little in the way of equities trading, they do a good job explaining both the mechanics ofoptions trading as well as the strategy.
OPTION BASICSYou can buy a call option to gain the opportunity to buy stock ata lower price in the anticipation of its appreciation, or you canbuy a put option in the anticipation of the stock’s decline. Thusoptions can be used in an almost unlimited fashion in conjunction with stocks to limit risk while leaving some upside. Whetheryour strategies are centered on making money from volatility orstability in the market, in all scenarios, options married to equities create synergistic opportunities to make money in virtuallyall market conditions. Bull markets, bear markets, stable markets,or volatile markets together make up the landscape of our marketstoday. Therefore, the intellectual assets a modern trader mustpossess must include options. Certainly, options apply to manyfinancial instruments, not just individual stocks. Options haveapplication in indices such as the S&P 500, the Dow Jones Industrial Average, industry-sectors, and indices such as the Oil Index,the Internet Commerce Index, as well as other optionable securities like financial futures.Many people have an incorrect perception that futures arethe same as options, but they are in fact very different instruments. As a quick side note, futures are standardized contracts(like options) that call for the “delivery” of a specific quantity ofa commodity on a specific date. Options do not create an obligation on both sides of a transaction as is the case with a futurescontract—hence, the very large difference between the two vehicles. While much more time could be spent on each vehicle, myfocus is to assure you that using options contracts in concertwith equities at times makes strong sense. Before discussing afew popular options strategies, let’s focus on the market forcesthat most influence options price. As the name implies, stockoptions are options that give the option buyer the right (not theobligation as in the case with futures contracts) to exercise. Theseller of the option contract is obligated to fulfill the contract by
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either buying or selling the underlying asset (stock). Therefore,the price of the underlying asset will have a huge impact on thederivative product, called an option. Thus, stock prices willmost influence option prices. The method used to measure thisimpact is called delta. Delta is the change in options prices dueto the change in the price of the stock that the option is based on.The next largest influence on options is the strike price—that is, the price at which an option is exersizable between theoption buyer and seller. For example, if you purchase the AMDMarch 45 calls at $3, your strike price is $45 because this iswhere you may exercise to buy the stock from the call optionseller. You paid the call writer (seller) $3 per share for the right(not the obligation) to buy AMD at $45 by the end of the thirdweek of March. Obviously you anticipate AMD to trade higherthan $45 by that time, thereby giving you the right to buy it at $45when the stock may in fact trade higher than that price at orsometime before the expiration date.The next two important factors that influence option pricingare volatility (vega) and the time left until option expiration(theta). Theta and vega are important, since theta erodes premium over time while vega increases premium over time. Therationale is simple: because option contracts have a limited lifecycle due to time expiration, they lose time value over time. Interms of vega, volatility inflates premium, because the likelihoodthat the underlying will have the range to meet the strike price isgreater. The combination of these market forces has an impact onthe pricing of options, which clear through the Options ClearingCorporation (OCC). Knowing this, we can now discuss how thisinformation can be used to form strategies that can help thetrader hedge risk while leaving upside potential.To establish additional rules for trading, let’s use anothermetaphor: the 80/20 principle. This principle states that 80 percent of the results are produced by 20 percent of the people. Thesame theory can be applied to the market in that 80 percent of amarket’s move will tend to occur during 20 percent of the tradingday. While this is not meant to be read too literally, the conceptdoes hold merit because price action occurs during limited periods of time since the reaction from the market participants isgenerally centered on an event. The event can be news, pricebreakouts and breakdowns, or other criteria that cause a reaction.
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Once the news or action in the market becomes known, it tendsto cause people to react, hence effecting a change in price directly correlated to the imbalance of supply and demand thatoccurs due to the reaction leading to the associated price change.If positive news enters the market, demand through buying creates an imbalance that will result in a temporary move in priceover a limited period of time, which is why this 80/20 principlealso applies to market movement in many situations (though notall). This is why it is so important for traders to react quickly totake advantage of large moves (80 percent) within short periodsof time (20 percent).To further support this theory against actual market activity,let’s move back to options to apply this concept and evaluatewhat the impact on options prices will be while price movesoccur during this limited 20 percent time horizon. This theory iswell supported by the fact that option premiums often becomeless expensive prior to larger moves. The stable nature of a stockwill tend to depress option premiums (historical volatility) during periods of stabilization and consolidation. The lack of activity depresses option prices as a rule, while volatility tends toincrease option premiums (implied volatility). Traders shouldknow what moves prices in both stocks and options and knowwhen to avoid volatility, which will inflate option premiums.These inflated premiums can work well for the option seller, butwork against the option buyer.When news strikes, overreactions often occur resulting inoverbought and oversold conditions. The activity that leads tothese conditions is volatility, and, as stated, volatility leads torich pricing in options premiums.The way in which market volatility benefits a day traderengaged in options trading is the same way that equity traders benefit from volatility. The ability to gain additional advantages as anoptions day trader through time value and volatility further benefits the sophisticated trader. Amateur call option buyers will oftenrush in to buy a stake during volatile markets and hence pay ahigher price to option sellers. Equity traders who own stock havean opportunity to sell or write option contracts on their underlying assets to the option call buyers who are willing to speculateon the anticipation of price appreciation. Because options offer somuch leverage, they seem to attract the least prepared and under-
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capitalized speculators. This is an advantage to the option seller.As volatility increases, consider selling call options to buyers toreceive premium in exchange for granting the right to the buyer tobuy stock at what would be a favorable price, called the strikeprice. In-the-money options are options with intrinsic value,meaning that the options already have intrinsic value at the timeof the transaction. A call option is in the money when the strikeprice is below current market value of the underlying asset, and aput contract is in the money when the strike is above the currentmarket value. All options have some element of time value priorto expiration. The greater the time, the greater the value. Sellingin-the-money options yields higher premium since the optionalready has intrinsic value if exercised. As a seller of an option,you become an insurance company, or the “house” in the sensethat you are being paid premium in exchange for accepting theobligation to sell for calls and the obligation to buy for puts.
THE COVERED CALLReceiving premium is a form of hedging that can be best explained by an example of what is known as a covered call or abuy-write. A buy-write is an open long equity position withanother leg added to the position where calls are sold against thelong position in stock. Buy-writes normally are done when theequity moves in your favor and calls are sold against the position. For example, suppose you purchase 1000 shares of AMD at$50 and the current market value of AMD is trading at $50. Themarket in AMD has been volatile, and you decide to sell calls onthe underlying stock. By selling the AMD 50 calls, you receive $4premium, bringing $4000 into your account, hence loweringyour cost basis from $50 to $46 due to the premium income. Bywriting the covered call, you have limited the upside because inthe event that AMD surges above $50 at expiration, the call buyerwill exercise, forcing you to sell your position; but at the sametime in this example you have also ensured a $4000 profit, plusany profit on the underlying stock over the cost basis. If AMDremains stable or even retraces in price, you make the $4000 premium and still own the underlying security, enabling you to
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write the calls again for the next expiration month to furtherreduce your cost basis in the stock, or hold the stock with nooption position, leaving the upside and downside.The point is that by using an option in conjunction with theequity position, you provide options for yourself that can loweryour cost basis. The downside of a covered call occurs when theunderlying security drops in price by more than the protectionprovided through the premium. For example, if AMD drops inprice to $40, the trader loses more in market decline than the$4000 premium he or she received even though the call optionwill not be exercised. The other disadvantage is that when theprice accelerates above the strike price, it can cause the option tomove “deep in the money” and be exercised by the call buyer,limiting participation in the upside. But even in this scenario,the covered call writer still profits even though the profit is limited from the move. This strategy provides downside protectionfor the call writer equal to the premium received at the cost oflimited upside potential; therefore, this strategy is good for thestable stock or slightly bullish stock. Another variation to thisstrategy would allow the trader to trade around the underlyingstock with options. I call this strategy trading around a post.
TRADING (DANCING) AROUND A POSTThis strategy is a variation to the covered call, allowing thetrader to speculate with less risk by comparison to a pure stocktrader. The strategy here is to sell calls against the position (thepost) during rallies and to buy back the calls on pullbacks. Theact of day trading options around the “post” underlying position,is like “rainmaking” or dancing around the position to continually lower the cost basis in the underlying stock position in thisexample. This is a particularly good trade when a stock isvolatile and the calls are sold when there is time value left in thepremium. This is best accomplished by selling calls three to fourweeks from expiration. This way, sudden volatility will notimmediately cause you to be called out of your position, and second, as the call seller, you enjoy the premium of time and volatility value that the call buyer pays for. The premise with this
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strategy is to have a bullish bias on a stock you know well basedon trading patterns and familiarity you acquire through activetrading (specialization). Here is an example:Suppose in the AMD example cited, you sell the AMD 50calls at $4, as stated above. You sell the calls during rallies in thestock, which in turn improves the premium (delta). During theday, the stock comes in a bit and retraces $3. Because of this,the calls are selling for $11⁄2; therefore, you buy them back andcover your short position and make $21⁄2. The post is the underlying stock, and by day trading calls around the position, yougain the ability to protect more downside risk while benefitingfrom volatility. Your biggest risk is limited upside and extremedownside, which you have anyway when owning stock. In fact,because your downside is mitigated to the amount of premiumreceived from selling the calls, trading around a position that isvolatile is a good way to day trade while controlling systematicrisk and benefiting from the premium. The numbers are workingtoward your favor as the seller, on the backs of the option buyers.In a sense, options have a unique way of automatically separating dumb money (buyers) from smart money (sellers). The exception to this is the professional trader who understands whenbuying options (weakness) makes sense.
THE PROTECTIVE PUTAnother strong strategy that supports the rule to understandoptions strategies is the protective put. This scenario is quitepopular for the stock trader who believes there is substantialupside potential but at the risk of substantial downside as well.Purchasing a put option in conjunction with an equity positionallows the trader to protect downside without limiting upsidepotential.The protective put allows the put buyer to “put” stock to theput seller at a predetermined strike price in the event the underlying security falls hard. For example, suppose you suspectstrongly that a biotechnology stock will move from phase I testing to phase II testing for a new drug. You realize that if the drugpasses to the next phase successfully, the stock will soar and you
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want to participate in such a dramatic move. At the same time ifthe drug does not pass testing, the stock will fall hard, and youdo not want the exposure. By purchasing the put option at astrike price slightly below the price you bought the stock for,your total downside risk is limited to the difference between thestock price and the strike price of the put option you purchasedplus the price you paid to buy the option. If the stock passes testing and runs much higher, your profits are unlimited and areaffected only by the price of the premium paid for the put option.This scenario reminds me of buying a new house (compatible tothe stock) and buying protection for it like fire insurance. Yes,you pay for the protection, but your downside is substantiallyeliminated, while the home can still appreciate. The same is truefor the protective put.Many ask, “Why not use a protective stop?” It is a fair question, but a protective stop has its limitations. For example, suppose your stock retraces to the stop level and “stops you out” butthen continues much higher. In this scenario, you would be outof the trade and not share in the upside, where the protective putwill be exercised only by you if, at or near expiration, your stockis still lower than the strike price. This strategy gives you thetime between your option purchase and expiration date to work,which you can predetermine based on the anticipated testing ofthe drug in question. Here the protective put makes strong senseby comparison to the protective stop.This strategy works well also with news events that can beanticipated such as earnings events, stock split pay dates, andeconomic news events that directly impact sectors and stockswithin the sectors.The strategies that can be employed for the “short” side ofthe market work equally as well. Suppose, for example, youshort stock on the belief the stock is overbought. To protectagainst follow-through where the stock may continue higher,the trader in this scenario would buy a call option in association with the short position. This is the exact opposite of theprotective put, and it is called a protective call. The trader hasthe ability to “call in” the stock, forcing the call seller to sell theunderlying stock to the call buyer at a strike price that is generally slightly above the price level where the underlying security was shorted.
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HEDGE BEFORE SPECULATING IN OPTIONSAs you can see, the options strategies discussed in this chapterhave been more associated with hedging risk than speculating.While many opportunities exist for speculation with optionscontracts, I suggest you speculate with equities and hedge withoptions due to the time decay that is inherent with option buying.As your sophistication grows, you can speculate with optionsthrough option buying or selling or through synthetic optionspositions, which is the process of combining calls, puts, andstock to create equivalent positions. This is in fact a popular tackfor experienced traders who understand complex strategies andwho also have an interest in predetermined risk management.One popular example of a synthetic position used byoptions traders is the spread, which can take the form of a bullish or bearish outlook. Spreads are created when you are longand short an option of the same type (calls and puts) at the sametime on the same underlying security (stock in our example). Forexample, a bull spread would be a synthetic position that has abias to the upside and can be achieved using call or puts, wherewith calls you create what is called a net debit position, and withputs you create a net credit position. Most bull call spreads thatare opened are what are called vertical spreads since, stackedtogether, they match in terms of expiration month, underlyingsecurity, type, and size. Refer to Figure 7.1When using call options, the trader is creating a weightedbias toward buying calls but offsets the cost or premium of thecall buying by selling (writing) out-of-the-money calls in conjunction with buying in-the-money calls. To buy an in-themoney call will cost more in premium since an in-the-moneycall has immediate intrinsic value defined by a strike pricebelow the current market value of the underlying stock. At the
FIGURE 7.1 What the call bull spread would look like
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same time, the trader would sell out-of-the-money calls andreceive a credit or premium for selling the calls. The calls soldwill draw less premium since they are out of the money, butwhat money they do draw will help offset the cost of the in-themoney calls purchased. This strategy creates a net debit spreadbecause there is a net cost to the overall position by buying callsfor more premium than what is received for selling calls. The neteffect is a synthetic position that mimics a long position in stockthat cost premium to put on the trade for a bullish outlook on thestock. Synthetic positions such as this limit risk by the net debitpaid at the cost of also limiting upside as well. Here is an example: Suppose a trader has a bullish outlook on XYZ when XYZ istrading at $55, and he or she decides to buy 10 October 50 (inthe-money) calls at $7. The cost would be $7000 since 1 contractrepresents 100 shares of XYZ stock, and the trader bought 10contracts, which represents 1000 shares of XYZ stock at a premium of $7 per share. At the same time and with the same expiration month, the trader wants to reduce his or her cost of theoption and is willing to cap his or her upside by selling 10 XYZOctober 60 calls (out of the money) at $3, bringing in $3000 premium. The net debit position is $4000 paid to put on this synthetic “call bull spread” ($7000 − $3000 = $4000).As the P&L graph shows, the maximum gain and loss arelimited. The maximum loss is limited to the net debit paid to putthe spread on, and the maximum gain is limited to the differencebetween the strike prices less the net debit paid [($60 − $50) =$10 less $4 = $6 (10 contracts) = $6000].Obviously the end result is that the trader is buying a rightto purchase XYZ stock at the strike price, which is favorable(under the CMV) to your position, while limiting the upsidesince, if the stock continues higher to the strike price of the callsold, the call buyer will exercise and call you out, forcing you tosell the position that limits any further participation in theupside move. This is best seen on a profit-and-loss graph asshown in Figure 7.2. The point is that options in conjunctionwith equities and even options by themselves give the electronictrader the ability to hedge risk and maintain control of marketconditions that otherwise would be outside his or her control.The most common use of spreads that I see and implement in myown trading style is for trading size. I like spreads that create a
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FIGURE 7.2 This profit-and-loss graph was created with tools provided bythe “Options Tool Box” available free at www.cboe.com. This is an excellenttool that I highly recommend using.
good risk-reward ratio where I can risk perhaps $1 to have anopportunity to make $4. If in this scenario I could have a netdebit on a bull call spread of $1, I can afford to trade much largersize such as 500 contracts. In this scenario, I spend $50,000 tomake the trade and have an opportunity to make $200,000. If Iam bullish on a stock, this is an example of a trade I would makeusing a spread. Of course, many different spread scenarios existfor going long and short as well.There are many other scenarios and positions that can bebuilt to complement the electronic trader. There are six syntheticpositions that can be created to simulate positions using theactual underlying security (assuming stock):1. Synthetic long stock = long call/short put2. Synthetic short stock = short call/long put3. Synthetic long call = long stock/long put4. Synthetic short call = short stock/short put
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5. Synthetic long put = long call/short stock6. Synthetic short put = short call/long stock
THE ZERO-SUM GAMEBy understanding how these scenarios interrelate to each other,you gain creative ideas about how one can hedge or speculateusing options. The number of scenarios is almost infinite, but bygrasping a solid understanding of options and how to apply theknowledge to equity trading, you will gain additional controlthat most amateur traders will never work toward. With theincredible increase in online trading, the market is poised forgrowth with plenty of amateur money to take advantage of.Although that may seem a bit aggressive, it is reality.I won’t say the stock market is a zero-sum game becausestocks in fact create and add value to the market and investors.One person’s gain is not another’s loss with equities, as is thecase with derivative products like options and futures. But theshorter the time horizon in equity trading such as day trading,the closer one gets to a zero-sum game. The same argument canbe made with the laws of supply and demand. The more activeone trades, the more your focus on this law must be, looking forrapidly changing releases of the forces of supply and demand.Therefore, the moral of this story is to recognize that as you tradeequities more actively and combine derivative positions withequity trading, the more you must poise yourself to competewith the market as if it were a zero-sum game. The more dumbmoney in the market, the more opportunity for the professional,educated trader.I included this chapter on options with the purpose ofexposing you to options, not to teach you all aspects of optionstrading. That is why my rule Acquire options experience is soimportant. The only way to truly understand options and stock isto trade them. The first step is to gain a solid foundation ofknowledge; once that is achieved, you will start to find whatstrategies appeal to you the most. Not all concepts will. Forexample, I do very few spreads since I do not like to limit myupside, which is what spreads do. When I do trade spreads, it is
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again with size. I am a more aggressive trader than most shouldbe as beginners. As traders find experience and success, many ofthem grow in aggressiveness at times in their journey of trading,and some do not. The point is that you need to find your ownpropensity for trading through as much exposure to the marketsas possible with the most flexibility. Options add opportunitiesthrough true synergistic growth potential. By adding optionstrading to your equity trading, the opportunities exceed the sumof the parts. Equities plus options equates to an almost infinitenumber of scenarios that can be adapted to your risk spectrum.With this knowledge, there is no need to trade outside your ownpersonal parameters. There is no need to take a stock tip, no needto assume, no need to gamble. Certainly there will always bea degree of speculation when trading financial instruments—without it there would be no opportunity for substantial gain—but adding options continues to put the statistical advantage onyour side as opposed to giving up your edge to the unforgivingmarket that will eat you alive given the chance.I truly believe that anyone with the ability to learn and applythese concepts can capture this statistical advantage and consistently beat the S&P 500. The S&P 500 has long been the benchmark barometer for mutual funds and private money managers.And statistics have shown that close to 80 percent of fund managers do not in fact beat the S&P 500. Sound familiar? The 80/20principle at work again? I think so. So what separates the twogroups? How do you become a 20 percenter? How about a 10 percenter or even a 1 percenter? Not only do you obtain the knowledge, but you combine that knowledge (through hard work,continuing education, research, reading, and adaptability—alldriven by your passion) with execution. Like a good businessplan, without equally good execution of the business plan, theyare just interesting ideas. Traders need to execute learned strategies through trading to gain the intangible attributes that are alsorequired. Those attributes include feel, intuition, and confidence(along with some healthy fear) to complete the circle of awarenessthat well-rounded traders have. When the maturation of thesequalities occur, I have confidence that you can beat the S&P 500handsomely. No book like this or any other can provide you withthe intangible skills you require. Going into battle with a solidunderstanding of what it will take to defeat your opponent (the
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market), combined with the right conditioning through hardwork, will always put you in a position to score. Enter with anything less, and you may be forced to cheat. In this business, theonly person you cheat is you, so ignore the shortcuts, tips, IPOs,and other seemingly sexy fast cash, and hunker down, do thework, employ what you learn, expect minor failures, and ultimately you will win.
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RULES FOR THETECHNICIANKnow the range within the time horizonyou are trading.Day trade the ranges and swing trade thetrends.Always use indicators to confirm chartsand patterns.Never replace instincts with technicalanalysis.Never ignore volume regardless of yourtrading style.Don’t make it rocket science, ’cause it ain’t.Stay grounded.
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echnicians of the market are a unique group. They formopinions based on a common belief system called technical analysis, which is a way of looking at the marketthrough chart formations and mathematical formulas designed tofind and uncover patterns that have a high likelihood of eitherrepeating or changing. The theory stems from the belief that allfactors in the market are built into the psychological patterns inwhich market participants (professionals and nonprofessionals)trade stock. Market events, such as earnings, R&D developments,and sector rotation, cause people to react. These reactions aremanifested in the way people buy and sell securities to reflecttheir up-to-the-minute perception of the market and stocks.Because of this perception, the purest technicians are not at allconcerned with market-moving news because the impact of suchnews will play itself out in the bid, offers, and prices of securities, which can and will be reflected on charts. These charts,therefore, are the foundation of all technical trading. Chartsallow the technician to read the psychological behavior of themarket as a whole, often referred to as market psychology or sentiment, as well as individual views.Because so many people have an opinion of the market andstocks, and most times those opinions are unfounded and withlittle merit (hence the reason to run from stock tips), techniciansare not interested in these opinions. This explains why news andmedia attention are of little value to them. Technicians pay attention only to the opinions of market participants that act on howthey feel about the market or stocks in terms of how, what, andwhen they trade. Therefore, do not confuse market sentiment asread through the media as the sentiment technicians trackthrough the charts.The value of patterns and charts goes far beyond the literalmeaning of what they are designed to reveal. It is important tounderstand these patterns, but it is even more important to know136
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when to rely on them. This is perhaps the greatest question toask: When do you rely on chart patterns? I would encourage younever to completely rely on them! Technicians like to believethat each trade or series of trades with a time stamp (1 minute, 5minutes, and so on) is a battle between the bulls and bears of themarket, and the winning side moves the stock price in its direction. While this is true at an elementary level, the focus must godeeper, using the tools of real-time data. The application of thesetools in concert with charts is where true utility is found, andthis will be the focus of this chapter. Let’s begin with ranges thatreveal themselves in the market every day.
TECHNICAL RANGESPerhaps the most popular chart formations among market participants are channels. My rule is Know the range within the timehorizon you are trading. Trading ranges are established byrepeatable patterns of support and resistance (for a more detailedunderstanding, refer to Appendix C for a list of books to read).Support and resistance are the most followed technical indicators among amateurs. Because of this fact, these levels can createself-fulfilling prophecies as participants rush in to buy at support and sell at resistance. By knowing these perceived levels, Ilike to day trade at these price points. I day trade them becauseimbedded in them are the ingredients that I need to formulate aday trade. First, there is generally good liquidity due to the perceived levels, and second, when reactions do occur, the trends,although often short-lived, are often more easily recognized. Thethird reason I trade support and resistance is that professionalbias can also be more readily seen. Because professionals alsoknow what I just stated, they think of these opportunities theway fishermen think of a hot new fishing hole. Expect them tocome and drop a line.By anticipating increased market activity at support andresistance levels, the day trader must stand ready to go long andshort, since it is at these points that price capitulation is at itspeak. When these support and resistance levels change, I perceive that to be a turning point and a good indication of a new
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trend line. For example, when a support level is breached, it iscalled a breakdown. This indicates a propensity for stocks todecline. Conversely, when resistance becomes support, it indicates a breakout and a propensity for stocks to go higher. As thesenew levels form, many amateurs are caught on the wrong side,buying at support when they should be shorting and shorting atresistance when they should be buying. The fact that new levelsare being formed is a good indication that the professionals aretaking the stock higher or lower at these levels. Keep in mindthat professionals here are defined as the participants withknowledge, experience, and the capital to move these stocks.They do not only represent market makers and specialists. Asthese new trends form, they create a good opportunity to find liquidity to not only open trades but also to open them at favorableprices. For example, if at resistance a stock is breaking higher orat least showing signs as such, many amateurs are selling, notbuying. This gives you an opportunity to buy stock from sellerswho perceive weakness, not strength. Therefore, it is easy to bidstock at lower prices and still attract sellers. The opposite is truewhen support is broken, forming a new resistance level wheremany perceive strength and will buy while professionals are selling or shorting. Once again, more favorable prices can beacquired from a day trading perspective due to the liquidity provided from the amateur crowd.In the preceding discussion, I do not mean to suggest thatperfect bottoms and tops will be traded. Good traders have indicators that support the idea as mentioned earlier in this chapterand the conviction to