a downward trend.
Beta A measurement of the volatility associated with a stock
relative to the S&P 500. A beta of 1.0 means the stocks volatility is
equal to that of the S&P 500.
Bid Price The highest price a market maker is willing to pay to buy
a security. The price an investor will pay to sell shares of stock.
Bid-Ask Spread The difference between the prices buyers are
willing to pay and what sellers are asking for.
Big Money A term used to refer to institutional money as it flows in
and out of the stock market.
Black Monday Refers to October 19, 1987, when the Dow Jones
Industrial Average fell 508 points after sharp drops the previous week.
Blue-Chip Company A large and creditworthy company which
is renowned for the quality and wide acceptance of its products and
services, and for its ability to make money and pay dividends.
Bond Debt issued for a period of more than one year. When
investors buy bounds, they are lending money. The seller of the bond
agrees to repay the principal amount of the loan at a specified time.

168

Glossary

Notes
Breakout A rise in the price of a security above a resistance zone
(commonly its previous high price) or a drop below a zone of support
(commonly the former lowest price). It can be used as a buy or sell
indicator.
Broker An individual who is paid a commission for executing
customer orders; an agent specializing in stocks, bonds,
commodities, or options, and must be registered with the exchange
where the securities are held.
Bullish Refers to the attitude of an investor as being optimistic; an
optimistic outlook.
Bull An investor who thinks the market will rise.
Bull Market Any market in which prices are in an upward trend.
Buy To purchase an asset, usually taking a long position.
Buy-and-Hold A passive investment strategy with no active
buying and selling of stocks.
Buy Limit Order A conditional trading order that indicates a
security may be purchased only at the designated price or lower.
Buy on Margin Borrowing to buy additional shares of stock, and
using those same shares as collateral.
Buy Order An order to a broker to purchase a specific quantity of
a security.
Buy Stop Order An order to buy that is not to be executed until
the market price rises to the stop price. Once the security breaks
through that price, the order is then treated as a market order.
Buyers Market A market in which the supply exceeds the
demand, creating lower prices.

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Notes

Capital Money available to invest.


Capital Gain When a stock is sold for a profit, the difference
between the net sales price of the securities and their net cost results
in your total profit, which you then report to the IRS as a capital gain
and pay capital gains taxes on.
Capital Gains Tax The tax levied on profits from the sale of
capital assets.
Capital Loss When a stock is sold below cost (sold at a loss), the
difference between the net cost of a security and the net sales price.
Cash Flow Represents earnings before depreciation, amortization,
and non-cash charges; sometimes called cash earnings. This
indicates the ability to pay dividends.
Ceiling The highest price, interest rate, or other numerical factor
allowable in a financial transaction.
Chart Patterns The pattern made by a stock on its stock graph
as it fluctuates over a given period of time. These patterns provide
traders with information about support and resistance, breakouts,
and so on.
Close The period at the end of the trading session; sometimes
used to refer to the closing price of a stock.
Closing Price The price of the last transaction of a particular
stock completed during a days trading session on an exchange.
Closing Quote The last bid and offer prices of a particular stock
at the close of a days trading session on an exchange.
Collateral An asset that can be repossessed if a borrower
defaults.
Commission The fee paid to a broker to execute a trade, based
on number of shares, bonds, options, contracts, or their dollar value.
Commodity A fixed physical substance that investors buy or sell,
usually through futures contracts. Commodities are basic goods and
products, such as food, steel, metal, and so on.
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Glossary

Notes
Common Stock Traditionally, units of ownership that do not give
guaranteed payments or dividends to their owners, and are usually
limited in their voting power. In return for accepting these restrictions,
owners of common stock normally receive all growth over the amount
paid to preferred shareholders.
Confirmation The comparison of technical signals and indicators
to ensure that the majority of them are pointing in the same direction;
information that validates your opinion of a buying or selling
opportunity.
Coupon Rate Interest rate on a bond the issuer promises to pay
to the holder until maturity, expressed as an annual percentage of
face value. The term derives from the small detachable segment of a
bond certificate which, when presented to the bonds issuer, entitles
the holder to the interest due on that date.
CPI (Consumer Price Index) Measure of change in consumer
prices, as determined by a monthly survey of the U.S. Bureau of
Labor Statistics. Traders use this as a way to track inflation. Also
known as the cost of living index.
CRB Index (Commodities Research Bureau) An index of 21
of the most influential commodity categories, such as oil, gas, steel,
etc.

Daily Price Limit The level at which many commodity, futures,


and options markets are allowed to rise or fall in a day. Exchanges
usually impose a daily price limit on each contract.
Day Order A request to buy or sell stock that is good only for the
day the order is placed. If the buy or sell request is not filled before
the close of the market, the order is cancelled. Most stock buy and
sell orders are day orders unless otherwise specified by the investor.
Day Trading Establishing and liquidating the same position or
positions within one days trading.
Debt Market The market in which bonds are issued and bought
and sold between investors.

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Notes
Debt-to-Equity Ratio Total liabilities divided by shareholders
equity. This shows to what extent owners equity can cushion
creditors claims in the event of liquidation.
Delayed Quote A stock or bond quote that shows bid and ask
prices 15 to 20 minutes after a trade takes place.
Depressed Market Market in which supply overwhelms
demand, leading to weak and lower prices.
Discount Broker A brokerage house featuring relatively low
commission rates in comparison to a full-service broker.
Diversification Dividing investment capital among a variety of
securities with different risks, rewards, and correlations in order to
minimize risk.
Dividend A portion of a companys profit paid to common and
preferred shareholders.
Domestic Market A nations internal market for issuing and
trading securities or entities domiciled within that nation.
Dow Jones Industrial Average (Dow) The best known U.S.
stock index. A price-weighted average consisting of 30 actively
traded blue-chip stocks, primarily industrial, including stocks
traded on the New York Stock Exchange and NASDAQ. It is also
a barometer of how shares of the largest U.S. companies are
performing.
Downtick A move down in a particular stock.
Downtrend The stage in which a stock begins making lower highs
and lower lows.
Downturn The transition point between a rising, expanding
economy to a falling, contracting one.
Drawdown The total amount of money your trading system will
lose during a losing trade or losing streak. Average drawdown can
be calculated by adding all of your losing trades over a given period
of time and dividing the total by the number of losing trades. This is a
way to establish the amount of risk you have taken historically for the
reward you have received.

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Notes

Earnings Net income for a company during a specified period of


time.
Earnings Surprise Positive or negative differences from the
consensus forecast of earnings by institutions.
Effective Date In an interest rate swap, the date the swap begins
accruing interest.
Entrance/Entry Threshold An entry price to buy stock at a
zone of support.
EPS (Earnings Per Share) Net income for a company during a
specified period of time expressed as a per share value. Net income
divided by shares outstanding.
Equities Market The various exchanges that make up the stock
market.
Exchange A location where buyers and sellers can exchange
securities. This can be a trading floor, such as the New York Stock
Exchange, or an electronic, computerized exchange, such as the
NASDAQ.
Exit Threshold An exit price to sell stock at a zone of resistance.
Expected Gains In a money management system, your reward
multiplied by your chances of winning over time.
Export Goods and products produced in the U.S. and sold in
foreign countries.
Exponential Moving Average A moving average, calculated
over any period of time, where the most recent price information is
weighed more heavily than later information.

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Notes

Fakeout The event that occurs when a stock appears poised to


break through a zone of support or resistance but fails to do so. A
false trading signal that can be minimized through the use of filtering
techniques.
Fed Funds Rate The rate banks charge to each other to cover
Federal Reserve requirements. These are usually very short-term
loans, often overnight.
Fed Funds Discount Rate The rate at which banks can borrow
money from the Federal Reserve Bank. Usually a relatively slowchanging rate, it is adjusted up or down in increments as the Fed
deems necessary to boost the economy or guard against inflation.
The stock market reacts dramatically to changes in this rate.
Filtering (see Price Filter, Time Filter, Volume Filter) A
method used to determine whether a market is breaking or holding
support or resistance zones.
Financial Analysis An analysis of a companys financial
statement, usually done by financial analysts.
Financial Analysts Professionals who analyze financial
statements, interview corporate executives, and attend trade shows
of companies in order to write reports that recommend purchasing,
selling, or holding various stocks. Also called securities analysts and
investment analysts.
Fiscal Quarter The three-month period of time the company
uses to track their quarterly performance. All quarterly statements
and financial reports are tied to this time period. Although this quarter
often follows standard calendar quarters, it just as often does not.
The quarter period a company follows is dictated by its fiscal year.
Fiscal Year The twelve-month period of time the company uses to
track their yearly performance. All year-end statements and financial
reports are tied to this time period. Although many companys fiscal
years follow the standard calendar year (JanuaryDecember) it is just
as common that they do not. A fiscal year can begin and end in any
twelve-month period on the calendar.
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Notes
Fixed Percentage A money management technique to dictate
how much of the investment capital an investor has will be used in
a single trade. Encourages more conservative position sizing which
helps to minimize risk.
Flight to Quality Moving capital to the safest possible investment
to protect oneself from loss during an unsettling period in the market.
This movement can manifest itself in any of the various financial
markets; for example, unexpected volatility and risk in the stock
market often results in investors selling stocks and buying more
government bonds.
Float Shares outstanding minus insider holdings. The float consists
of all shares that are available for trade in the stock market at any
given time. This number can help identify how liquid a stock is as well
as how much control of the stock insiders maintain.
Fluctuation A price or interest rate change.
Forecasting Making projections about future performance on the
basis of historical and current conditions data.
Full-Service Broker A broker who provides clients an allinclusive selection of services such as advice on security selection
and financial planning.
Fully Invested Used to describe an investor whose assets are
totally committed to investments, typically stock.
Fundamental Analysis Security analysis that seeks to detect
mis-valued securities through an analysis of a firms business
prospects and historical performance, focusing on earnings, dividend
prospects, expectations for future interest rates, and risk evaluation of
the firm.
Futures A term used to designate all contracts covering the sale
of financial instruments or physical commodities for future delivery on
a commodity exchange.
Futures Contract An agreement to buy or sell a set number of
shares of a specific stock in a designated future month at a price
agreed upon today by the buyer and seller. The contract is often
traded on the futures market. A futures contract differs from option
as an option is the right to buy or sell, while a futures contract is the
promise to actually make the transaction.

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Notes

Gain A profit on a securities transaction recognized by selling a


security for more than the security originally cost. The gain is the
difference between the cost and the sale.
Gross Profit Sales minus the cost of goods sold.
Gross Profit Margin The gross profit divided by sales, which is
equal to each sales dollar left over after paying for the cost of goods
sold.
Growth Opportunity Opportunity to invest in profitable projects.

Hedge A transaction that reduces the risk of an investment.


Hedging A strategy designed to reduce investment risk using call
options, put options, short-selling, or futures contracts. Its purpose
is to reduce the volatility of a portfolio by reducing the risk of loss; it
helps lock in profits.
Held Order An order that must be executed without hesitation or
if the stock can be bought or sold at that price in sufficient quantity.
High-Tech Stock Stocks of companies operating in hightechnology fields. Intel, Microsoft, IBM, Yahoo! and Amazon.com are
example of high-tech stocks.
Hold To maintain ownership of a stock over a long period of time;
also a recommendation of an analyst who is not positive enough on a
stock to recommend a buy, but not negative enough on the stock to
recommend a sell.

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Glossary

Notes

IRA (Individual Retirement Account) Tax deferred accounts


one can contribute to as long as there is earned income.
Independent Financial Market A financial market that trades
a specific type of financial instrument. The stock market, bond
market, currency market, and commodity market are all examples of
independent financial markets, because although each can impact
the other, they dont necessarily depend on each other to operate on
their own.
Index Statistical composite that measures changes in the economy
or in financial markets, often expressed in percentage changes from a
base year or from the previous month. Indices measure the ups and
downs of stocks, bonds, and some commodities markets, in terms of
market prices and weighting of companies in the index.
Indicator Technical or fundamental measurement securities
analysts use to forecast the markets direction, such as investment
advisory sentiment, stock trading volume, interest rates direction, and
corporate insiders buying or selling.
Individual Investor Average, typical investors who trade their
own money, rather than doing it for institutions. Even wealthy, very
successful investors who trade their own accounts are considered
individual investors.
Industry A subcategory of market organization below the sector level.
Industry Groups A subcategory of market organization below the
Industry level.
Inflation Rise in the prices of goods and services, as happens
when spending increases relative to the supply of goods on the
market - too much money chasing too few goods. Moderate inflation
is a common result of economic growth, while prices rising at more
than 100% per year are considered hyperinflation and reflective of a
lack of confidence in the dollar.
Interest Rates Cost of borrowing money, expressed as a rate per
period of time, usually one year, in which case it is called an annual
rate of interest.
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Notes
Intermarket Analysis The process of analyzing each of the
independent financial markets to determine their impact on the stock
market.
Intermediate Trend A trend period of six to nine months.
Changes in the Intermediate Trend are generally taken as market
corrections.
Insider Information Material information about a company that
has not yet been made public.
Insiders Directors and senior officers of a corporation; those who
have access to inside information about a company; someone who
owns more than 10% of the voting shares of a company.
Institutional Investors Money invested in the market by mutual
funds, investment banks, insurance companies, brokerage houses,
and major corporations. Large dollar volume transactions that can
dramatically impact the price of a stock in a short period of time.
Investment Income The revenue from a portfolio of invested
assets.
Investment Manager The individual who manages a portfolio of
investments; also called a portfolio manager or money manager.
Investments The study of financial securities, such as stocks and
bonds, from the investors viewpoint.
Investment Strategy A strategy an investor uses when deciding
how to allocate capital among several options, including stocks,
bonds, cash equivalents, commodities, and real estate.
Investor The owner of a financial asset; one who is looking to earn
money in the stock market through a buy and hold strategy. Most
earnings are either long-term capital gains, dividends, or interest.
Import Goods and services brought into a country from sources
outside its borders.

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Notes

Keogh Plan A type of pension plan in which taxes are deferred.


Available to those who are self-employed.

Large-Cap Stock A stock with a high level of market


capitalization, usually at least $5 billion in market value.
Leader A stock or group of stocks first to move in a market
upsurge or downturn.
Limit Order An order to buy stock at or below a specified price,
or to sell stock at or above a specified price. A conditional trading
order designed to avoid the danger of adverse unexpected price
changes.
Listed Stocks Stocks traded on an exchange.
Long-Term Capital Gains Gains from the purchase or sale of
capital assets that are held for longer than 12 months.
Long-Term Investor A person who makes investments for a
period of at least five years in order to finance his or her long-term
goals.
Lower Band The bottom range of a technical oscillator such as
MACD or Stochastic.

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MACD A hybrid technical analysis tool which combines the
characteristics of an oscillator with trend tracking to identify buying
and selling signals.
Majority Shareholder A shareholder who is part of a group that
controls more than half of the outstanding shares of a corporation.
Margin Allows investors to buy securities by borrowing money
from a broker; the difference between the market value of a stock and
the loan a broker makes.
Margin Account An account that can be leveraged, in which
stocks can be purchased for a combination of cash and a loan. The
load is collateralized by the stock; if the value of the stock drops
sufficiently, the owner must either put in more cash, or sell a portion
of the stock.
Market Analysis An analysis of technical, corporate, and market
data used to predict movements in the market.
Margin Call A demand for additional funds because of adverse
price movement in a stock bought on margin; maintenance margin
requirements; security deposit maintenance.
Market Capitalization The total dollar value of a companys
equity. Calculated by multiplying the current price of the stock by the
shares outstanding.
Market Ceiling The most immediate zone of resistance in a
stock.
Market Floor The most immediate zone of support in a stock.
Market Index A measure of the market consisting of weighted
values of the components that make up a certain list of companies.
A tracking of the performance of certain stocks by weighting them
according to their prices and the number of outstanding shares using
a particular formula.
Market Opening The start of a formal trading day on an
exchange.
Market Order An order to buy or sell a stated amount of a
security at the most advantageous price obtainable after the order
is presented in the trading crowd. Special restrictions cannot be
specified (all or none or good till cancelled orders) on market orders.
Market Prices The amount of money a willing buyer pays to
acquire stock from a willing seller.
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Glossary

Notes
Market Research A technical analysis of factors such as volume,
price trends, and market breadth that are used to predict price
movement.
Market Return The return on the market portfolio.
Market Risk Risk that cannot be diversified away.
Market Share The percentage of total industry sales that a
particular company controls.
Market Value The price at which a security is trading and could
presumably be purchased or sold; what investors believe a stock is
worth, calculated by multiplying the number of shares outstanding by
the current market price of the stock.
Mature To cease to exist; to expire.
Merger An acquisition in which all assets and liabilities are
absorbed by the buyer; any combination of two companies.
Midcap A stock with a capitalization of usually between $1 billion
and $5 billion.
Momentum The amount of acceleration of an economic, price, or
volume movement.
Money Management A complete, holistic set of trading rules
and specifications that defines how you should make your stock
trades. Establishes the balance you need to maintain between reward
and risk to be successful in your trading over time.
Moving Average The mean price of a stock calculated at any
time over a past period of fixed length to help define trend direction
and support and resistance zones.
Moving Average Crossover The point when moving averages
reflecting different time periods (such as a 20-day MA and a 50-day
MA) intersect and cross. Depending on the direction of the trend,
these crossovers can be seen as critical breakthrough points to the
upside as well the downside. Many oscillators use these crossover
points to identify specific buying or selling signals.

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Notes

NASDAQ The National Association of Securities Dealers Automatic


Quotation System. A nationwide computer network for buying and
selling NASDAQ-listed stocks.
Narrow Market An inactive market, which displays large
fluctuations in prices due to a low volume of trading.
Narrowing the Spread Reducing the difference between the bid
and ask prices of a security.
Net The gain or loss on a security sale as measured by the selling
price of a security less the adjusted cost of acquisition.
New York Stock Exchange The most well-known stock
exchange in the world. Also called the Big Board or the Exchange.
News Daily events reported on news programs and the Internet
which can often have a sudden and dramatic effect on the price of a
stock.
NYSE Amex (formerly the American Stock Exchange)
Located in downtown Manhattan, this stock exchange consists
primarily of index options and shares of small and medium-sized
companies.
NYSE Composite Index Composite index covering price
movements of all common stocks listed on the New York Stock
Exchange. It is based on the close of the market on December 31,
1965, at a level of 50.00 and is weighted according to the number of
shares listed for each issue. The composite index is supplemented by
separate indexes for four industry groups; industrial, transportation,
utility and finance.

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Glossary

Notes

Offer Price Indicates a willingness to sell at a given price.


Open Having either buy or sell interest at the indicated price level
and side.
Open Position A long-or-short position whose value will change
with a change in prices.
Opening The beginning of the trading session officially designated
by an exchange during which all transactions are considered made
at the opening.
Opening Price The range of prices at which first bids and offers
are made on an exchange.
Order Instruction to a broker/dealer to buy, sell, deliver, or receive
securities or commodities that commits the issuer to the terms
specified.
Oscillator A tool used to confirm trend direction and short-term
buying and selling signals. Oscillators are generally designed to
measure momentum and overbought/oversold conditions.
Over the Counter (OTC) A market in which securities
transactions are conducted through a telephone and computer
network connecting dealers in stocks and bonds, rather than on the
floor of an exchange. The NASDAQ is an OTC market. Also, a stock
that is not listed and traded on an organized exchange (bulletin board
stocks, for example) is traded over the counter.
Overbought A condition in which a stock is considered to have
risen as much as it is likely to in the short term, forecasting a shortterm pullback.
Oversold A condition in which a stock is considered to have
dropped as low as it is likely to in the short term, forecasting a shortterm increase in price.

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Par Value The face value of a bond. A bond selling at par is


worth the same dollar amount it was issued for or at which it will be
redeemed at maturity.
Paper Gain/Loss Unrealized capital gain/loss on securities held
in a portfolio based on a comparison of the current market price to
the original cost.
Paper Trading Placing stock trades in paper format rather than
with actual dollars to gain experience in using research and timing
techniques without putting investment at risk.
P/E Ratio The price to earnings ratio, which is calculated by
dividing the current stock price by trailing annual earnings per share
or expected annual earnings per share.
Peak The high point at the end of an economic expansion until the
start of a contraction.
PEG Ratio A derivation of the P/E ratio and expected growth
rates. It is calculated by dividing the current P/E ratio by the expected
EPS.
Portfolio Manager A professional who assumes responsibility for
the securities portfolio of an individual or institutional investor. In return
for a fee, the manager manages the portfolio and chooses which
types are most appropriate over time.
Position A market commitment. The number of shares bought or
sold for which no offsetting transaction has been entered into. The
buyer of a security is said to have a long position, and the seller of a
security is said to have a short position.
Position Sizing The process of determining what portion of an
investors capital should be placed in a single position. This is an
important component of risk management in an effective trading
system.
Preferred Shares Shares that give investors a fixed dividend
from the companys earnings and entitle them to be paid before
common shareholders.

Glossary

Notes
Price Divergence A condition in which technical indicators such
as Stochastic and MACD begin to move in the opposite direction of
the price of the stock. Rather than confirming a buying signal, this is
a warning sign in an uptrending stock.
Price Filter A method for identifying breakthroughs of support
and resistance zones. Price filtering refers to waiting for a stock to
break through a specific price that has been identified as support or
resistance before initiating a buy order on the stock.
Primary Market Where a newly issued security is first offered. All
subsequent trading of this security occurs in the secondary market.
Primary Trend The longest-term trend, lasting nine months to
two years. This trend is most directly impacted by the fundamental
strength of the broad economy.
Prime Rate The interest rate banks charge to their most
creditworthy customers, and which acts as a baseline for loans to
less creditworthy customers.
Profit Revenue earned minus the cost and the commission. Total
amount made on the transaction.
Profit Forecast A prediction of future profits of a company that
could affect investment decisions.
Profit Margin An indicator of profitability. The ratio of earnings
available to stockholders to net sales. Determined by dividing net
income by revenue for the same 12-month period. Also known as net
profit margin.
Profit Taking Action taken by short-term securities traders to
cash in on gains created by a sharp market rise, which pushes prices
down temporarily but implies an upward market trend.
Public Offering A stock offering to the investment public, after
compliance with registration requirements of the SEC, usually by an
investment banker or a syndicate made up of several investment
bankers, at a price agreed upon between the issuer and the
investment bankers.
Public Ownership The portion of a companys s stock that is
held by the public.
Publicly Held Describes a company whose stock is held by the
public.
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Notes
Publicly Traded Assets Assets that can be traded in a public
market such as the stock market.
Purchase Order A written order to buy specified goods at a
stipulated price.

Q
Quarterly Occurring every three months.
Quoted Price The price at which the last trade of a particular
security or commodity took place.

Rally (Recovery) An upward movement in the price of a stock or


the broad market.
Range The high and low prices recorded during a given period of
time.
Real Time A stock or bond quote that is current with the current
buy or sell price of the stock or bond.
Realized Return The return that is actually earned over a given
time period.
Recession A temporary downturn in economic activity, usually
indicated by two consecutive quarters of a falling gross domestic
product.

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Glossary

Notes
Relative Strength The rate at which a stock falls relative to other
stock groups in a falling market or rises relative to other stocks in a rising
market. Analysts reason that a stock that holds value on the downside will
be a strong performer on the upside and vice versa. This logic can also be
applied to industry group and sector comparisons.
Resistance A price level above which it is supposedly difficult for a
security or market to rise. A price ceiling at which technical analysts and
traders note persistent selling of the security or market.
Return The change in the value of a portfolio over a period of time,
including any distributions made from the portfolio during that period.
Return on Equity (ROE) An indicator of profitability determined by
dividing net income for the past 12 months by stockholder equity and
shown as a percentage. ROE is used to measure how a company is using
its money.
Return on Investment (ROI) Book income as a proportion of net
book value. Revenue Total dollars brought into a company through sales,
stated on a quarterly and annual basis.
Reversal A change in the direction or trend of a stock.
Reward: Risk Ratio The potential reward in a given trade or set of
trades over time divided by the amount of risk taken. If a trade appears
to have $2 of upside potential against $1 of downside potential, then
the reward: risk ratio is 2:1. A critical component of risk and money
management.
Risk The risk that the issuer cash flow will not be adequate to meet its
financial obligations. Additional risk a companys shareholder bears when
the firm uses debt and equity.
Risk Factor A set of common factors that impact returns (e.g., market
return, interest rates, inflation, etc.).
Risk Management (see also Money Management) The process
of identifying and evaluating risks and selecting and managing techniques
to minimize risk.
Roth-IRAA type of IRA account that allows contributors to invest up
to $2,000 per year, and for assets to grow completely tax-free, and to
withdraw the principal and earnings tax-free under certain conditions. This
differs from a traditional IRA, however, in that yearly contributions are not
tax deductible.

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Notes

Scaling In A conservative approach to position sizing and money


management that places smaller amounts of money in a position at
the beginning of the trade, then increases the size of the position as
the stock extends into an upward trend.
SEC Securities and Exchange Commission. A federal agency that
regulates the U.S. financial markets, oversees the securities industry
and promotes full disclosure in order to protect the investing public
against malpractice in the securities market.
Sales Forecast A key input to a firms financial planning process
based on historical experience, statistical analysis, and consideration
of various macroeconomic factors.
S&P 500 Composite Index An index of 500 widely held
common stocks that measures the general day-to-day performance
of the market.
Sector Used to characterize a group of securities that are similar
with respect to maturity, type, rating, industry, and coupon.
Sector Rotation The flow of institutional money into various
sectors of the stock market.
Securities Stocks and their derivatives, bonds, and commodities.
Any financial instrument that can be publicly traded.
Sell Limit Order Conditional trading order that indicates a
security may be sold at the designated price or higher.
Sell Off The sale of securities under pressure.
Sell Order An order that may take many different forms by an
investor to a broker to sell a stock, bond, option, future, mutual fund,
or other holding.
Sellers Market A market in which demand exceeds supply. As a
result, the seller can often dictate the price and terms of the sale.
Selling Short Selling a stock not actually owned. If an investor
thinks the price of a stock is going down, the investor could borrow
the stock from a broker and sell it. Eventually, the investor must buy
188

Glossary

Notes
the stock back on the open market to close the position and repay
the obligation to the broker.
Sentiment The general attitude or feeling about a stock or market.
Most accurately reflected by tracking buying and selling volume.
Shareholder A person or entity that owns shares or equity in a
corporation.
Shareholder Equity Total assets minus total liabilities of a
corporation.
Shares Certificates or book entries representing ownership in a
corporation or similar entity.
Shares Outstanding Shares of a corporation, authorized in the
corporate charter, which have been issued and are outstanding.
Short One who has sold a contract to establish a market position
and has not yet closed out the position through an offsetting
purchase.
Short Position Occurs when a person sells stocks he or she
does not yet own. Shares must be borrowed from the broker before
the sale to make good delivery to the buyer. Eventually, the shares
must be bought back to close out the transaction. This is done when
an investor believes the stock price will drop.
Short-Term Any investments with a maturity of one year or less.
Short-Term Gain/Loss A profit or loss realized from the sale of
securities held for less than a year. This is taxed at normal income tax
rates if the net total is positive.
Short-Term Trend A trend that lasts two to four weeks. Changes
in the short-term trend generally come about from random news
events such an analyst ratings and downgrades and profit forecasts.
Sideways Trend (see Trendless) A horizontal price movement
within a narrow price range over an extended period of time, creating
the appearance of a relatively straight line on a stocks price graph.
Simple Moving Average A moving average that is calculated by
adding the closing prices over a given period of time, then dividing the
sum by the number of days in the period. Each day in the calculation
is given the same weight. This contrasts with an exponential moving
average which places a heavier weighting on the most recent days.
Slump A temporary fall in performance, often describing
consistently falling security prices for several weeks or months.

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Small-Cap A stock with a small capitalization, meaning a total
equity value of less than $500 million.
Smart Money Experienced, sophisticated investors who use
advanced techniques to track sector rotation and institutional money
flow as a guide for stock trades.
Speculation Purchasing risky investments that present the
possibility of large profits, but also pose a higher-than-average
possibility of loss.
Split When a company splits its outstanding shares into more
shares. The investors equity in the company remains the same, and
the share price is one-half the price of the stock on the day prior to
the split.
Stage I Trend The highly speculative early period of an upward
trend. The immediate trend at this time is flat or sideways.
Stage II Trend The period of an upward trend immediately after a
breakout from support or resistance zones. The period of time where
investors buy into a stock hoping the early price surge will continue.
Stage III Trend The final upward thrust of an upward trend when
everybody who wants to be in the stock now is. This is usually the
beginning of the end of the upward trend.
Stage IV Trend The final period of the upward trend where the
stock begins to test support zones and fails to break resistance
zones, resulting in a sideways movement of the stock.
Stochastic An oscillator that measures overbought and oversold
conditions in a stock over time.
Stock Ownership of a corporation indicated by shares, which
represent a piece of the corporations assets and earnings.
Stockbroker A person registered with the SEC who is employed
by and solicits business for a commission house or futures
commission merchant.
Stock Buyback A corporations purchase of its own outstanding
stock, usually in order to raise the companys earnings per share.
Stock Certificate A document representing the number of
shares of a corporation owned by a shareholder.

190

Stock Dividend The payment of a corporate dividend in the form


of stock rather than cash; often used to conserve cash needed to
operate the business. Stock dividends are not taxed until sold.

Glossary

Notes
Stock Exchanges Formal organizations approved and regulated
by the SEC that are made up of members who use the facilities to
exchange certain common stocks.
Stock Index An index such as the Dow Jones Industrial Average
that tracks the performance of a basket of stocks.
Stock Market Also called the equities market.
Stock Split Occurs when a firm issues new shares of stock and
in turn lowers the current market price of the stock to a level that is
proportionate to pre-split prices.
Stock Ticker A letter designation assigned to securities and
mutual funds traded on U.S. financial exchanges.
Stop-Limit Order A stop order designating a price limit. Unlike
the stop order, which becomes a market order once the stop is
reached, the stop-limit order becomes a limit order.
Stop Loss Order An order to sell a stock when the price falls to a
specified level.
Stop Order An order to buy or sell at the market when a definite
price is reached, either above (on a buy) or below (on a sell) the price
that prevailed when the order was given.
Stopped Out A purchase or sale executed under a stop order at
the stop price specified by the customer.
Strengthening Trend An upward or downward trend that
becomes steeper as buying or selling activity increases in the stock.
This usually serves to extend the current trend even higher in the
short term.
Success Rate The rate at which winning trades make money.
This is correlated with drawdown rates to identify reward: risk profiles
and appropriate position sizes in specific trades.
Support (see Price Floor) Price zone at which a security tends
to stop falling because demand begins to outweigh supply.
Symbol Letters used to identify companies on the exchanges.

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Target Price The price an investor hopes a stock will reach in a


certain time period.
Technical Analysis Security analysis that seeks to detect and
interpret patterns in past security prices.
Technical Analysts Analysts who use mechanical rules to detect
changes in the supply of and demand for a stock in order to capitalize
on the expected change.
Technical Indicators Information that confirms or supports
trading signals. Oscillators such as MACD and Stochastic are
examples of effective technical indicators.
Threshold Trading Method A systematic approach to
identifying entry and exit points in stock trades.
Tick Refers to the minimum change in price a security can have
either up or down.
Time Filter A method for identifying breakthroughs of support
and resistance zones. Once a stock has broken a support or
resistance zone, waiting one to three days to see if the stock holds
the new higher price can provide confirmation of the move.
Time Order An order that becomes a market or limited price
order, or is cancelled at a specific time.
Total Cost The price paid for a security, plus the commission and
any accrued interest owed to the seller (as with a bond).
Total Dollar Return The dollar return on a non-dollar investment,
including the sum of any dividend/interest income, capital gains or
losses, and currency gains or losses on the investment.
Total Return In performance measurement, the actual rate of
return realized over an evaluation period.
Total Revenue Total sales and other revenue for the period
shown.

192

Total Volume The total number of shares or contracts traded on


national and regional exchanges in a stock, bond, commodity, future,
or option on a certain day.

Glossary

Notes
Trade An oral (or electronic) transaction involving one party buying
a security from another party. Once a trade is consummated, it is
considered final. Settlement occurs one to five business days later.
Traders Individuals who take positions in stock investments with
the objective of making profits. Traders take proprietary positions in
which they seek to profit from the directional movement of prices or
spread positions that can be held for either the long-term or shortterm.
Trading The buying and selling of securities.
Trading Costs Costs of buying and selling securities, including
commissions, slippage and the bid/ask spread.
Trading Pattern The long-range direction of a securitys price,
charted by drawing a line connecting the highest prices the security
has reached and another line connecting the lowest prices at which
the security has traded over the same period.
Trading Range The difference between the high and low prices
traded during a period of time.
Trading Rules A set of predetermined, customized rules that
must be followed on each and every trade you place.
Trading Signal An indication of a buying or selling opportunity.
Trading System A holistic view of the trading process that
encapsulates trading rules, fundamental, technical and intermarket
analysis, and money management techniques to increase the odds of
success over time.
Trading Volume The number of shares transacted every day.
Because there is a seller for every buyer, trading volume is half of the
number of shares traded.
Trailing Stop A stop loss order that trails the progress of an
upward trending stock. It helps to preserve profit while also providing
downside protection.
Transaction The delivery of a security by a seller, and its
acceptance by the buyer.
Treasury Securities Short-and long-term bonds issued by
the Treasury Department and backed by the full faith of the U.S.
government. Treasury yields are commonly used to track fluctuations
in interest rates.
Trend The general direction of the market.

193

Guide to Options Strategies

Notes
Trendless (see Sideways Trend) A horizontal price movement
within a narrow price range over an extended period of time, creating
the appearance of a relatively straight line on a stocks price graph.
Trendline A technical chart line that depicts the past movement of
a security, and that is used to help predict future price movements.

Under Perform When a security appreciates at a slower pace


than the overall performance of the market.
Undervalued A stock price perceived to be too low, as indicated
by a particular valuation model. For instance, a companys stock price
may be considered cheap if the companys P/E ratio is much lower
than the industry average.
Unissued Stock Shares authorized in a corporations charter, but
not issued.
Unmargined Account A cash account held at a brokerage firm.
Up Market indication that securities, or the market in general, is
doing well in volume trading.
Up Tick A plus tick; a price movement in the upward direction. A
trade occurring at a price higher than the previous trade.
Upgrading Raising the quality rating of a security because of new
optimism about the prospects due to tangible/intangible factors. This
can increase investor confidence and push the price of the security
up.
Upside Potential The amount by which analysts or investors
expect the price of a security may increase.
Upswing An upward turn in a securitys price after a period of
falling prices.
Uptrend Upward direction in the price of a stock, bond, or
commodity future contract or overall market.
194

Upper Band The top range of a technical oscillator such as MACD


or Stochastic.

Glossary

Notes

Validation The comparison of technical signals and indicators to


ensure that the majority of them are pointing in the same direction;
information that confirms your opinion of a buying or selling
opportunity.
Valleys The low point at the end of an economic contraction until
the start of an expansion.
Valuation A determination of the value of a companys stock
based on earnings and the market value of assets.
Variable An element in a model; variables change through time
and are not constant.
Volatility A measure of risk based on the standard deviation of the
asset return. A variable that appears in option pricing formulas where
it denotes the volatility of the underlying asset return from now to the
expiration of the option.
Volume The daily number of shares of a security that change
hands between a buyer and a seller.
Volume Filter A method for identifying breakouts through
support and resistance zones. Volume Filtering refers to waiting for an
increase in buying or selling volume to support the breakout you are
observing.

Wall Street Generic term for the security industry firms that buy,
sell, and underwrite securities.
Watch List A list of securities selected for special attention as
potential investments.
195

Guide to Options Strategies

Weak Market A market with few buyers and many sellers, and a
declining trend in prices.
Well-Diversified Portfolio A portfolio that includes a variety
of securities in order to approximate the overall market risk. The
unsystematic risk of each security is diversified throughout the
portfolio.
Whipsaw A highly volatile environment in which a stock
experiences severe fluctuations on both the upside and downside.
Traders will sometimes get stopped out of these trades only to see
the stock continue to rally higher after they have exited the trade.

Year-End Dividend A special dividend declared at the end of


a fiscal year that usually represents higher-than-expected company
profits.
Year-to-Date (YTD) The period beginning at the start of the
calendar year up to the current date.
Yield The percentage rate of return paid on a stock in the form of
dividends.

Zone A price level of support or resistance for a stock. Looking


for breakouts through support and resistance zones provides
opportunities to buy stocks at the early stage of new rallies.

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