term and the protection of longer-term investments, especially during times when the value of the longer-term holdings declines. No matter your time frame – whether you hold positions for short or long periods – your goal is essentially the same. You want to have more money at some point in the future than what you have now and increase your wealth using opportunities provided by the markets. This chapter is all about giving you the big picture on options and setting the stage for the more detailed chapters that follow.
Before you start any kind of trading or investing program, it’s a good idea to know three things:
✔ Your risk profile
✔ Your financial situation
✔ Your time commitment possibilities
Any time you add a new trading strategy, only one thing is certain: the early stages will be challenging and will require a fair amount of your attention, or you will lose money, often in a hurry.
As you prepare to become an options trader, here are some simple steps to consider in order giving yourself a good start. Even if you are experienced in other forms of investing, or have experience with options, you should still stop and consider the following:
✔ Check your financial balance sheet. Before you start trading, go over your living expenses, review your life and health insurances, and put together a financial net worth statement. Make sure it’s healthy before you take extraordinary risks.
✔ Set realistic goals. Don’t trade beyond your experience levels, and don’t risk too much money in any one trade.
✔ Know your willingness to take risks. If you are a cautious person who thinks that mutual funds are risky, you may not be a good options trader. But you shouldn’t count yourself out either. There are many options strategies that could suit you, especially once you understand the built-in safety nets that make some of them really decrease your risk. Just make sure you read through the book and find the ones that make you comfortable before you jump in. The chapters in Part IV have excellent information on this topic.
✔ Become a good analyst. If you like to roll the dice without doing your homework, you could get in trouble with options pretty rapidly. In order to maximize your chances of trading options successfully, place a high priority on improving your technical and fundamental analysis skills. You should do this both for the entire market and for the underlying securities that are the basis for your options.
✔ Don’t be afraid to test your strategies before deploying them. Doing some paper trading on options strategies before you take real-life risks is a good idea. Chapter 7 guides you through this process.
✔ Never trade with money that you aren’t willing to lose. Even though options are risk-management vehicles, you can still lose money trading them. And as you progress to more sophisticated and riskier strategies, your losses could be significant. Bottom line: Don’t trade options with your car payment or your rent money.
Options are financial instruments that are priced based on the value of another underlying asset or financial measure. In this book, the focus is mainly on options with value based on stocks and stock market indexes, although there is also a very useful section on options based on exchange traded mutual funds (ETFs).
There are two kinds of options – calls and puts. When you add them to your current investing and trading tools and strategies, you can participate in both bullish (rising markets) and bearish (falling markets) moves in either underlying you select. You can use options to limit your total portfolio risk or to protect an individual existing position, such as a stock or ETF.
To fully understand and use stock and index options to limit risk or as a standalone trading strategy, you must also have a thorough understanding of the asset on which they’re based. This understanding is likely to require another layer of analysis beyond your current approach. Because volatility is a key component of option prices, for example, you will have to look at the underlying’s volatility more carefully as part of your analysis in order to pick the best possible option for your particular strategy.
This book will help you by focusing on techniques that compare options to their underlying security or other securities. Chapter 9 goes into detail on several approaches that you can apply toward this goal when you analyze stocks and index options.
Contrary to what many in the mainstream may believe, your primary focus for trading any security is not to learn about how to profit from its use, but to understand the risks associated with its use, including all of the following:
✔ Knowing what conditions, both in the markets and in the individual security, to consider when analyzing a trade
✔ Using proper trade mechanics when creating a position
✔ Recognizing, understanding, and following trading rules and requirements for the security
✔ Understanding what individual variables make any position gain and lose value
The sections that follow address these key components of options trading to give you a good platform for creating rewarding positions and cutting any losses before they become catastrophic.
Knowing option essentials
A listed stock option is a contractual agreement between two parties with standard terms. All listed options contracts are governed by the same rules. When you create a new position, one of two things is triggered:
✔ By buying an option, you are buying a specific set of rights
✔ By selling an option, you are acquiring a specific set of obligations
These rights and obligations are standard and are guaranteed by the Option Clearing Corporation (OCC), so you never have to worry about who’s on the other end of the agreement. Chapter 3 provides more information and detail on the Options Clearing Corporation and its central role in options trading.
Time means everything to option traders. The one particular wrinkle in options, and the primary risk involved, is time risk, because options contracts have a limited lifespan. The price of a call option rises when its underlying stock goes up. But if the move in the stock is too late, because it happens too close to the expiration date, the call can expire worthless. You can literally buy yourself more time, though – some options have expiration periods as late as 9 months to 2 1/2 years.
When you own call options, your rights allow you to
✔ Buy a specific quantity of the underlying stock (exercise).
✔ Buy the stock by a certain date (expiration).
✔ Buy the specific quantity of stock at a specified price (known as the strike price).
In other words, the price of the call option rises when the stock price goes up because
