rel="nofollow" href="#i000034010000.jpg"/> A swap is an insurance contract whose terms are privately agreed upon by the participants. They can be thought of as non-exchange traded options and they can be used to bet on the direction of just about anything that the two parties agree upon. By design, swaps are very sophisticated securities that are not available to individual investors because of the financial requirements and the specific agreements required to be signed before you trade them. When you own shares in a leveraged ETF, check the prospectus carefully to see if this is what you are buying. We’re not suggesting that you don’t consider leveraged ETFs if they make sense for your portfolio. We use them often in our personal trading. It’s important for you to always know what you are investing in, even if it’s an indirect investment such as an ETF.
When swaps get out of control, the markets can suffer. This is what happened in 2008 as lots of big money players bet (correctly) that subprime mortgage holders would not be able to make their monthly mortgage payments. They were right, and the rest, as they say, is history.
Part of knowing your risks and rewards results from understanding how an investment derives its value and what affects the rise and fall in its price. In order to value an option, you must know the following:
✔ The type of option (put or call)
✔ The market value of the underlying security
✔ The characteristics of the past trading pattern of the underlying security calm or volatile
✔ The time remaining until the option expires
Knowing your rights and obligations as an options trader
There are two types of options: calls and puts. By owning a call you have the right to buy a certain stock at a pre-specified price by a certain date. Owning a put give you the right to sell a certain stock at a specific price by a certain date. Put option prices go up when the price of the underlying security falls. Call option prices rise when the underlying security’s price rises. When you own options, you can assert your rights at your own discretion. So, between the time you buy an option and its expiration date, you can
✔ Sell the option for a profit.
✔ Sell it for a loss.
✔ Exercise it.
✔ Let it expire with no value (for a loss).
As an option seller, you are obligated to complete a specific set of requirements. In fact, selling options gives you fewer choices, and the actionable choices are heavily influenced by the action in the markets. As the expiration date nears, you can
✔ Buy the option back for a profit.
✔ Buy it back for a loss.
✔ Let the option expire with no value (for a profit).
Terms of endearment and importance
Here are key terms you have to nail down in order to make good option trading decisions:
✔ Underlying security: The stock that you buy or sell and that determines the value of the option.
✔ Strike price: The price you would pay if you decided to exercise your rights as an option buyer.
✔ Expiration date: The date the option and your rights disappear.
✔ Option package: The number of shares and the name of the underlying security that you can call away or put to someone.
✔ Market quote: The most current price of a security that is being bid on by buyers and offered by sellers of options.
✔ Multiplier: The number used to determine the value of the option and how much money you pay when you call away or put options to someone.
✔ Premium: The total value of the option you buy or sell. The premium is based on the market quote for the option and its multiplier.
Good decisions are only as good as the information you have and how well you understand it. So, whether you trade options without ever considering owning the underlying stock or otherwise, you will need the best data possible in order to assess their value and develop your strategies. Just as important is knowing the basic structure of how options quotes work and how the expiration cycle operates. This section is about deciphering the information you will require to understand your rights and obligations when trading options.
Identifying options
Although not all stocks have options, those that do feature multiple strike prices and expiration dates. The list of options for a stock is also known as the option chain. When you look through a stock’s option chain you see all the calls and puts available, along with specific data for each listing, including the following:
✔ Open interest: The number of existing contracts for this option
✔ Market quotes: May be delayed or in real time, depending on your data source
✔ Recent trading levels: Current or delayed
Option symbols have been standardized and radically changed since the first edition of this book. The old “root” nomenclature methodology that made it difficult to sometimes identify options for Nasdaq listed stocks with four letter symbols was replaced by the new Options Clearing Corporation (OCC) system. The new symbol system is much easier to decipher and has several components:
✔ The underlying stock or ETF’s symbol
✔ The expiration date, expressed in six digits using the mmddyy format
✔ The option type, P for put, C for call
✔ The strike price × 1000
Mini options are a different type of option. These options are based on smaller amounts of the underlying. They afford you rights and obligations for 10 shares
