atility.
Most charts will also plot volume underneath the price area. Volumerefers to the total activity in the underlying asset during the course of aday, week, month, and so on. For a stock, the volume refers to the numberof shares traded.
To some traders, volume is the single most important indicator usedin technical analysis. When a stock is rising and volume increases, it sug-gests that buyers are actively bidding the price higher and shorts are run-ning for cover. Strong volume during an advance is considered a bullishsign. On the other hand, when volume swells during a decline, bears aredriving prices lower, bulls are in pain, and the action of the stock is con-sidered poor. Therefore, studying volume gives the analyst a better senseof whether the bulls or bears are in control of the stock.
Volume is the total number of shares associated with a speciﬁc stockor market. Also known as turnover, it reﬂects the number of shares boughtor  sold  relative  to  a  speciﬁc  security.  For  instance,  if  you  purchase  100shares of Microsoft, the volume of that trade is equal to 100. Volume is con-sidered  during  daily  time  periods.  For  instance,  on  Wednesday,  February18, 2004, total volume on the Nasdaq Stock Market equaled 1,777,995,664shares.  Therefore,  daily  volume  is  generally  deﬁned  as  the  number  ofshares traded in one day and can be considered for one individual stock, anoptions  contract,  or  an  entire  market.  On  a  chart,  volume  is  plotted  as  ahistogram such as can be seen in Figures 18.2 and 18.3. Tall bars suggestheavy volume while short bars indicate periods of low trading volume.
COMPUTER SOFTWARE
When I started trading, the charts we had available to us were newspapersor other print publications. Today, however, charting software makes theprocess extremely fast and easy. While there are a large number of greatpackages out there, we will just mention the three that our students seemto  use  most  often:  The  Optionetics  Platinum  site,  ProﬁtSource  and  Ad-vanced GET from eSignal.
Optionetics Platinum site is a web-based computer software program de-signed for options traders. Access is available for an annual fee. Once insidethe site, traders can perform a host of options related studies including creat-ing  hypothetical  trades,  plotting  volatility  charts,  back-testing  strategies,viewing  historical  prices  and  implied  volatility  levels,  monitoring  put/call
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ratios,  initiating  trade  searches  based  on  speciﬁc  parameters,  and  plottingrisk graphs. Many of the case study examples in this book were created usingOptionetics.com Platinum.
ProﬁtSource is a market analysis program that combines a fully fea-tured technical analysis suite with a comprehensive set of special marketdirection  tools  such  as  Elliott  wave,  trend  ﬁlters,  and  gap  ﬁlters.  Thesetools enable the user to adopt a rule-oriented approach to trading. In addi-tion, it has the ability to scan for potentially proﬁtable opportunities suchas Wave 4 and Wave 5 trades, a state-of-the-art “Walk Through Mode” forlearning how to apply concepts such as Elliott wave, alerts functionalityfor price, indicator and Elliott wave parameters, and a complete portfoliomanagement  package.  ProﬁtSource  can  be  used  in  multiple  markets  in-cluding stocks, indexes, futures, and foreign exchange and gives the useraccess to international markets.
Advanced  GET  from  eSignal  has  also  gained  popularity  among  op-tions traders. It is a graphical charting package that gives traders accessto  a  full  set  of  technical  analysis  tools,  specialty  tools  and  indicatorsbased on Elliott waves and Gann theory, and also one of the most com-plete sets of standard studies available in the market today. Many optionstraders use these three software packages to enhance their ability to con-ﬁdently use options strategies.
PUTTING IT ALL TOGETHER
In  order  to  get  a  better  understanding  of  how  traders  combine  tradingtools  to  create  a  promising  trade,  let’s  work  through  a  simple  example.The ﬁrst thing we need to employ is a method of ﬁnding stocks that areexpected  to  make  a  strong  directional  move  to  the  upside  or  the  down-side. In this case, we are looking for an explosive move higher.
There are several tools on Platinum that help us ﬁnd stocks, but for thisexample  we  will  use  the  Candlestick  I  tool.  This  tool  searches  for  stocksbased on candlestick formations. (There is a wide array of different candle-stick formations that go well beyond the scope of this book. Traders inter-ested in the topic are encouraged to visit Optionetics.com and look throughthe  article  archives  for  a  complete  discussion  of  the  various  patterns.)  Inthis case, we chose the Bullish Patterns search using stocks that were trad-ing above $12.50 and that had volume above 300,000. Once a list of stocksappears, we need to look at various price charts and implied volatilities.
To keep things simple, suppose we ﬁnd a bullish stock and decide tobuy a long call. When buying a call, we want the implied volatility to be be-low the average IV for at least six months. Remember, when IV is low, the
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options  are  cheaper.  After  eyeballing  the  charts,  we  found  that  LehmanBrothers  (LEH)  looked  like  a  strong  candidate.  Figure  18.4  is  a  chart  ofLEH on May 20, 2003 showing the candlestick pattern known as Red Can-dle + Doji that ﬂagged the stock.
Not only did the stock form a bullish pattern known as a Harami, butit  also  bounced  off  support  at  its  ascending  trend  line.  Once  we  ﬁnd  astock that looks promising, we want to check IV to make sure it isn’t toohigh.  Figure  18.5  is  an  IV  chart  of  the  stock  on  May  20,  2003,  the  day  itcame up on the Candlestick I search.
We can see by looking at this chart that IV was deﬁnitely low on a his-toric basis. This is important because the higher the IV, the more the op-tion  will  cost.  IV  also  acts  like  elastic,  stretching  to  extremes,  butultimately coming back to its mean. If we buy a call and IV increases, itraises the price of the option.
Now that we have a stock picked out that ﬁts our criteria, we can en-ter the data into Platinum to view the risk graph. Before we actually enterthe data into the Create Trade screen, we need to ﬁrst decide which op-tion strike and expiration month we want to test. Of course, after this isentered  into  the  graph,  we  can  view  it  to  see  if  the  trade  makes  sensegiven our outlook and resources.
Since we are buying an option, we want to give the trade enough time
FIGURE 18.4 Daily Chart of LEH (Source: Optionetics Platinum © 2004)
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7 – 30 day = unk30 – 60 day = 27.19%60 – 90 day = unk>90 day = 30.73%
462
ytilitaloVdeilpm
I
MTA
05
04
03
12/16         01/15         02/13         03/14        04/11
FIGURE 18.5 IV Chart for LEH (Source: Optionetics Platinum © 2004)
Currently:    2003–05–20
to work in our favor. Mainly, we don’t want to hold long options that ex-pire in less than 30 days because time erosion picks up the last month ofan option’s life. The stock closed the session at $66.04 and since we don’tnormally  want  to  use  too  far  out-of-the-money  options,  let’s  look  at  theOctober 70 call. We choose the October expiry month because June andJuly  are  too  close  and  there  aren’t  any  August  or  September  options  onMay 20 to choose from. After entering the data into Platinum, we get theinformation shown in Figure 18.6 from the program.
This screen is just part of what Platinum tells us about the trade, butthere  is  plenty  to  see  from  just  this  information.  First,  we  see  that  themodel price is between our bid-ask spread, so we know that option isn’toverpriced. Second, we can see our breakeven point at expiration. It is im-portant to remember that the breakeven point here is ﬁgured as of expira-tion. Usually, we will see a proﬁt well before this point. This screen alsogives us the Greeks and the speciﬁc option information. The next thing wewant to look at is the risk graph (Figure 18.7).
This graph gives us a visual of what the proﬁt or loss would be givena  move  in  the  stock  and  using  different  time  frames.  Obviously,  if  thestock  moves  up  in  the  short  term,  we  will  see  higher  proﬁts  than  if  ittakes three months to occur. Our initial debit was $340 in this trade forbuying one long October 70 call. By looking at the chart, we can see that
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Lehman Brothers Holdings, Inc (LEH) Option Trade
Log Date 
Position 
Num  OptSym 
Expire  Strike 
Type  Entry 
Bid/Ask  Model 
IV %  Vol 
01  Days
2003-05-20 
Bought 
1 
LEHIN 
OCT03 
70 
Call 
3.4 
3.2/3.4 
3.314  28.1 
0 
2569  150
Entry DB  Profit  Max Profit  Max Risk  Delta (Shares)  Gamma  Vega  Theta    
$340.00 
$–20.00  Unlimited 
$–340.00 
41.8 
3.2692 
$16.46  $–1.53
Downside Breakeven  Upside Breakeven  Max Profit/Max Risk  Max Profit/Debit
73.40 
73.40 
Unlimited% 
Unlimited%
FIGURE 18.6 Trade Data for LEH Call (Source: Optionetics Platinum © 2004)
the stock would need to move to approximately $72 for our call option todouble in price.
Another  tool  we  can  use  to  assess  the  trade  is  the  implied  volatilitychart.  The  IV  chart  shown  in  Figure  18.8  details  the  proﬁts  we  wouldachieve on a move in IV alone. This graph assumes the stock stays at thesame price. We can see that a rise in IV can affect the trade drastically, andthat is why we want IV in our favor.
Before we enter the trade, we should have already decided on our exitpoints. The price we decide to sell at should be based on our outlook andmoney  management.  Remember  that  it’s  always  important  to  have  a  setexit point before entering a trade to take the emotion out of it. An oft-used
66.00 open 
66.69 high 
 65.07  low 
 66.04  close 
   +0.25
Today:   150 days left100 days left50 days leftExpiry:  0 days left
ecirPkcot
S
59
09
58
08
57
07
56
06
55
05
54
04
53
04/07 
04/17 
Currently:    2003–05–2004/30 
05/12 
–1,000
0 
 1,000 
  2,000
FIGURE 18.7 Risk Graph for LEH Call (Source: Optionetics Platinum © 2004)
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7 – 30 day = unk30 – 60 day = 27.19%60 – 90 day = unk>90 day = 30.73%
Today: 150 days left100 days left50 days leftExpiry:  0 days left
464
03
ytilitaloVdeilpm
I
MTA
04/07 
04/17 
Currently:    2003–05–2004/30 
05/12 
–400
–300
–200
–100          0       100       200
FIGURE 18.8 IV Chart for LEH Trade (Source: Optionetics Platinum © 2004)
exit strategy for a long call is to sell if the option loses half its value to thedownside or when the option doubles in price to the upside. Of course, wecan always set stops once our price target is achieved to let our proﬁts run,but the last thing we want to do is see a proﬁtable trade turn into a loser.
This trade did indeed work out well, with LEH shares moving up fol-lowing this bullish sign. As originally expected, the stock went higher andour option was at a double on June 2 with the stock trading near $72.50.At this point, either the option could be closed or the trader could set astop to make sure that if the stock were to move lower, the option wouldbe sold before the proﬁts were lost. Keep in mind that buying long calls isa great way to use leverage, but it is also a high-risk one. When the strate-gist identiﬁes an explosive situation like in the Lehman Brothers example,he or she might want to consider other trades like bull call spreads, callratio backspreads, or some of the other bullish strategies discussed in theearlier chapters of this book.
CONCLUSION
Not all traders use charts or computers. In fact, 20 years ago much of thisinformation was either not available or extremely expensive. So, tradersdo not need to spend a lot of money on research and analytical tools. A
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high-speed  Internet  connection,  a  brokerage  ﬁrm  that  specializes  in  op-tions trading, and access to research can produce enough information totrade successfully.
Hopefully, this chapter has helped to expand your knowledge regard-ing the tools that are available and how a trader uses information to cre-ate a trade. The example toward the end of the chapter explained how toﬁnd an explosive opportunity and how to analyze the situation to ﬁnd thebest options contract for the given strategy. Not all successful traders usethe  same  approach.  Through  time,  you  will  undoubtedly  develop  yourown  tools  and  methods  for  picking  winning  trades.  Hopefully,  the  chap-ters in this book are helping you along the way.
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FinalSummary
T his book has reviewed a variety of strategies that can be applied in
various markets. It has avoided trying to forecast market direction oranalyzing  charts  with  detailed  market  patterns,  and  has  not  refer-enced highly technical data or difﬁcult-to-interpret fundamental informa-tion.  Although  these  trading  tools  may  have  their  place  in  your  tradingarsenal, they are exhaustively studied in many other publications. The pur-pose of this book is to focus on options trading strategies and to demon-strate how professionals trade without overanalyzing the markets. Whentraders get bogged down in trying to process too much information, the re-sult is what I often call “analysis paralysis.”
I have tried to make the information contained in this book as straight-forward as possible. Learning to trade can be quite difﬁcult and perplexing.Each  strategy  has  an  inﬁnite  number  of  possibilities  when  applied  to  themarkets.  Each  trade  is  unique,  and  your  task  as  a  trader  is  to  learn  fromyour achievements and your mistakes. There are no absolutes in trading.
However,  I  do  believe  that  you  will  be  able  to  build  a  solid  tradingfoundation  based  on  the  delta  neutral  strategies  explored  in  this  book.This approach to trading comes from years of experience from my tradingteam and my own endeavors. To become successful, it’s up to you to take asystematic approach to becoming a conﬁdent market player. However, youmust be willing to spend the time and energy it takes to study the marketsif you want to learn how to trade successfully.
In late October of 1997, the Dow Jones Industrial Average dropped554 points  or  7  percent.  By  most  people’s  standards,  this  constitutes  a
466
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mini-crash. It was not as severe as the 1987 crash when there was a 22 per-cent drop, but it deﬁnitely shook up the markets. Throughout the day ofthe mini-crash, I talked with a number of traders and investors to discussour views on this market decline. At many brokerage ﬁrms, clients werebeing forced to meet margin calls as their positions declined. Eventually,there  were  more  sell  orders  than  the  markets  could  bear  and  tradingclosed early at the New York Stock Exchange. Compared to the millionsof individuals who lost a great deal of money, traders who were using thestrategies  included  in  this  book  fared  much  better.  They  knew  how  tohedge  their  positions  and  either  made  money  or  at  least  minimized  thelosses  to  their  accounts.  This  approach  to  trading  offers  protection  andenables players to keep playing the game.
To get started, ﬁnd one market you like and get to know it very well.Find out how many shares or contracts are traded. What is the tick value?What are the support and resistance levels? What are the strike prices ofthe available options? How many months of options should be analyzed?Is this a volatile market? Does it have high liquidity? Do you have enoughcapital to play this market?
Once  you  determine  the  right  market  for  you,  focus  your  efforts  onevaluating  which  strategies  best  take  advantage  of  this  market’s  uniquecharacteristics.  This  can  be  accomplished  by  paying  close  attention  tomarket  movement  trends.  For  example,  stock  shares  tend  to  go  up  inprice over the long run. This means that in many cases I take a bullish biasover the long run in top stocks. Since many futures markets go sideways, Ilike to apply the appropriate range-bound strategies.
By concentrating your attention on one market, you will become fa-miliar with that market’s personality. When change occurs, this familiaritywill enable you to proﬁt the most from the change. Practice these strate-gies  by  paper  trading  your  market  until  you  get  the  hang  of  it.  I  recom-mend  three  to  six  months  of  paper  trading  before  investing  a  dime.  Forevery  great  trade  you  missed,  there  will  be  mistakes  that  could  havewiped out your whole account. Take small steps up the ladder of experi-ence and you’ll learn what you need to master along the way.
In  addition,  you  need  to  determine  what  inﬂuences  a  speciﬁc  mar-ket. Markets have spheres of inﬂuences. You need to get to know whatinternal and external forces drive your chosen market. For example, thebond market affects the S&Ps. What affects Dell, Intel, Microsoft, gold,and silver? All of this research combines to increase your overall knowl-edge of trading, which will help to make you a more successful trader inthe years to come.
During  one  of  my  two-day  Optionetics  seminars,  I  kept  saying that very few traders and investors really know what is going on in the
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markets. The very next day, as if by magic, the following article appearedin USA Today. I promptly revealed it to the students at my seminar.
Garbagemen Good at Predicting Economy
In  December  of  1994,  the  economists  sent  a  questionnaire  to  fourchairmen  of  multinational  companies,  former  ﬁnance  ministersfrom  four  countries,  four  Oxford  University  students,  and  fourgarbagemen. They were asked to predict average economic prospectsincluding world economic growth, inﬂation, the price of oil, and thepound’s exchange rate against the dollar in the ten years following1994. The economists said the garbagemen and company bosses tiedfor ﬁrst with the predictions. The ﬁnance ministers came in last.
So,  let  me  get  this  straight.  Politicians  supposedly  run  entire  coun-tries,  right?  Then  how  come  their  own  ﬁnance  ministers  cannot  beatgarbagemen at predicting economic prospects? This only emphasizes thepoint  that  the  markets  are  great  equalizers  of  education.  It  is  irrelevantwhether you have an MBA or a PhD or are a rocket scientist. High schooldropouts can do just as well at trading, if not better, if they are disciplinedand have the skills and knowledge to succeed. It is actually easier for meto  train  individuals  with  very  little  experience  or  none  whatsoever  thanthose who have years of experience. This is due to the fact that many ex-perienced traders have developed bad habits that need to be broken.
Approximately 99 percent of the time that I trade delta neutral, I amable to manage my risk on entering the trade and monitor it each day asthe market moves. Delta neutral trading is a scientiﬁc system that signiﬁ-cantly reduces your stress level. It provides you with the means to limityour risk and make a consistent proﬁt. It directs you to take advantage ofmarket  movement  by  making  adjustments.  By  learning  to  trade  usingdelta neutral strategies, traders have the opportunity to maximize proﬁtsby making consistent returns.
OPTIONS-TRADING DISCIPLINE
Proper  money  management  and  patience  in  options  trading  are  the  cor-nerstones to success. The key to this winning combination is discipline.Now, discipline is not something that we apply only during the hours oftrading, opening it up like bottled water at the opening bell and storing itaway at the closing. Discipline is a way of life, a method of thinking. It is,most  of  all,  a  serious  approach.  A  consistent  and  methodical,  or  disci-plined, system leads to proﬁts in trading. On one hand, it means taking a
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quick,  predeﬁned  loss  because  the  ﬁrst  loss  is  always  the  best.  On  theother hand, discipline gives you the impenetrable strength to keep holdingon to an options position when success is at hand or passing on the tradeor an adjustment when you don’t have a signal. It also entails doing all ourpreparatory work before market hours. It is getting ourselves ready andsituated before the trade goes off so that, in a focused state, we can moni-tor market events as they unfold.
Discipline can sometimes have a negative sound, but the way to free-dom  and  prosperity  is  an  organized,  focused,  and  responsive  process  oftrading. With that, and an arsenal of low-risk/high-proﬁt options strategies,proﬁts can indeed ﬂow profusely. The consistent disciplined application ofthese strategies is essential to your success as a professional trader.
Finally, as option traders, in order to improve in the area of discipline,we must identify, change, or rid ourselves of anything in our mental environ-ment that doesn’t contribute to the strictest execution of our well-plannedtrading approach. We need to stay focused on what we need to learn and dothe work that is necessary. Your belief in what is possible will continue toevolve as a function of your propensity to adapt. On a cautionary note, avoidhigh commissions, brokers soliciting business, and software that promisesor boasts impossible results. High turnaround fees can really eat into yourproﬁts.  Remember,  nothing  beats  your  own  ability  to  trade  effectively.  Noone wants to take better care of your money than you do.
CHOOSING THE OPTIMUM OPTION STRATEGY
For  the  skilled  investor,  stock  options  can  be  a  very  powerful  tool.Whether  they  are  used  alone  or  in  combination  with  other  options  orstock, options offer the ﬂexibility to address any number of unique invest-ment  goals  and  parameters.  However,  before  the  search  for  a  suitablestrategy can even begin, the investor needs a solid understanding of howoption investments work.
The options strategist is always faced with a variety of alternatives. Todetermine  which  one  is  best  you  must  consider  your  investment  goals,market outlook, and risk tolerance all of which are key in narrowing downthe list of reasonable candidates. The same goals and predictions can alsolimit the choice of suitable strike prices and expiration dates. Each strat-egy and each contract has its own advantages and drawbacks.
Forecasting  the  price  of  the  underlying  equity  is  a  prime  motive  be-hind directional option strategies. Whether the goal is proﬁt or protection,the market outlook certainly narrows the list of strategic alternatives.
More  often  than  not  directional  strategies  require  the  investor  to
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make at least three assessments about the future price of the stock. Theﬁrst  one  is  obviously  direction  itself.  Based  on  our  market  analysis,  weneed to determine if we expect the price of the stock to rise, fall, or stay atthe current level. The second judgment is about the size of the move. Thiswill have a distinct bearing on the choice of strike prices.
For some option strategies, it is not enough to decide on a direction.The magnitude of the projected price move may determine which strikeprices are suitable candidates. For instance, when analyzing a call optionwith  an  out-of-the-money  strike  price,  you  will  need  to  determine  howhigh  would  the  underlying  stock  have  to  rise  to  make  the  position  prof-itable as well as how realistic this move would be based on your research.The third decision concerns the time frame in which the stock priceforecast  must  take  place.  Options  have  a  limited  time  span.  If  both  theprojected direction and size of the move come true, but only after the op-tion  expires,  the  option  strategist  still  would  not  have  achieved  the  in-tended goal. That is why timing is just as crucial in strategy selection as itis for everyday life.
So, option strategists who are making a directional call must be righton three levels; the stock price must move in the right direction, by a sufﬁ-cient amount, and by the expiration date. If the trader is wrong about anyof the three projections, it could have an adverse impact on the success ofthe strategy.
For  some  strategies,  it  is  enough  for  XYZ  to  reach  a  certain  level  atsome  point  before  expiration,  but  the  exact  timing  is  less  important.  Theconsequences for being a bit off the mark are much more serious in othercases. There are some that succeed only if the stock price behaves correctlyfor the duration of the contract. A clear idea about where the underlyingequity is likely to move and when, should improve the option strategist’schances  of  success  with  selecting  and  implementing  an  appropriate directional strategy.
Finally, even when two traders’ forecasts are exactly the same, differ-ent goals may dictate two very different approaches. For example, is thetrade intended primarily to generate income or is it to protect an existingposition in the same stock? Or is it a way to set a price objective for enter-ing or exiting a stock position? The answers to these kinds of questionswill  guide  the  trader  in  ruling  in  some  strategies  and  ruling  out  otherswhen attempting to select the optimum options strategy.
IMPLIED VOLATILITY AND TRADE SELECTION
When it comes to professionally trading options, there is no more impor-tant component than volatility. As discussed in earlier chapters, vol