Welcome to the Option Basics Guide

and learn how to trade options!

Before continuing, we need to emphasize that options represent a

higher-level form of investment, and carry a much higher amount of
risk. As such, investors are advised to thoroughly understand and
learn how to trade options before investing, and to only invest with
risk capital.

Stock options are more complex and risky than stocks.

Carefully study and learn how to trade options before
investing. Also, only invest with money that you can
afford to lose.

This guide helps you learn stock options .

This guide assumes that you already have a basic understanding of the
stock market.

What are Options?

Starting Stock Options

For beginners, starting stock options can be very daunting, with all the
new terms and concepts. This guide will hopefully shed some light on
options for you with its simpler explanations.

Options are another form of security that you can invest and trade in
the stock market. Like futures, they are considered derivatives of - or
based on - normal stocks.

Options are securities derived from - or based on -

normal stocks. They are traded on Options Exchanges.
Buying an option gives you the right, but not the requirement or
obligation, to buy an underlying stock at a specified price at a later
specified date. For example, you can buy an option to buy shares in
ITC in say 2 months' time at a predefined price.

The most widely used method of explaining this is via the housing
industry:

Imagine that you just found your dream home, but can't afford the Rs
100,000 you need to buy it today. You then contact the owner, and
the both of you agree to a contract where you get the right to buy the
house in 6 months' time at say Rs 110,000 (taking into account the
rising cost of housing).

However, since you could possibly run away without buying the house,
leaving the owner waiting 6 months for nothing, you agree to pay him
a token "down payment" or premium, of Rs 5,000 for the right to buy
his house.

So, fast-forward 6 months. No matter what the new market value of

the house is, you have the right to buy the house at Rs 110,000. 2
things can happen: the market value of the house could have
skyrocketed to Rs 200,000. In this case, you still get to buy it at Rs
110,000, keeping the rest as profit (or savings, depending on how you
look at it).

On the other hand, if the price of the house drops to Rs 80,000, you
can decide not to buy it, since you have the right, but not the
obligation, to buy it. So all you've lost is the initial Rs 5,000 premium
you spent to lock in the contract.

When you buy an option, you get the right, but not the
obligation, to buy the related stock at a future date, but
at a price you specify now. If the stock's market value
rises above your agreed-upon price, you profit. If the
stock's value crashes, all you've lost is your premium.
 Calls and Puts - Buying Stock Options

So far in our previous housing example, we bought an option hoping

that the price of the house will go up. That is actually just one type of
option, called a Call Option.

One reason why investors like buying stock options is because you can
profit from them whether your stock goes up in price, or down. This
differs from buying normal stocks, where you only make money when
your stock goes up in price.

This is because there are various types of options in the market, to

suit the needs of different investors. The 2 simplest forms are the Call
Option, which we mentioned above, and its opposite, Put Options.

Basically, when buying stock options, you would buy a Call Option if
you expect the underlying stock price to go up. Conversely, you would
buy Put Options on a stock which you expect to drop.

If it seems too difficult to remember the difference between calls and

puts when buying stock options, you might want to remember this
adage instead:

You Call Up your friend to talk, and when you're done, you Put Down
the phone.

Easy to remember isn't it? The call option is for when you expect the
stock to go up, otherwise known as a Long Position. Put options are for
when you expect the stock to go down, otherwise known as Short
Positions.

While you only profit with stocks when they go up, you can
profit with options both when the stock goes up or
down. The 2 basic types of options are Calls and Puts.
Remember: you Call Up a friend, and you Put Down the
phone when you're done.

Now comes the tricky part. If a Call Option gives you the right, but not
the obligation, to buy a stock at a later date, what do Put Options do?

Exactly the opposite. Put Options give you the right, but not the
obligation, to sell a stock at a later date.

Put options are usually more difficult to understand than the

straightforward Call option, because to "use" or "exercise" Put options,
you need to own the related stock first, since "exercising" the option
would require you to sell the stock.

Suffice to say at this point that when buying stock options, you would
buy Put Options when you expect the price of the related stock to go
down.

Exactly opposite to the Call Option, when you buy Put

Options, you have the right, but not the obligation, to
sell the stock. You would profit if the price of the stock
goes down.

So, to repeat the difference between Calls and Puts, you would buy a
Call option if you expect the stock in question to go up, and you would
buy Put options if you expect the stock to go down.

Options Lingo - Understanding Stock Options

 Investing

Now that we understand the basic concept of option trading, it's time
to mention the terminology used in the option trading world.

Premium - The premium is the amount that you pay up front for the
option. This amount is once-off and non-refundable.

Strike Price - The strike price is the amount that you agree to pay for
the stock at a later date.

Underlying Stock - The underlying stock is the stock for which you
are purchasing the option.

Exercising Options - No, we are not talking about choosing to jump

up and down in front of an exercise video featuring Anna. By
exercising an option, you are using your right to buy, and actually
purchasing the underlying stock.

Expiration Date - The expiration date is the last day for you to
exercise your option. If you don't exercise it by then, your option will
expire worthless. In the United States, the expiration date is the 3rd
Friday of the month. So if you have a June option, that option will
expire on the 3rd Friday of June.

American Options - American options are options (not limited by any

geographic boundaries) that allow you to exercise the options at any
time until the expiration date.

European Options - European options are options (not limited by any

geographic boundaries) that allow you to exercise the options at only
the expiration date. Do check with your local Options Exchange which
form of options are used in your country.

Contract - Option investing is carried out in numbers of contracts.

One contract equates to 100 underlying shares. If you buy one call
option contract, you are buying the right to buy 100 shares of the
underlying stock.

In-The-Money - An option is said to be in-the-money if it is worth

something if you choose to exercise it now.

Out-Of-The-Money - An option is said to be out-of-the-money if it is

worthless if you choose to exercise it now.

In our previous housing example, you paid a Premium of Rs 5,000 for

the Call Option, or the right to buy the Underlying house, at a Strike
Price of Rs 110,000. You may exercise the right to buy the house at
the Expiration date of 6 months' time.

Looking at our 2 possible scenarios, if the underlying house is worth Rs

200,000 in 6 months' time, your option is considered In-The-Money.
If you had bought it, you would have made a profit of Rs 200,000 - Rs
110,000 - Rs 5,000 = Rs 85,000. Your profit would be the market
value of the house, minus the amount you paid for it, and minus the
option Premium you paid at the start for the right to buy the house.

In the 2nd scenario, if the underlying house is worth Rs 80,000 in 6

months, your option would be Out-Of-The-Money, and you would not
want to exercise it and pay more for the house than it was actually
worth. Your loss would be the initial Rs 5,000 you paid for the option.

Scenario Scenario
Item
1 2
Initial Premium Rs 5,000 Rs 5,000
Rs Rs
Strike Price
110,000 110,000
Expiration Date 6 months 6 months
House Market Rs
Rs 80,000
Value 200,000
In-The-Money? In Out
Profit Rs 85,000 - Rs 5,000
Now let's look at an option investing example in the stock market:

You are monitoring stock ABC, which is currently priced at Rs 19.00

on the 1st of June. You think ABC is doing well, and should go up in
price very soon.

You decide to buy a June Call Option for ABC, with a Strike Price of
Rs 20.00, and an Expiration Date of the 3rd Friday of June (options
always expire on the 3rd Friday of the month)(In India, it’s the last
Thursday of the Month). The Premium for the option is Rs 0.75. As
of now on the 1st of June, the option is Out-Of-The-Money, since
ABC's price of Rs 19.00 is still below your Strike Price of Rs 20.00

On the 3rd Friday of June, you find that ABC has increased in price by
Rs 3.00 bringing it up to Rs 22.00. Your option is now In-The-Money,
and you could exercise it now for a profit. Your profit would be the
market value, minus your strike price, minus your premium, which is Rs
22 - Rs 20 - Rs 0.75 = Rs 1.25.

3rd
ABC 1st June
Friday
Initial Premium Rs 0.75 Rs 0.75
Strike Price Rs 20.00 Rs 20.00
3rd 3rd
Expiration Date
Friday Friday
Current Stock
Rs 19.00 Rs 22.00
Price
In-The-Money? Out In
Profit - Rs 0.75 Rs 1.25
Be aware that since each option contract covers 100 underlying shares,
all costs and profits should be multiplied by 100 for the proper
perspective.

And also be aware that option investing in general is very risky, and
should only be done after understanding stock options intimately. Since
options provide such a large amount of leverage (you can earn a larger
percentage, as well as lose a larger percentage), you could lose a
fortune without properly understanding stock options.
 Option Strategies

Hedging Strategies - One of the basic reasons investors (especially

institutions that manage large funds) use Options is for hedging
purposes.

Imagine that you've bought some shares of a particular stock, which

you expect to rise. However, there might be some uncertainty as to
whether it will actually rise, or drop instead.

One thing you can do to hedge - or protect - your investment would be

to buy a Put Option on that stock. (Remember, you buy a Put Option
when you expect the stock price to go down). So you are hedging your
stock by buying a put option on it.

If the price of the stock goes up, your Put Option expires worthless,
but your original stock investment will be giving you profit. If the price
goes down, your losses in your stock investment will be reduced by
your Put Option, which will be worth more as the price drops.

These hedging strategies will lower your profit slightly, since you need
to spend extra to buy the Put Option for hedging, but they give you a
safety net in case your stock goes down.

Hedging strategies are suitable for mildly bullish stocks, where you
expect the stock to go up, but fear that it might go down. If you think
the stock will go down, you would not use hedging strategies. You
would sell the stock and just buy put options.

To protect your stock investment, you implement hedging

strategies by buying Put Options on the stock. This will
limit your losses if the price drops.

Trading Options - So far, the only option strategies we have touched

are about buying options, and then exercising them or letting them
expire worthless. However, the majority of investors do not actually
hold their options until the expiration date. They do what's called
"Option Trading".

When you buy an option, you are considered to be Opening a Position

by purchasing the option. There are 3 ways you can Close the Position:

 Firstly, you can exercise the option before the expiration date to
buy the underlying stock.
 Secondly, you can let the option expire worthless, i.e. don't do
anything.
 The third and most popular of the option strategies would be to
sell the option.

Buying options is like buying stocks. You buy them on the open
market, where there will be other people buying and selling the same
options. As such, there will be Bid and Ask prices for options, same as
for stocks.

A new term to remember when looking at option strategies is the

Open Interest. This represents the number of Open Positions there are
for that particular option. If the Open Interest is zero, it means either
that nobody has bought that option, and/or that the people who
previously bought it have Closed their Positions.

Let's look at trading option strategies with our previous example on

the ABC company:

To recap, we bought an option on the 1st of June for the ABC

company, when the stock was trading at Rs 19.00. We bought the
June option with a strike price of Rs 20.00, at a premium of Rs 0.75.

We now have an Open Position on the ABC Rs 20 June Call option.

Let's assume that a week later, on the 8th of June, the price for the
ABC stock has gone up to Rs 24.00. That means our option is now In-
The-Money by Rs 4, since our strike price is Rs 20 and the current
value is Rs 24, allowing us to theoretically exercise the option and buy
the stock at Rs 20, and immediately sell it at Rs 24 for a Rs 4 profit.
(Remember that since we are trading American Options, we can
exercise anytime before expiration day.)

However, a more convenient method (and cheaper too, since we don't

have to spend the Rs 20 to buy the stock), would be to sell the option
to someone else. Since the option is now In-The-Money, its premium
would have risen quite a bit too, say to Rs 4.50. That is the price we
can sell the option at.
We don't have to worry about finding someone to buy the option from
us. The American options market has Market Makers who will maintain
market liquidity, i.e. they will make sure all buyers will find
corresponding sellers, and vice versa.

So we will sell the Call Option at Rs 4.50. Since we initially paid Rs

0.75 for the option premium, we have just made a profit of Rs 4.50 -
Rs 0.75 = Rs 3.75. In case you were wondering, that's a 400% profit
on our Rs 0.75 investment. Congratulations!

ABC 1st June 8th June

Current Premium Rs 0.75 Rs 4.50
Strike Price Rs 20.00 Rs 20.00
3rd
Expiration Date 3rd Friday
Friday
Current Stock
Rs 19.00 Rs 24.00
Price
Out by Rs In by Rs
In-The-Money?
1 4
Profit - Rs 0.75 Rs 3.75
Be aware that the stock price could just as easily have gone down,
which would result in us losing our entire Rs 0.75 premium. Be careful,
most option strategies are risky!

Open Straddles and Straddle Strategy

Thus far, we have been looking at basic option plays, ie. buying either
a call or put, and then either exercising or selling them.

From here on, we will be covering a few more advanced option

strategies that will require more understanding and experience in
trading options. We recommend that you try trading or paper trading
in the basic options as covered in the earlier topics before trying the
strategies in the following topics.

We will be covering 3 of the more common option strategies, but do

note that the number of strategies in use in the stock market by more
experienced traders are plentiful, and are implemented by various
combinations of buying and selling options as well as the underlying
stock.

The option strategies covered from this topic onwards are

for people who have understood and tried trading in
basic options. These strategies may become quite
complex. A misunderstanding of a strategy can result in a
huge loss.

Option Straddles - The straddle strategy is an option strategy that's

based on buying both a call and put of a stock. Note that there are
various forms of straddles, but we will only be covering the basic
straddle strategy.

To initiate an Option Straddle, we would buy a Call and Put of a stock

with the same expiration date and strike price. For example, we would
initiate a Straddle for company ABC by buying a June Rs 20 Call as
well as a June Rs 20 Put.

Now why would we want to buy both a Call and a Put? Calls are for
when you expect the stock to go up, and Puts are for when you expect
the stock to go down, right?

In an ideal world, we would like to be able to clearly predict the

direction of a stock. However, in the real world, it's quite difficult. On
the other hand, it's relatively easier to predict whether a stock is going
to move (without knowing whether the move is up or down). One
method of predicting volatility is by using the Technical Indicator called
Bollinger Bands.

For example, you know that ABC's annual report is coming out this
week, but do not know whether they will exceed expectations or not.
You could assume that the stock price will be quite volatile, but since
you don't know the news in the annual report, you wouldn't have a
clue which direction the stock will move.

In cases like this, an option straddle strategy would be good to adopt.

If the price of the stock shoots up, your Call will be way In-The-Money,
and your Put will be worthless. If the price plummets, your Put will be
way In-The-Money, and your Call will be worthless.

This is safer than buying either just a Call or just a Put. If you just
bought a one-sided option, and the price goes the wrong way, you're
looking at possibly losing your entire premium investment. In the case
of Straddles, you will be safe either way, though you are spending
more initially since you have to pay the premiums of both the Call and
the Put.

In a Straddle strategy, you buy both a Call and a Put for

the same stock, with identical expiration dates and strike
prices. This strategy is good for stocks where you expect
volatility but don't know which direction it will go. You
will profit whether the stock jumps or falls.

Let's look at a numerical example:

For stock XYZ, let's imagine the share price is now sitting at Rs 63.
There is news that a legal suit against XYZ will conclude tomorrow. No
matter the result of the suit, you know that there will be volatility. If
they win, the price will jump. If they lose, the price will plummet.

So we decide to initiate a Straddle strategy on the XYZ stock. We

decide to buy a Rs 65 Call and a Rs 65 Put on XYZ, Rs 65 being the
closest strike price to the current stock price of Rs 63. The premium
for the Call (which is Rs 2 Out-Of-The-Money) is Rs 0.75, and the
premium for the Put (which is Rs 2 In-The-Money) is Rs 3.00. So our
total initial investment is the sum of both premiums, which is Rs 3.75.

Fast forward 2 days. XYZ won the legal battle! Investors are more
confident of the stock and the price jumps to Rs 72. The Rs 65 Call is
now Rs 7 In-The-Money and its premium is now Rs 8.00. The Rs 65
Put is now Way-Out-Of-The-Money and its premium is now Rs 0.25.
If we close out both positions and sell both options, we would cash in
Rs 8.00 + Rs 0.25 = Rs 8.25. That's a profit of Rs 4.50 on our initial
Rs 3.75 investment!

Let's look at this in tabular format:

XYZ Day 1 Day 3

Stock Price Rs 63 Rs 72
Rs 65 Call In-The-Money Out Rs 2 In Rs 7
Rs 65 Call Premium Rs 0.75 Rs 8.00
Rs 65 Put In-The-Money In Rs 2 Out Rs 7
Rs 65 Put Premium Rs 3.00 Rs 0.25
Total Option Value Rs 3.75 Rs 8.25
Profit - Rs 3.75 + Rs 4.50
Of course, we could have just bought a basic Call option and earned a
greater profit. But we didn't know which direction the stock price would
go. If XYZ lost the legal battle, the price could have dropped Rs 10,
making our Call worthless and causing us to lose our entire investment.
A Straddle strategy is more conservative and will profit whether the
stock goes up or down.

If Straddles are so good, why doesn't everybody use them for every
investment?

It fails when the stock price doesn't move. If the price of the stock
hovers around the initial price, both the Call and the Put will not be that
much In-The-Money.

Furthermore, the closer it is to the expiration date, the cheaper

premiums are. Option premiums have a Time Value associated with
them. So an option expiring this month will have a cheaper premium
than an option with the same strike price expiring next year.

So in the case where the stock price doesn't move, the premiums of
both the Call and Put will slowly decay, and we could end up losing a
large percentage of our investment. The bottom line is: for an option
straddle strategy to be profitable, there has to be volatility, and a
marked movement in the stock price.

Options have a Time Value associated with them. The

closer they are to expiration date, the less they're
worth. Therefore, a Straddle will fail if the stock price
doesn't move. The premiums of both the Call and Put will
slowly decay, and will result in a loss.

A more advanced investor can tweak Straddles to create many

variations. They can buy different amounts of Calls and Puts with
different Strike Prices or Expiration Dates, modifying the Straddles to
suit their individual strategies and risk tolerance. This is beyond the
scope of this Guide.

Writing Covered Calls

From looking at Straddles, which thrive on volatility, we now take a

look at a strategy that's much more conservative. It's so conservative
that some retirement funds allow this strategy in their portfolio.

Writing Covered Calls are a "moderate" investor's favourite strategy. It

works particularly well when the stock in question doesn't move
dramatically up or down, but rather just trends sideways.

Basically, it works for stocks that are deemed too "boring" for option
plays.

Writing Covered Calls is an extremely conservative

strategy that works best on stocks that don't move much
in price.

So far, we've only considered buying options. For writing Covered

Calls, we need to take a look at the opposite side of that transaction,
which is selling stock options . The term "writing" refers to the act of
selling stock options. So when we write covered calls, we are actually
selling a call option.

To recap, buying a call option gives you the right, but not the
obligation, to buy a stock at a specified price at a specified date.
Conversely, if you sell a call option, you now have the obligation to sell
the stock to the option buyer at the agreed upon price at the specified
date.

Taking a look at our housing example earlier on, the owner of the
house basically wrote / sold an option to us by promising to sell us the
house at the agreed price. We could decide whether we wanted to buy
the house, but if we did want to buy it, the house owner is required to
sell it. He does not have the luxury of saying no.

So a Call Writer is agreeing to the obligation to sell stock, while a Put

Writer is agreeing to the obligation to buy stock.

When you are Writing or Selling stock options, you are

agreeing to the obligation to fulfill the option contract,
which is to sell stock in the case of a Call, or to buy
stock in the case of a Put.

Scary isn't it? Who would want to enter a contract with such
obligations?

The good part is, when you sell an option, you receive the Premium of
the option. Which means you instantly make money from a
transaction.

In that case, why doesn't everyone start selling options?

Let's take a closer look at selling Call options.

To recap: when you buy an option, you buy the option to Open a
Position, and sell it later on to Close the Position. Similarly, when you
Write options, you write the option to Open the Position, and you must
Close the Position somehow, whether it's by letting the option expire
worthless, or by buying the option back.

In the case of selling Call options, remember that Call options are
more In-The-Money the higher the stock price goes. So if you sell a
Call option and the underlying stock price goes down below the
option's strike price (meaning the option becomes Out-Of-The-Money),
the option will expire worthless. You therefore don't need to do a
thing, and can pocket the profit you earned by selling the option.

However, the danger happens when the stock price keeps climbing. If
it keeps going up, it will never become worthless, and come expiration
day, someone is going to exercise the option and buy the stock from
you. You have been Called Out.

The problem is, you don't own the stock! You would need to buy the
stock at the current market price (which has gone up), and sell the
stock to the option buyer at the previously agreed strike price, which
would have been lower. This would cost you a lot!

Let's take a look at a numerical example:

Say the price of stock ABC is now sitting at Rs 18. You sell a Call
option for a strike price of Rs 20, expecting the stock to hover around
the Rs 18 level. Let's say you earned Rs 1.00 on the option premium
(which is Rs 2 Out-Of-The-Money).

Scenario 1: If by expiration day the stock price ends up at Rs 19,

which is below the strike price of Rs 20, you're fine, since the option is
Out-Of-The-Money and will expire worthless.
Scenario 2: What if by expiration day the stock price jumps to Rs 26?
The option is now In-The-Money by Rs 6, and you have been Called
Out. So you will need to buy the stock at the current market value of
Rs 26, then sell it to the option buyer at Rs 20. That's a loss of Rs 6 for
you, and if you include the Rs 1.00 you made earlier, still results in a
nett loss of Rs 5.00.

Let's look at this in tabular format:

Scenario
ABC Scenario 2
1
Premium Earned Rs 1.00 Rs 1.00
Strike Price Rs 20 Rs 20
Final Stock Price Rs 19 Rs 26
In-The-Money? Out Rs 1 In Rs 26
Cost of Stock Purchase --- Rs 26
Earnings from Stock Sale --- Rs 20
Total Profit Rs 1.00 - Rs 5.00
And that's just if the stock price goes up to Rs 26. What if it had gone
higher, to say Rs 36? Your losses would increase by another Rs 10.
Considering that one contract covers 100 (different lot size for
different scripts) underlying shares, that's a lot of money. Therefore,
selling stock options on their own, also known as selling Naked or
Uncovered options, is extremely risky.

Selling stock options on their own is known as selling

Naked or Uncovered options. They are extremely risky,
and can result in unlimited losses.

In order to lessen that risk, what we can do is to actually buy the

underlying stock the same time we sell the option. For example, if you
want to sell 1 contract of ABC options, you would buy 100 shares of the
ABC stock at the same time (remember that 1 option contract is
equivalent to 100 underlying shares).

By buying the shares, we eliminate the risk of having to buy the shares
later at a higher price in case we get called out. This is called covering
your call writing, ie. we just wrote a Covered Call.

Let's return to our numerical example, but this time we write covered
calls on it. Previously, we sold a Rs 20 Call option for a premium of Rs
1.00 when the stock was currently at Rs 18. This time, we also bought
100 shares of the stock at Rs 18.

Let's look at 2 scenarios, one where the stock went down in price, and
another where the stock climbs above the option strike price.

Scenario 1: If the stock price falls to Rs 17 by expiration day, the

option expires worthless and we are not called out. We lost Rs 1.00
because we bought the stock at Rs 18 and it's now at Rs 17. However,
since we previously sold the option for Rs 1, we actually broke even.
And we still own the stock.

Compare this with just a simple purchase of the stock. When we write
covered calls, ie. selling an option together with buying the stock, we
actually increase our loss tolerance by the option's premium amount. In
this example, we increased out loss tolerance by the option premium of
Rs 1, meaning we could afford to have the stock drop Rs 1 without
actually losing anything.

That is our break even level. As long as the stock price stays above that
level, we profit. Anything less and we lose. That's why we need to look
at stable or moderately bullish stocks to consider for writing covered
calls.

This is important in the stock market, where stocks we buy usually

don't go up the way we expect them to...

Scenario 2: If by expiration day, the stock goes up to say Rs 26, we

would be called out. However, there is no risk, because we already own
the stock, and can just sell it immediately. However, since we already
agreed to sell the stock at Rs 20, that is the price we have to honor. So
we sold the stock at Rs 20. In total, we earned Rs 2 from selling the
stock (Rs 20 minus the Rs 18 we spent earlier), and earned another Rs
1 from selling stock options earlier on. That's a total Rs 3 profit.
Let's look at this in tabular format:

Scenario Scenario
ABC
1 2
Cost of Stock Rs 18.00 Rs 18.00
Premium Earned Rs 1.00 Rs 1.00
Strike Price Rs 20 Rs 20
Final Stock Price Rs 17 Rs 26
In-The-Money? Out Rs 3 In Rs 26
Earnings from Stock Sale --- Rs 20
Change in Value of Held
-Rs 1.00 ---
Stock
Still Keep the Stock? Yes No
Total Profit Rs 0.00 Rs 3.00
Now let's take a look again at Scenario 1. The Call option has expired
worthless, and we keep the stock. This means that month after month
we can keep selling stock options on those 100 shares we own, and as
long as we don't get called out, we can make constant monthly income!
And what if we get called out? As Scenario 2 shows, getting called out
still earns us a profit!

This is how investors write covered calls to generate a monthly income.

This strategy usually earns about 3% to 15% a month. Not bad for a
strategy that's almost risk-free!

However, do note that if you are unlucky enough to choose to buy a

stock that keeps falling lower and lower, no strategy is going to help
you! (Unless you buy a Put option on that stock to reduce your losses).

We write covered calls by buying stocks to cover an

option sale. This is a conservative strategy that can be
used to create monthly income, by selling call options
 month after month.

On a side note, some investors who have held particular stocks that
haven't moved for a long time can also decide to write Covered Calls.
They can sell call options on their stock, and either earn monthly
income on the stocks, or (sometimes hopefully!) get called out and sell
their stocks, getting back their capital to invest elsewhere.

Spread Options and Spread Trading

Spread option trading is a technique that can be used to profit in

bullish, neutral or bearish conditions. It basically functions to limit risk
at the cost of limiting profit as well.

Spread trading is defined as opening a position by buying and selling

the same type of option (ie. Call or Put) at the same time. For
example, if you buy a call option for stock XYZ, and sell another call
option for XYZ, you are in fact spread trading.

By buying one option and selling another, you limit your risk, since you
know the exact difference in either the expiration date or strike price
(or both) between the two options. This difference is known as the
spread, hence the name of this spread treading technique.

Spread trading is carried out by buying an option, and

selling an option of the same type for the same stock.
This technique limits your risk, since you know the spread
between the two options. However, profits are limited as
well.

Various strategies can be carried out using this technique. The main
ones are vertical spreads, horizontal spreads and diagonal spreads.

A Vertical Spread is a spread option where the 2 options (the one

you bought, and the one you sold) have the same expiration date, but
differ only in strike price. For example, if you bought a Rs 60 June Call
option and sold a Rs 70 June Call option, you have created a Vertical
Spread.

Let's take a look at why you would do this.

Let's assume we have a stock XYZ that's currently priced at Rs 50. We
think the stock will rise. However, we don't think the rise will be
substantial, maybe just a movement of Rs 5.

We then initiate a Vertical Spread on this stock. We Buy a Rs 50 Call

option, and Sell a Rs 55 Call option. Let's assume that the Rs 50 Call
has a premium of Rs 1 (since it's just In-The-Money), and the Rs 55
Call has a premium of Rs 0.25 (since it's Rs 5 Out-Of-The-Money).

So we pay Rs 1 for the Rs 50 Call, and earn Rs 0.25 off the Rs 55 Call,
giving us a total cost of Rs 0.75.

Two things can happen. The stock can either rise, as predicted, or drop
below the current price. Let's look at the 2 scenarios:

Scenario 1: The price has dropped to Rs 45. We have made a mistake

and predicted the wrong price movement. However, since both Calls
are Out-Of-The-Money and will expire worthless, we don't have to do
anything to Close the Position. Our loss would be the Rs 0.75 we spent
on this spread trading exercise.

Scenario 2: The price has risen to Rs 55. The Rs 50 Call is now Rs 5

In-The-Money and has a premium of Rs 6. The Rs 55 Call is now just
In-The-Money and has a premium of Rs 1. We can't just wait till
expiration date, because we sold a Call that's not covered by stocks we
own (ie. a Naked Call). We therefore need to Close our Position before
expiration.

So we need to sell the Rs 50 Call which we bought earlier, and buy

back the Rs 55 Call that we sold earlier. So we sell the Rs 50 Call for
Rs 6, and buy the Rs 55 Call back for Rs 1. This transaction has earned
us Rs 5, resulting in a nett gain of Rs 4.25, taking into account the Rs
0.75 we spent earlier.

What happens if the price of the stock jumps to Rs 60 instead?

Here's where the - limited risk / limited profit - expression comes in.
At a current price of Rs 60, the Rs 50 Call would be Rs 10 In-The-
Money and would have a premium of Rs 11. The Rs 55 Call would be
Rs 5 In-The-Money and would have a premium of Rs 6. Closing the
position will still give us Rs 5, and still give us a nett gain of Rs 4.25.

In tabular format:
 Resulting Stock
Rs 45 Rs 50 Rs 55 Rs 60
Price
Premium of Rs 50
--- Rs 1 Rs 6 Rs 11
Call
Premium of Rs 55 Rs
--- Rs 1 Rs 6
Call 0.25
Difference in Rs
--- Rs 5 Rs 5
Premium 0.75
Rs Rs Rs Rs
Initial Cost
0.75 0.75 0.75 0.75
-Rs Rs Rs
Total Profit Rs 0
0.75 4.25 4.25
Once both Calls are In-The-Money, our profit will always be limited by
the difference between the strike prices of the 2 Calls, minus the
amount we paid at the start.

As a general rule, once the stock value goes above the lower Call (the
Rs 50 Call in this example), we start to earn profit. And when it goes
above the higher Call (the Rs 55 Call in this example), we reach our
maximum profit.

So why would we want to perform this spread option?

If we had just done a simple Call option, we would have had to spend
the Rs 1 required to buy the Rs 50 Call. In this spread trading exercise,
we only had to spend Rs 0.75, hence the - limited risk - expression. So
you are risking less, but you will also profit less, since any price
movement beyond the higher Call will not earn you any more profit.
Hence this strategy is suitable for moderately bullish stocks.

This particular spread we have just performed is known as a Bull Call

Spread, since we performed a Call Spread with a bullish or upward-
trending expectation. Similarly, Bull Put Spreads, Bear Call Spreads
and Bear Put Spreads are all based on the same technique and
function quite the same.

Bull Put Spreads are strategies that are also used in a bullish market.
Similar to the Bull Call Spread, Bull Put Spreads will earn you limited
profit in an uptrending stock. We implement Bull Put Spreads by buying
a Put Option, and by selling another Put Option of a higher strike price.
The Bear Spreads are similar to the Bull Spreads but work in the
opposite direction. We would buy an option, then sell an option of a
lower strike price, since we anticipate the stock price dropping.

A Vertical Spread is a spread where the options you buy

and sell only differ in strike price. A Bull Call Spread is a
spread performed on a bullish stock. You Buy a Call at a
particular strike price, and Sell a Call with a higher strike
price. Breakeven occurs when the stock rises above the
lower strike price, and maximum profit occurs when the
stock rises above the higher strike price.

We now look a Horizontal Spreads Options. Horizontal Spreads,

otherwise known as Time Spreads or Calendar Spreads, are spreads
where the strike prices of the 2 options stay the same, but the
expiration dates differ.

To recap: Options have a Time Value associated with them. Generally,

as time progresses, an option's premium loses value. In addition, the
closer you get to expiration date, the faster the value drops.

This spread takes advantage of this premium decay.

Let's look at an example. Let's say we are now in the middle of June.
We decide to perform a Horizontal Spread on a stock. For a particular
strike price, let's say the August option has a premium of Rs 4, and the
September option has a premium of Rs 4.50.

To initiate a Horizontal Spread, we would Sell the nearer option (in this
case August), and buy the further option (in this case September). So
we earn Rs 4.00 from the sale and spend Rs 4.50 on the purchase,
netting us a Rs 0.50 cost.

Let's fast-forward to the middle of August. The August option is fast

approaching its expiration date, and the premium has dropped
drastically, say down to Rs 1.50. However, the September option still
has another month's room, and the premium is still holding steady at Rs
3.00.
At this point, we would close the spread position. We buy back the
August option for Rs 1.50, and sell the September option for Rs 3.00.
That gives us a profit of Rs 1.50. When we deduct our initial cost of Rs
0.50, we are left with a profit of Rs 1.00.

That is basically how a Horizontal Spread works. The same technique

can be used for Puts as well.

A Diagonal Spread Option is basically a spread where the 2 options

differ in both strike price and expiration date. As can be seen, this
spread contains a lot of variables. It is too complex and beyond the
scope of this guide.

A Horizontal Spread is a spread where the 2 options

differ in expiration date. You Sell the Closer option, and
Buy the Further option. You close the position once the
Closer expiration date nears. A Diagonal Spread is a
spread where both strike prices and expiration dates
differ.

We hope you have enjoyed this guide, and benefited from the simpler
terms we've used to describe option trading. Do note that throughout
the guide, we have not taken into account additional costs such as
commissions and differences in bid/ask prices. Including these would
have complicated this guide more than we wanted. Just note that these
costs exist and will add to your costs and lower your profits.
 Advanced Options Strategies Guide

Before continuing, we need to emphasize that options represent a

higher-level form of investment, and carry a much higher amount of
risk. As such, investors are advised to thoroughly understand and
learn how to trade options before investing, and to only invest with
risk capital.

Stock options are more complex and risky than stocks.

Carefully study and learn how to trade options before
applying these advanced options strategies. Also, only
invest with money that you can afford to lose.

This guide assumes that you already have a basic understanding of the
fundamentals of option trading, such as buying and selling calls and
puts. If you wish to read up on the foundations of option trading, do
check out our Option Basics Guide.

In essence, every option strategy - no matter how complicated they

are - comes down to a combination of buying and selling call and put
options at various strike prices and expiration dates. Different
combinations of these basic building blocks of option trading are used
to suit the investor's risk profile and market outlook.

Are you bullish, neutral or bearish on a particular stock? Are you

prepared to risk more or prefer a more conservative strategy? Do you
prefer to monitor your trades daily or buy a position and wait till
expiration? Whatever your preferences are, there's an option strategy
for you. This guide will cover some of the more advanced options
strategies such as butterflies and iron condors.
 Call and Put Synthetics

A synthetic trade involves buying a call and selling a put with the same
strike price and expiration date or vice versa depending on your
outlook for the stock. A Long Synthetic is the name for the bullish
trade option, where a call is bought and a put is sold.

The effect of these call and put synthetics is similar to just buying a
basic call option, where your profits are unlimited the higher the
stock climbs. However, there are a few key differences. Firstly, a long
synthetic requires you to sell a put option. Doing so means you will
need to close this position before expiration to prevent the put
option being exercised.

As can be seen in the chart below, buying a basic call option means
that the maximum you will lose is the premium of that call. However,
you won't start to see profits till the stock climbs a bit higher than the
strike price of the option. In a long synthetic, selling a simultaneous
put option changes both these characteristics.
By combing the profit charts of the call purchase and put sale, it can
be seen that the potential loss of the trade has become
unlimited. In a basic call option, the maximum you will lose is the
premium you spent buying that call. In a long synthetic however, you
have an open put option which you will need to buy back before
expiration, and that put option will cost more the lower the stock price
becomes.

However, with this extra risk comes couple of key benefits. Firstly,
because you are selling a put option (thus earning premium) together
with buying a call, the long synthetic becomes cheaper than simply
buying a call. In addition, by adding the profit charts of the call
purchase and put sale together, you can see that this position starts to
see a profit as soon as the stock goes over the strike price.
Call and put synthetics involve buying a call and selling a
put at the same strike price, or vice versa. A long
synthetic is a bullish strategy and involves buying a call
and selling a put. It has unlimited profit as the stock
price climbs, and unlimited loss as the stock price falls.
Since options are sold, this position needs to be closed
before expiration.

A Short Synthetic is basically the opposite of the long synthetic

position. This is a strategy for when you are particularly bearish on a
stock. You buy a put option while simultaneously selling a call
option at the same strike price with the same expiration date.
Similar to the above scenario, if you had only bought a basic put
option, you don't start seeing profit till the stock goes a bit below the
strike price. On the other hand, a basic put will cost you the full cost of
the put option's premium, and your maximum loss is that premium.

Conversely, a short synthetic allows you to see profit the moment

your stock goes below the strike price, and the initial premium
spent on the put option is offset by the amount made selling the
corresponding call option. However, these advantages come with a big
caveat: you now risk unlimited losses. If the stock keeps climbing
higher and higher, the cost to buy back the call option before
expiration will increase correspondingly, making this position very
costly if you wrongly predict the direction of the stock movement.
 A short synthetic is a bearish strategy that involves
buying a put option and selling the corresponding call
option at the same strike price. You will see unlimited
profits if the stock price keeps falling, but also suffer
unlimited losses if the stock keeps climbing. Since
options are sold in this position, it needs to be closed
before expiration.

A lot of people think of synthetics as a cheap way of playing basic

options, since the option premiums are offset by selling the opposite
option contracts. However, please bear in mind that this position is
similar to trading in futures. If you wrongly predict the stock direction,
call and put synthetics can become very costly.
 Backspreads (Reverse Ratio Spreads)
Backspreads, also known as reverse ratio spreads, are an option
strategy utilized when you believe there will be much volatility in
the stock but are not 100% sure whether it will go up or down.
If the stock moves a lot in the predicted direction, you will earn a tidy
profit. If the stock moves a lot, but in the opposite direction, you will
earn a small profit. However, if the stock doesn't move much and is
stuck in a trading range, you will experience a loss.

The backspread position used when you are bullish on the stock is
known as a Call Backspread, since call options are used to create this
position. The call backspread is created by buying a certain number of
Out-of-The-Money (OTM) call options (i.e. call options whose strike
price is higher than the current stock price), and selling a lesser
number of In-The-Money (ITM) call options (i.e. call options whose
strike price is lower than the current stock price). You can create a call
backspread by buying and selling any number of call options, but for
the purposes of this article, we will talk about buying 2 OTM call
options and selling 1 ITM call option.
Because you are selling a call option that is ITM and buying 2 call
options that are OTM, this position should be a credit position, that is
you will earn a premium by opening a call backspread. However,
because you are selling an option, you are not able to allow this
position to expire. You will need to buy back the option before
expiration date, which brings us to the risks involved with this position.

If the stock price goes below the strike price of the call option that was
sold (the ITM price), you can allow the position to expire since the calls
at both strike prices are now worthless. Your profit in this case would
be the initial premium made when the position was opened. If the
stock moves above that ITM strike price but is still below the strike of
the 2 calls that you bought (the OTM price), you will be in trouble. The
2 calls with the OTM strike price would still be worthless, but the call
you sold at the ITM strike price would be worth something and will
need to be bought back before expiration. Once the stock moves
above the OTM strike price, your profits are limitless. The ITM call will
still increase in value (and must still be bought back), but that cost is
negated by the fact that you now have the 2 calls (bought at the OTM
strike price) gaining value just as quickly and can be sold for profit.
A call backspread is created by buying 2 out-of-the-
money calls and selling 1 in-the-money call, earning
you a net credit premium. It is meant for stocks that are
high volatility and bullish. You earn unlimited profit if
the stock climbs. If the stock falls, you get to keep your
original net credit premium. If the stock price doesn't
 move, you will incur a loss.

A Put Backspread functions in the same way but in the opposite

direction, and is a bearish position. You would use this position on a
stock that you expect to move a lot, with a high likelihood that it will
go down in price. The reason it is known as a put backspread is
because it is created by buying and selling put options.

The put backspread is opened by buying any number of out-of-the-

money (OTM) put options (i.e. put options whose strike price is below
the current stock price, and selling a smaller number of in-the-money
(ITM) put options (i.e. put options whose strike price is above the
current stock price). Doing this should give you a net credit
premium. Similar to the call backspread, a put backspread can be
created by buying and selling any number of put options, but for this
article we will talk about the simplest case, which is selling 1 ITM put
option and buying 2 OTM put options.
If the stock moves above the strike price of the ITM put option you
sold, you can allow the position to expire and keep your original credit
premium, since all 3 put options will be worthless. If the stock price
ends up between that ITM strike price and the strike price of the 2
OTM put options you bought, then you will incur a loss, since you will
need to buy back the ITM put option which is now worth something,
but the 2 OTM put options are still worthless. Once the stock price
drops below the strike price of the OTM put options, you will start to
see unlimited profit since the cost of buying back the ITM put option is
more than offset by the profits from selling the 2 OTM put options.
A put backspread is opened by buying 2 OTM put
options and selling 1 ITM put option, earning you a net
credit premium. This position is for high volatility with
a bearish outlook. If the stock climbs, you keep your
credit premium, if the stock falls, you earn unlimited
profits. However, if the stock price doesn't move, you will
incur losses due to buying back the put option you sold.

Do bear in mind that you cannot allow a backspread position to

expire, since you have sold options that need to be bought back to
prevent them being exercised. As such, you will need to make sure
you have enough funds to buy back those options in case the stock
price doesn't move.
 Long and Short Strangles
Strangles are an option trading strategy that takes advantages of a
stock's volatility. A long strangle is ideal for stocks with high volatility,
while short strangles are meant for stocks with very little volatility and
that stay within tight trading ranges. The strangle position is created
by either buying or selling a matching set of call and put options
whose strike prices are out-of-the-money.

The long strangle is the position to be used when high volatility is

expected for the underlying stock. It is created by buying an out-of-
the-money (OTM) call option (i.e. a call option whose strike price is
above the underlying stock's current price), and buy an OTM put
option (i.e. a put option whose strike price is below the underlying
stock's price). Both these options have the same expiration date.
While the stock price is below the call option's strike price, the call will
not be worth anything. Once the price goes above that strike price, the
call option will give a profit. Similarly, while the stock price is above
the put option's strike price, no profit is seen for that put option. When
the stock goes below that strike price, the put option becomes worth
something. Combining the profit profiles of these 2 options, we get the
long strangle which has the potential for unlimited profit the
higher the stock price climbs or the lower it falls. However, if the
stock price stays in between the 2 strike prices, both the call and put
options will be worthless, hence producing a loss.

This long strangle position needs to be close before expiration. This

can be done by selling just the component or option leg that has value
(potentially saving transaction fees by letting the other leg expire). So
if the stock has climbed, you would sell the call option and let the put
option expire. The opposite would be true if the stock price fell. If the
stock price did not move, you have no choice but to let both options
expire worthless (or hopefully sell them if they have any time value
left in them before expiration).

As can be seen from its profit profile, the long strangle is ideal for
volatile stocks whose price is expected to either climb or crash in the
near future. This can be a useful strategy to be employed for stocks
just before their earnings reports are released. A good report might
cause the stock to skyrocket, while a bad report could cause it to
crash. Similarly, other news such as research results or lawsuit
resolutions that affect the stock could be triggers for high volatility.
 A Long Strangle is a strategy for stocks with high
volatility but whose direction is uncertain. It is created
by buying an OTM call option and an OTM put option
with the same expiration date. If the stock climbs or falls,
potential profits are unlimited. If the stock price doesn't
move, you lose the premium spent on this position.

A Short Strangle is the exact opposite to the long strangle, both in

strategy and execution. This position is meant for stocks whose prices
are known to basically stay still and not fluctuate. It is therefore a
neutral strategy that sees profit when there is little market
movement.

The short strangle position is created by shorting or selling an OTM

call option and an OTM put option with the same expiration date.
The credit premium that you earn by selling these 2 options is your
maximum profit for this position. In other words, you earn your profit
up front and have to cross your fingers hoping that both these options
expire worthless so you do not need to buy them back.
The call option that you sell in a short strangle is an OTM call (i.e. a
call option whose strike price is above the stock's current price), and
the put option is also an OTM (i.e. its strike price is below the stock's
current price). Hence for both options to expire worthless and for this
position to be profitable, the stock's price must stay in between the 2
strike prices. If the stock's price is below a call's strike price, the call
will be worthless. Similarly if the stock is above a put's strike price, the
put will be worthless.

Do bear in mind that if you incorrectly predicted the stock's movement

and one of the options turn out to be in-the-money, you will need to
close the short strangle position by buying up the in-the-money option
to prevent it from being exercised. The risk here is high, since the
stock could climb or fall very far from your option strike prices, making
it very expensive to buy back.
A short strangle is a neutral strategy for stocks that do
not move much. It is created by selling an OTM call and
selling an OTM put with the same expiration date. It
provides an initial credit premium, which will be your profit
if the stock stays within the 2 strike prices. If the stock
climbs or falls beyond these strike prices, losses can be
unlimited.

Note that the long and short strangles are very similar to the straddle
strategies. The difference is that the 2 options in the straddle have the
same strike price, while a strangle's options have 2 separate strike
prices. This difference affects the initial premium of the options (a
straddle's premiums will be higher), and the extra room for error in
the strangle's strike prices.

Long and Short Butterfly Trading

The Butterfly is an option position that is composed of 2 vertical
spreads that have a common strike price. In other words, butterfly
trading involves an opening position where options (either calls or
puts) are bought (or sold) at 3 different strike prices. The way in which
these options are created makes the butterfly a position that has both
limited losses and limited profits.

The Long Butterfly can be created using either all call options or all
put options. Due to put-call parity, a long butterfly created using call
options will behave like a long butterfly created using put options. In
other words, it doesn't really matter whether you use calls or puts to
create your long butterfly. Our example here will focus on the version
using call options.

The long butterfly can be created by buying an In-the-Money (ITM)

call option, selling 2 At-the-Money (ATM) call options and
buying another Out-of-the-Money (OTM) call option. This is
actually a combination of 2 opposing vertical spread options, hence
why the butterfly is also known as the butterfly spread.
Combining the profit profile of these 4 call options, you will find that if
the stock price falls, you will face limited losses (which is the initial
premium you paid for the entire butterfly trade). Similarly, if the stock
price climbs too high, you will also face limited losses. However, if the
stock price stays around the vicinity of the ATM option strike price, you
will receive limited profit.

This makes the long butterfly a good neutral option strategy for
low volatility, since you are betting on the stock price not moving
much in order to collect maximum profits. It is also a low-risk
strategy, since your losses are limited if the stock crashes or climbs
unexpectedly. Unfortunately, this is accompanied by limited profits as
well. As has been mentioned above, the long butterfly can also be
created using all put options instead of all call options.
A long butterfly involves buying an ITM call, selling 2
ATM calls and buying an OTM call. It is a neutral low-risk
strategy for low volatility stocks. You reach maximum
limited profits if the stock doesn't move much. You
will incur maximum limited losses if the stock climbs
too high or falls too low.

A Short Butterfly is the exact opposite of the long butterfly. Instead

of buying an ITM call, selling 2 ATM calls and buying an OTM call, a
short butterfly is constructed by selling an ITM call, buying 2 ATM
calls and selling an OTM call. As before, the short butterfly can be
created using all put options instead of all call options.
The short butterfly's profit profile is the opposite of the long
butterfly's. If the stock price falls, you will receive your maximum
limited profits (which is the initial credit premium you received when
opening the short butterfly position). Similarly, when the stock price
climbs, you will also receive limited profit. However, if the stock price
doesn't change much, you will face a loss, though that loss is limited
as well.

As can be seen from the above description, the short butterfly is

meant to be a strategy that is high in volatility but neutral in
direction (ie. you expect the stock to move a lot, but do not know in
which direction). As a side note, this might not be the best strategy for
you if you are indeed expecting high volatility and are uncertain in
stock price direction. Both the Straddle and the Strangle strategies
also have the same lean towards high volatility and neutral direction,
but with the extra benefit that they have the potential for unlimited
profit. However, the benefit of the short butterfly is that it is a credit
position where you pocket the initial premium when creating it.
A short butterfly involves selling an ITM call, buying 2
ATM calls and selling an OTM call. It is a strategy that is
high in volatility but neutral in position. It is a credit
position. You make limited profit if the stock climbs or
falls. You incur losses if the stock doesn't move much.

One warning about both long and short butterfly trading: these
positions involve buying and selling options at 3 strike prices. For most
option brokers, this means you will be paying 3 commissions to open
the position, and another 3 commissions to close it. You will need to
consider these extra commissions (which differ from broker to broker)
when trying to determine if the butterfly will be profitable for your
circumstances.
 Welcome to the Technical Analysis Basics
Guide!

This guide attempts to provide a simple, easy-to-understand primer on

technical analysis. We have filled it with plenty of examples and
graphical charts. By doing so, we hope to provide you the technical
analysis basics without you having to spend hours trying to figure out
the various technical indicators and techniques used in this industry.

Technical Analysis Trends

Generally, when investors are deciding which options or stocks to buy,

they will need to analyze the stocks to see whether they're worth
buying. There are 2 methods of analyzing stocks, technical analysis
and fundamental analysis (following hot tips from your neighbor
doesn't count, unless your neighbor happens to be a Mr. Buffett).

Fundamental analysis involves researching to see if the market in

general, as well as the stock in particular, is currently undervalued or
overpriced. The fundamental analyst does so by comparing the current
stock price with what they think is the fair value.

To gauge a stock's fair value, the fundamental analyst will look at the
"basics" of a company. He will check the company's management
practice, cash flow, total assets, earnings and revenue, debt, paid-up
capital and so forth, to determine exactly how much the company's
stock should be worth.

Once he has that value, he will compare it with the current stock price.
If the stock price is cheaper than his estimation of its fair value, he will
conclude that the stock is undervalued and worth buying.

On the other hand, Technical Analysis involves trying to predict a

stock's price movement by looking at how it has previously performed,
and how people might act in the future. To a Technical Analyst, a stock
price's past movement tells a lot about how it will move in the future.

A Technical Analyst doesn't care what a stock is really worth. Instead,

he cares whether the public will buy the stock or not. He will use
various charts and indicators (which we will discuss in the following
pages) to monitor the trend and momentum of a stock as well as
investors' behavior.

If a stock is on a roll and investors appear greedy, the technical

analyst will probably decide that the price will continue to rise, and will
invest in the stock. On the other hand, if the stock is losing steam, the
technical analyst will probably conclude that investors are starting to
lose interest in the stock, and he will avoid buying it since the price
trend might reverse.

Fundamental Analysis attempts to uncover

undervalued or overpriced stocks. Technical Analysis
attempts to read the trend and momentum of a stock to
determine if the trend will continue or reverse.

So which method is better? There are pros and cons to both methods,
and both are utilized in the market. However, when we're dealing with
options, the preferred method is using Technical Analysis trends.

Fundamental Analysis tends to deal with annual reports and quarterly

forecasts, and to predict the steady growth of a stock. When we're
working with stock options, "annual" and "quarterly" timeframes are
just too long.

In option trading, the options we buy or sell usually have timeframes

measured in weeks or months, and we do not have the luxury of
waiting for a company's next annual report to confirm our move.

On the other hand, since Technical Analysis trends work to predict

trends and momentum in stock prices, it is better suited to analyze
short-term movement in stock prices. These momentum indicators can
be used to show short-term trends, even to the extent of 5-minute
intervals.

Technical Analysis is better able to predict short-term

price movement, and is therefore more suitable for
 option-trading, where timeframes are measured in
weeks, rather than years.

However, be warned that neither method (Fundamental or Technical)

is 100% accurate in predicting a stock's movement, long-term or
short-term.

Stock and market levels are easily affected by external forces such as
global terrorism, oil prices, inflation and political change, as well as
news that is directly related to the stock in question.

Therefore, caution must always be used when trying to predict a

stock's movement, whichever method you choose to utilize.

Technical Indicators

As the name suggests, Technical Indicators are used to indicate trends

and possible turning points in stock prices. These are the tools used by
Technical Analysts to predict cycles, and to predict when is the best
time to buy or sell a stock or option.

Technical Indicators are calculated based on a particular stock or

derivative's price pattern. Data such as opening price, closing price,
highs, lows, as well as the volume, are used to create the many
technical indicators out there.

The indicators generally take the stock's price data from the last few
periods (for example the last 30 days). They use that data to create a
trend or chart to indicate what has been happening to the stock, and
hopefully predict what may happen in the future.

Technical Indicators are used to indicate trends and

predict future stock price movement. They are based
on the stock's price data, usually from recent periods.

There are two main types of indicators: Leading Indicators and

Lagging Indicators.
Lagging Indicators are indicators which follow the stock's price pattern,
hence the name "Lagging" Indicators. Since they are based on past
data, they are good in showing whether a trend is developing, or
whether at stock is in a trading range (ie. trading sideways). For
example, lagging indicators can show that a stock has developed a
very strong downtrend, and is therefore likely to continue falling.

On the other hand, Lagging Indicators are not good when predicting
future rallies or pullbacks. They can show what trends have developed
until the current point, but are not able to predict the next few days'
movement.

Examples of Lagging Indicators include trending indicators such as the

Moving Average, MACD and ADX indicators, which we will be covering
later on.

Lagging Indicators are good in showing the trends

that have developed, but are not good in predicting
future price movement.

On the other hand, Leading Indicators, as the name implies, are better
at predicting possible future price rallies and crashes. Most Leading
Indicators are momentum indicators, gauging the momentum of a
stock price's movements.

Imagine a football we are throwing up in the air. Common sense

indicates that the football cannot keep going higher forever. We might
not know how high it will go, but we do know that once its upward
speed starts to slow down, it will soon stop going up and start falling
down again. That is the basis of momentum indicators.

Leading Indicators are good at telling us whether a stock's price has

gone too high up or too far down, and whether there is a slowdown in
price movement. If the stock's price has gone too high up, we say that
the stock is now overbought. If the price has gone too far down, we
say it is oversold. In either case, the leading indicators will show that
the stock will not remain overbought or oversold for long. A pullback is
imminent.

Examples of Leading Indicators include the RSI which we will cover

later, as well as other momentum indicators.

Leading Indicators include momentum indicators that

can predict if a stock is overbought or oversold, and
thus can predict pullbacks in the near future.

Both Leading and Lagging Indicators are equally important. We need

to know both the trends that are developing as well as possible
slowdowns and price pullbacks.

In fact, investors are advised not to base their decisions on just one
indicator. After all, no indicator is perfect. All indicators can produce
false signals from time to time. Therefore, it is recommended that
investors take 2 or 3 indicators they are comfortable with, and base
their decisions on them (ie. only buy when all 3 indicators tell you to
buy).

There are hundreds of indicators in use at the moment. In fact, any

high-profile stock market guru will most likely have developed his own
indicator to predict the market. However, in this guide we will only
cover 5 indicators, which are based on different data and serve
different functions.

In doing so we hope to expose you to the various types of indicators

out there, and enable you to choose which type of indicator you are
more comfortable with.
 Moving Averages

Moving averages are among the most simple technical indicators

available. They are used to smooth the price pattern of the stock, and
provide an easy-to-see indication whether the stock is currently
trending (moving up or down) or in a trading range (moving
sideways).

As the name implies, moving averages are based on the averages of

the stock's price (most commonly its closing price).

A 20-day average will take the average of the stock's closing price for
the 20 most recent trading days. The next day, the new day's stock
price will be added to the average, and the oldest price of the previous
20 days will be taken out. This will create a slowly-moving trend of the
stock's price, in this case a 20-day moving average, as seen in the
chart below.

Click here to view a larger updated version of the chart at Stockcharts.com

As seen above, the actual price pattern of the stock is very volatile,
with a single day's price changing by over Rs 3. However, once we
apply a 20-day indicator to it, the pattern is smoothed, and we can see
a trend develop. As can be seen in early February, even though the
stock's price jumped more than Rs 5, the moving average did not
change much, since it took into account the last 20 days worth of data,
and smoothed the trendline.

For example, in mid February, just looking at the stock's price pattern,
it seemed that the stock had stopped its upwards trend and was
beginning to go down. However, the moving averages indicated that
the stock was still in a strong uptrend which would continue till early
March. Heeding the moving averages would have kept investors in the
stock during the rally in late February.

Likewise, the spike in the stock price in late May and early June might
have tempted investors to buy into the stock again. However, the
moving averages told a different story. The moving average was flat
and indicated that an uptrend had not developed. True enough, the
stock started trading downwards from early June right into July.

Moving averages are one of the most simple technical

indicators. It is based on the average of a stock's
closing price. It is used to smooth the price pattern
and show whether the stock is trending upwards or
downwards.

What we covered above are called Simple Moving Averages, or just

Moving Averages. Another form of averaging is known as Exponential
Moving Averages or EMA for short .

In simple moving averages, say a 20-Day moving average, each of the

20 days' prices have equal weight in calculating the average. However,
in exponential moving averages, the most recent prices have more
weight than the earliest ones.

As such, during a surprise rally, the exponential moving average will

respond faster and start to trend upwards earlier. Take the chart below
for example. The simple moving average is marked in blue, and the
exponential moving average is marked in red.

In late May, there was a sudden surge in RYL's stock price. The
exponential moving average, being more sensitive, reacted quickly and
started trending upwards. On the other hand, the simple moving
average still took into account the previous down days, and did not
even register an upward trend till the rally was almost over!
 Click here to view a larger updated version of the chart at Stockcharts.com

So which type of moving average is better?

Both have their own merit. The simple moving average is less prone to
whipsaws and false alarms, and will only indicate trends when the
price pattern is more pronounced, while the exponential moving
average might register false alarms.

On the other hand, exponential moving averages are more sensitive to

sudden price changes and are able to react faster. Since we are
dealing with option trading, we would tend to follow the exponential
moving averages, since their sensitivity and quick movement are ideal
for the short-term and volatile nature of option trading.

Exponential Moving Averages give more weight to the

most recent data, and are therefore more sensitive and
can react better to sudden price changes. This makes
them more suitable for option trading.

So, how do we use moving averages?

As has beem mentioned, both simple and exponential moving

averages are primarily meant to indicate whether the stock is in an
uptrend, downtrend or sideways trading range. This can help prevent
investors from buying into a stock that is stuck in a trading range or
starting to trend downwards.
Another common way of using both simple and exponential moving
averages is by noticing when the stock price crosses above or below
the moving average. This shows that the trend (either up or down) has
reversed, and a new trend is developing.

Looking at the RYL chart above, the stock price crossed upwards from
below the exponential moving average in late Februrary and late May,
indicating that investors are starting to buy the stock and the trend is
moving upwards. These would be good times to buy call options or any
bullish option strategy on the stock.

Conversely, at the end of March and early July, the stock price crossed
below the exponential moving average, indicating that it was time to
implement bearish option strategies.

When the stock price crosses above the moving average

from below, it is time for bullish strategies. When the
price crosses below the moving average from above, it is
time for bearish strategies.

However, it can be seen that the stock price crossed the exponential
moving average many times in those 6 months, creating a lot of false
alarms. Heeding every crossover would have been a very painful and
costly experience.

The reason for that is that a 20-Day exponential moving average is

probably too sensitive and erratic. The moving average can be
modified to accomodate different periods or date ranges. For example,
the chart below presents both the 20-Day (in blue) and 50-Day
exponential moving averages for CAT.
 Click here to view a larger updated version of the chart at Stockcharts.com

As can be seen, the 50-Day exponential moving average (in red) is

much smoother than the 20-Day, and therefore can indicate trends
better. In addition, the stock price crosses it less often, producing less
false signals.

However, by the time the stock price crosses the 50-Day exponential
moving average, the rally or crash is almost over. In other words, the
longer the period being averaged, the less sensitive it is, and the
slower it is to react.

So what period moving averages should we choose? This depends on

the individual's risk profile and investment strategies. Someone with a
low risk profile and long-term strategies might choose slower moving
averages, while someone willing to risk more might go for faster
moving averages. The most common ones are 20-Day, 50-Day and
200-Day simple and exponential moving averages; for short-term to
long-term strategies, in that order.

Since most option strategies are volatile and short-term in nature,

shorter moving averages (though more risky with more false alarms)
are needed to "catch the wave". Some options investors compromise
by using a slightly slower moving average such as the 24-Day and 30-
Day averages.

Please be reminded that this indicator should not be used on its own,
but rather with one or two additional indicators, in order to confirm
any signals.
 Different periods can be used for moving averages. The
longer the period, the more confirmed the trend, but
the less sensitive it is to sudden price movements.

Moving Average Convergence Divergence

Indicator (MACD) Charts

The Moving Average Convergence Divergence charts, or MACD charts

for short, are a technical indicator that is derived from the more simple
moving average.

The MACD charts are oscillating indicators, meaning that they move
above and below a centerline or zero point. As with other oscillating
and momentum indicators, a very high value indicates that the stock is
overbought and will likely drop soon. Conversely, a consistently low
value indicates that the stock is oversold and is likely to climb.

The MACD charts are based on 3 exponential moving averages, or

EMA. These averages can be of any period, though the most common
combination, and the one we will focus on, are the 12-26-9 MACD
charts.

There are 2 parts to the indicator MACD. We will focus on the first part
first, which is based on the stock's 12-Day and 26-Day EMA. As can be
seen on the chart below, the 12-Day EMA (in blue) is the faster EMA
while the 26-Day (in red) is slower.

The logic behind using a faster and slower EMA is that this can be used
to gauge momentum. When the faster (in this case 12-Day) EMA is
above the slower 26-Day EMA, the stock is in an uptrend, and vice
versa. If the 12-Day EMA is increasing much faster than the 26-Day
EMA, the uptrend is becoming stronger and more pronounced.
Conversely, when the 12-Day EMA starts slowing down, and the 26-
Day begins to near it, the stock movement's momentum is beginning
to fade, indicating the end of the uptrend.
 Click here to view a larger updated version of the chart at Stockcharts.com

The MACD charts use these 2 EMA by taking the difference between
them and plotting a new line. In the chart above, this new line is the
thick black line in the middle chart.

When the 12-Day and 26-Day EMA are at the same value, the MACD
line is at zero, such as in early February and mid June. When the 12-
Day EMA is higher than the 26-Day EMA, the MACD line will be in
positive territory. The further the 12-Day EMA is from the 26-Day
EMA, the further the MACD line is from its centerline or zero value.

This line on its own doesn't tell much more than a moving average. It
becomes more useful when we take into account its 9-Day EMA. This is
the third value when we talk of 12-26-9 MACD charts. Note that the 9-
Day EMA is an EMA of the MACD line, not of the stock price. This EMA
(the thin blue line alongside the MACD line) acts like a normal EMA and
smoothes the MACD line.

The 9-Day EMA acts as a signal line or trigger line for the MACD. When
the MACD line crosses above the 9-Day EMA from below, it indicates
that the downtrend is over and a new uptrend is forming. Time to
consider bullish strategies. This can be seen in early February and mid
May.

Conversely, when the indicator MACD line drops below its 9-Day EMA,
a new downtrend is forming and its time to implement bearish
strategies. This can be seen on the chart in early March and early
April.

Moving Average Convergence Divergence (MACD)

charts are oscillating indicators based on exponential
moving averages. When the MACD line (the difference
between 12-Day and 26-Day EMA) crosses above its 9-
Day EMA, the stock becomes bullish. When the MACD
line crosses below its 9-Day EMA, its becomes bearish.

So far, we have covered the most simple form of interpreting the

MACD charts. We now look at the MACD histogram. The MACD
histogram is the blue-and-grey bar chart alongside the MACD line. A
larger version has been added beneath it. Just as the MACD line is the
difference between the 12-Day and 26-Day EMA, the MACD histogram
is basically the difference between the MACD line and its 9-Day EMA.

So when the MACD line crosses above its 9-Day EMA, the MACD
histogram will cross above zero. In order words, a bullish signal is
obtained when the MACD histogram crosses above zero, and a bearish
signal is obtained when it crosses below zero.

Let's look now at the chart below. It is the same chart as the one
above, but with different markings. Notice the thick red line drawn on
the MACD histogram. The red line shows that the MACD histogram
reached a peak in mid February, and reached a subsequent smaller
peak in the beginning of March. These progressively lower peaks
constitue what is known as a negative divergence.
 Click here to view a larger updated version of the chart at Stockcharts.com

A negative divergence on the MACD histogram is an indication that the

current uptrend might reverse in the near future. This could happen
even though the actual stock price seems to be making higher peaks
in the chart. Basically, the MACD histogram negative divergence is a
warning that the stock might turn down soon, which it did in the chart
above.

Similarly, the positive divergence on the MACD histogram in January

and early February correctly predicted the subsequent uptrend.

However, the positive divergence in March was a false alarm. If we

had followed this signal, we would have bought into a downtrend.

The primary reason this happened is that during the month of March,
the stock was in a trading range, with lower price fluctuations. Note
that the MACD line was hovering just above and below zero during this
month. Periods of stability and low volitility usually precede a sudden
change, the direction of which is usually uncertain. We discuss this
phenomenon further when describing Bollinger Bands.
As such, we again remind you that individual indicators such as the
Moving Average Convergence Divergence indicator (MACD) charts
should not be used on their own, but rather with one or two additional
indicators of different types, in order to confirm any signals and
prevent false alarms.

The MACD histogram is the difference between the MACD

line and its 9-Day EMA. A positive divergence in this
histogram can be used to predict potential uptrends,
while a negative divergence can predict potential
downtrends.

Relative Strength Index ( RSI )

The Relative Strength Index, or RSI, is a leading indicator, in that it

can predict a stock's price movement before it happens. This is
because the RSI is a momentum indicator, and indicates overbought
(price is too high) and oversold (price is too low) conditions. In
overbought conditions, the price of the stock is bound to retreat and
stabilize in the near future. Similarly with oversold conditions.

Whereas moving averages are based on a stock's closing price, the

RSI is based on gains and losses. Basically, the number and size of
gains and losses are used to calculate the relative strength for a
particular period, say a 14-Day period. Subsequent relative strengths
are then used to plot the RSI chart.

The RSI is an oscillating indicator, fluctuating between 0 and 100,

where 0 is the most oversold, and 100 is the most overbought. 50 is
the centerline. Anything above 70 is considered overbought, and
anything below 30 is considered oversold. While this 70/30 levels are
more common, some investors do use 75/25 or even 80/20 levels to
mark overbought and oversold conditions. These levels will confirm
overbought or oversold conditions much better, but are less sensitive
to normal price movements. For example, a stock in a trading range
might never hit the 80 or 20 levels, and we will miss out on all signals.

While the RSI can tell us when a stock is overbought or oversold, its
true value is its ability to indicate when the stock is coming out of
overbought or oversold conditions, ie. when the stock is going to move
back towards the moving average. So the points to watch are those
when the RSI moves below 70 from above, or moves above 30 from
below.

Click here to view a larger updated version of the chart at Stockcharts.com

In the chart above, the RSI crossed below 70 in March, and again in
June. It also crossed above 30 in May. Therefore, we would implement
bearish strategies in March and June, and bullish strategies in May.

Note that the RSI produced signals days (even more than a week)
before the 20-Day EMA did in the chart above. This is due to the fact
that the RSI, being a momentum indicator, is a leading indicator and
can predict price movement before it happens.

However, this might not be a good thing, as can be seen in March. The
RSI produced a bearish signal a month before the actual downturn
happened. In the world of options trading, a month is a long time.

The RSI is a momentum, oscillating and leading

indicator. It is used to indicate when a stock comes off its
overbought or oversold conditions. A stock is
overbought at RSI values above 70, and oversold at
values below 30.
Similar to the MACD, we can also plot positive and negative
divergences with the RSI. A positive divergence is when the RSI makes
valleys or troughs that get higher and higher, and indicates a potential
upturn. A negative divergence is when the RSI creates peaks that
become gradually lower, and indicates a potential downturn.

For example, in the chart below, the RSI formed a negative divergence
in January 2004. This is despite the fact that the actual stock price was
making higher peaks. Sure enough, the negative divergence correctly
predicted a sharp price drop in early February.

If we extrapolate further, we can see that after January, the RSI was
forming lower and lower peaks all the way till June. This is a very
bearish sign.

Click here to view a larger updated version of the chart at Stockcharts.com

We have only touched on a few of the basic techniques involving RSI.

There are other methods of reading RSI charts, and are beyond the
scope of this guide.

We have to mention again that individual indicators should not be used

on their own, but rather with one or two additional indicators of
different types, in order to confirm any signals and prevent false
alarms.

The RSI can also contain positive and negative

divergence patterns. A positive divergence predicts
future upturns, while a negative divergence predcits
future downturns.

Bollinger Bands Strategies

The Bollinger Band theory is designed to depict the volatility of a

stock. It is quite simple, being composed of a simple moving average,
and its upper and lower "bands" that are 2 standard deviations away.
Standard deviations are a statistical tool used to contain the majority
of movement or "deviation" around an average value. Bear in mind
that when you use the Bollinger Band theory, it only works as a gauge
or guide, and should be use with other indicators.

Normally, we use the 20-Day simple moving average and its standard
deviations to create Bollinger Bands. Strategies some investors use
include shorter- or longer-term Bollinger Bands depending on their
needs. Shorter-term Bollinger Bands strategies (less than 20-Days)
are more sensitive to price fluctuations, while longer-term Bollinger
Bands (more than 20-Days) are more conservative.

So how do we use the Bollinger Band theory?

The Bollinger Band theory will not indicate exactly which point to buy
or sell an option or stock. It is meant to be used as a guide (or band)
with which to gauge a stock's volatility.

When a stock's price is very volatile, the Bollinger Bands will be far
apart. In the chart below, these periods can be seen in early March,
mid April and mid May. On the other hand, when there is little price
fluctuation, hence low volatility, the Bollinger Bands will be in a tight
range. This can be seen in the circled sections in February, late March
and late June.
 Click here to view a larger updated version of the chart at Stockcharts.com

The Bollinger Band theory provide indicators to measure

the volatility of a stock price. It is derived from a simple
moving average and its standard deviations. Wide bands
indicate volatile conditions, while narrow bands
indicate stable conditions.

As for how we use the Bollinger Band theory, here are a couple of
guidelines.

History shows that a stock usually doesn't stay in a narrow trading

range for long, as can be gauged using the Bollinger Bands. Strategies
include relating the width with the length of the bands. The narrower
the bands, the shorter the time it will last. Therefore, when a stock
starts to trade within narrow Bollinger Bands, such as in the circled
sections in the chart, we know that there will be a substantial price
fluctuation in the near future. However, we do not know which
direction the stock will move, hence the need to use Bollinger Bands
strategies together with other technical indicators.

When the stock starts to become very volatile, it is depicted in the

chart above by the actual stock price "hugging" either the upper or
lower Bollinger Bands, with the Bands widening substantially. The
wider the Bands are, the more volatile the price is, and the more likely
the price will fall back towards the moving average.

When the actual stock price moves away from the Bands back towards
the moving average, it can be taken as a signal that the price trend
has slowed, and will move back towards the moving average.
However, it is common for the price to bounce off the Bands a second
time before a confirmed move towards the moving average.

The longer a Bollinger Band remains narrow, the more

likely a sudden price movement will occur. The wider a
Bollinger Band becomes, the more likely the price will
move back towards the moving average.

As usual, and for the Bollinger Band theory in particular, it should be

noted that individual indicators should not be used on their own, but
rather with one or two additional indicators of different types, in order
to confirm any signals and prevent false alarms.

Average Directional Index (ADX) Indicator

The Average Directional Index, or the ADX indicator for short, acts as
a guide to confirm the signals produced by other technical indicators.
The Average Directional Index is an indicator that measures the
strength of a trend. For example, it can measure whether an uptrend
or downtrend is gaining momentum or slowing down.

The Average Directional Index (ADX) indicator is a combination of the

positive directional indicator (+DI) and the negative directional
indicator (-DI). The +DI tracks the upward trend of the stock, while
the -DI tracks the downward trend. The ADX indicator combines the
two and produces a unified trend strength indicator.

The ADX indicator is an oscillating indicator, ranging from 0 to 100,

with 0 indicating flat trading, and 100 indicating either a skyrocketing
or plunging stock. The ADX only indicates the strength of the trend,
and does not indicate its direction.

However, it is unlikely to see ADX indicator values above 60, since

such high values indicate a trend that usually only appears in long bull
runs or long recessions. Usually, any ADX value above 40 is considered
to be a strong trend, while any ADX value below 20 indicates that the
stock is in a trading range.
In the chart below, the +DI is depicted as a thin green line, and the
-DI is depicted as a thin red line. The ADX indicator is the thick black
line.

From the chart, the ADX indicates that from late February to mid April,
the stock was in a strong trend, in this case an upward trend. For this
stock, the ADX indicator did not go below 20, which indicates that
there wasn't a period where the stock was trading flat. This is quite
accurate, since it can be seen from the stock price that the first 3
months was an uptrend and the last 3 months was a downtrend.

Click here to view a larger updated version of the chart at Stockcharts.com

The Average Directional Index (ADX) indicator depicts

the strength of a trend, and does not differentiate
between an uptrend or a downtrend. ADX indicator values
above 40 indicate a strong trend, while ADX values
below 20 indicate a sideways trading range.

As for signals produced by the Average Directional Index (ADX)

indicator, a move below 40 from above indicates that the trend is
slowing. Since most option strategies rely on large price movements in
short timeframes, a slowing trend is bad. Therefore an ADX move
below 40 would indicate that it is time to close our positions.

Conversely, an ADX indicator move above 20 from below indicates that

the sideways trading is over, and a new trend is developing. This
would indicate that it is time to make a move, either bullish or bearish.

In the chart above, the ADX indicator produced a signal in mid April
indicating that the trend (in this case upwards) is fading. In early July,
the ADX indicator briefly touched 20 from above and immediately
turned back up. This indicates that momentum is picking up and a new
trend (in this case downwards) is forming.

Also, signals can be obtained by looking at where the positive

directional index +DI (green) and negative directional index -DI (red)
lines cross each other. When the +DI crosses above the -DI from
below, it is a bullish signal, such as in early February. When the -DI
crosses above the +DI from below, it is bearish, such as in late April.

We again stress that basing your investment decisions on only one

indicator is not recommended. It is best to use it with one or two
additional indicators of different types in order to confirm signals and
prevent false alarms.

An ADX move below 40 from above indicates a trend

slowing down. An ADX move above 20 from below
indicates a new trend forming.

We hope you have enjoyed this guide, and the way we described the
concepts of technical analysis. There are many technical indicators out
there. We chose to cover these 5 indicators in order to give you a feel
of the various types in existance. It is good practice to take 2 or 3
indicators of different types, and using signals from all of them to
make decisions.