and  youagree to sell or write a call option on IBM. Why would you do this? Well,some  traders  sell  options  in  order  to  collect  the  premium  and  earn  in-come. However, if the stock rises dramatically, the trader may be asked tosell IBM shares to the option holder at the call strike price, which is wellbelow the current market price.
Knowing Your Options
Exercise: If you own a put or call, you can implement your right to exer-cise an option.
Assignment: If  you  are  an  option  seller,  you  face  the  possibility  of assignment.
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Options on stocks, indexes, futures, and exchange-traded funds aresimilar. However, each option will have a different underlying asset. It isimportant to understand the underlying asset, how its price changes, andhow  those  changes  impact  the  price  of  the  option.  Options  are  deriva-tives, which means their price changes are derived from the value of an-other asset (stock, futures contract, index, etc.). The asset is known asthe underlying security.
In  addition  to  understanding  the  underlying  asset,  traders  must  alsounderstand  the  trading  terms  used  to  describe  an  options  contract.  Forexample, every option has a strike price—a price at which the stock or fu-ture can be bought or sold until the option’s expiration date. Options areavailable in several strike prices depending on the current price of the un-derlying asset. As a result, the proﬁtability of an option depends primarilyon the rise or fall in the price of the underlying stock or futures contract(and  its  relation  to  the  strike  price  of  the  option).  An  option’s  premiumalso depends on the time left until expiration, volatility, and other factorsdiscussed later in this book.
Stock Options
Not all stocks have options available to be traded. Currently in the UnitedStates there are more than 4,000 stocks that have tradable options. Thisnumber  grows  daily.  Each  stock  option  represents  100  shares  of  a  com-pany. Therefore, if you buy one XYZ stock option, it represents 100 sharesof XYZ stock. If XYZ shares are trading at $10 per share, then you are con-trolling  $1,000  worth  of  stock  with  one  option  ($10  per  share  × 100shares).  And  you  may  be  controlling  this  $1,000  amount  with  only  $250,depending  on  the  price  of  the  option’s  premium.  This  would  give  youleverage equal to four to one—not too shabby odds.
Futures Options
Most  futures  markets  have  tradable  options,  including  gold,  silver,  oil,wheat, corn, soybeans, orange juice, Treasury bonds, and so on. However,unlike stocks, each contract represents a unique quantity. Options on fu-tures have the futures contract as the underlying instrument. It is the fu-tures contract that is to be delivered in the event an option is exercised.Each futures contract represents a standardized quantity of the commod-ity.  As  you  begin  to  trade  futures,  you  have  to  become  familiar  with  thespeciﬁcs of each futures market. (If you have any questions, you can al-ways  call  your  broker.)  For  example,  a  gold  futures  contract  is  equal  to100 ounces of gold. With gold trading at $410 per ounce, the futures con-tract  is  worth  $41,000:  (100  ounces  × $410  per  ounce).  Each  futures
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Option Characteristics
1. Options give you the right to buy or sell an underlying instrument at a
2.
3.
speciﬁc price.If  you  buy  an  option,  you  are  not  obligated  to  buy  the  underlyinginstrument; you simply have the right to exercise the option.If you sell a call option, you are obligated to deliver the underlying as-set at the price at which the call option was sold if the buyer exerciseshis or her right to take delivery. If you sell a put you must buy the un-derlying if exercised.
4. Options are good for a speciﬁed period of time after which they expireand the holder loses the right to buy or sell the underlying instrumentat the speciﬁed price.
5. Options when bought are purchased at a debit to the buyer. That is,
the money is debited from the brokerage account.
6. Options when sold are sold at a credit to the seller. Money is added to
the brokerage account.
7. Options are available in several strike prices at or near the price of the
underlying instrument.
8. The cost of an option is referred to as the option premium. The pricereﬂects  a  variety  of  factors  including  the  option’s  volatility,  time  leftuntil expiration, and the price of the underlying asset.
9. There are two kinds of options: calls and puts. Calls give you the rightto buy the underlying asset and puts give you the right to sell theunderlying asset.
10. All the put or call options with the same underlying security are calleda  class  of  options.  For  example,  all  the  calls  for  IBM  constitute  anoption class.
11. All put and call options that are in one class and have the same strike
price and expiration are called an option series.
12. Options  are  available  on  a  variety  of  different  underlying  assets 
including stocks, futures, and indexes.
contract has its own unique speciﬁcations, and that can be quite confus-ing to a novice futures trader.
Options on Indexes and Exchange-Traded Funds
An index option is an option that represents a speciﬁc index—a group ofitems that collectively make up the index. We have already discussed theindex markets and exchange-traded funds. Options on indexes and ETFsﬂuctuate with market conditions. Broad-based indexes cover a wide range
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of industries and companies. Narrow-based indexes cover stocks in oneindustry or economic sector.
Index options allow investors to trade in a speciﬁc industry group ormarket without having to buy all the stocks individually. The index is cal-culated as the average change of the stock price of each stock in the in-dex. Each index has a speciﬁc mathematical calculation to determine theprice change, up or down. An index or ETF option is an option that is tieddirectly to the change in the value of the index or exchange-traded fund.
Index  options  make  up  a  very  large  segment  of  the  options  that  aretraded.  Why  are  so  many  options  traded  on  indexes?  The  explosivegrowth in index trading has occurred in recent years due to the increasein  both  the  number  of  indexes  and  the  number  of  traders  who  have  be-come  familiar  with  index  trading.  The  philosophy  of  an  index  is  that  agroup  of  stocks—a  portfolio—will  diversify  the  risk  of  owning  just  onestock. Hence, an index of stocks will better replicate what is happening inan industry or the market as a whole. This allows an investor or trader toparticipate in the movement of a speciﬁc industry, both to the upside andto the downside.
It appears that index and ETF options will continue to proliferate andtrading volume will increase in many of the instruments. A word of cau-tion: A number of these instruments do not have much liquidity. However,used wisely, index options can be an important instrument in your tradingarsenal.  Also,  it  is  important  to  understand  the  difference  between  theway  ETF  options  and  index  options  settle.  Namely,  exchange-tradedfunds, which can be bought and sold like stocks, settle for shares. Cash in-dexes cannot be bought or sold. They settle for cash.
Liquidity
Liquidity  is  the  ease  with  which  a  ﬁnancial  instrument  can  be  traded.  Itcan be deﬁned as the volume of trading activity that enables a trader tobuy or sell a security or derivative and receive fair value for it. A high vol-ume of people trading a market is needed to make it rewarding. Liquidityprovides  the  opportunity  to  move  in  and  out  of  positions  without  difﬁ-culty. For example, at-the-money options often have excellent liquidity be-cause they have a better chance of being proﬁtable than out-of-the-moneyoptions. Therefore, they are easier to trade and many traders focus solelyon the at-the-money contract.
When I ﬁrst started trading, I visited the exchanges. A friend who wasa ﬂoor trader walked me from one pit to another. In one pit, there weretwo guys sitting around reading the newspaper. Was there a lot of opportu-nity there? I didn’t think so. I ﬁgured when an order hits that pit, everyoneprobably starts laughing at the poor sucker who placed it. Then I checked
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out the bond pit. There were 500 people ﬁghting for an order. I quickly rec-ognized that the bond market had high liquidity and plenty of opportunity.I went to the natural gas pit at the New York Mercantile Exchange. It wasa madhouse. There were 200 people in a pit 10 feet wide (prior to movingto their new state-of-the-art building), yelling and screaming. I couldn’t un-derstand a thing they were saying, but once again I recognized high liquid-ity. To this day, I look for pits where there are plenty of people playing thegame because plenty of players equals opportunity.
How  can  you  avoid  illiquid  markets?  Well,  since  you  probably  don’thave the ability to actually visit an exchange, you can still check out theliquidity of a market by reviewing the market’s volume to see how manyshares or contracts have been traded. Both The Wall Street Journal andInvestor’s Business Daily report volume changes. It is vital for a trader toascertain whether trading volume is high or low, increasing or decreasing.It’s hard to quantify just how much volume is enough to qualify a marketas  one  with  liquidity.  However,  as  a  rule  of  thumb,  I  prefer  to  look  forstocks that are trading at least 300,000 shares every day. Futures marketsvary widely, and it is best to monitor activity daily and pick a market thattrades many more contracts than you trade. Since there are no absolutes,there  are  situations  when  this  rule  can  be  tossed  out  the  window  in  ex-change  for  common  sense.  But  until  you  have  enough  experience,  thismay be a good rule of thumb to follow. Bottom line, a plentiful number ofbuyers and sellers and an elevated volume of trading activity provide highliquidity, which gives traders the opportunity to move in and out of a mar-ket with ease. Illiquid markets can make the process much more difﬁcultand more costly.
Volatility
Proﬁtable markets are those markets that provide opportunity for makinggood  returns  on  investments.  Obviously,  some  markets  are  more  trader-friendly than others. Opportunity in a market is contingent on a number offactors. Volatility is one of the most important and misunderstood of thesefactors. It measures the amount by which an underlying asset is expectedto ﬂuctuate in a given period of time. In more simple terms, volatility canbe thought of as the speed of the change in the market.
There are two basic kinds of volatility: implied and historical. Histori-cal  volatility,  often  referred  to  as  actual  or  statistical  volatility,  is  com-puted using past stock prices. It can be calculated by using the standarddeviation of a stock’s price changes from close-to-close of trading goingback  a  given  number  of  days  (10,  20,  90,  etc.).  High  or  low  historicalvolatility also gives traders a clue as to the type of strategy that can bestbe implemented to optimize proﬁts in a speciﬁc market. That is, strategies
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that work well in volatile markets will not generate big proﬁts in a low-volatility  environment.  A  variety  of  indicators,  such  as  Bollinger  bands,can be used to create historical volatility computations that are graphedon a chart.
Implied volatility (IV) is another type of volatility. It is calculated byusing the actual market price of an option and an option pricing model(Black-Scholes for stocks and indexes; Black for futures). If the premiumof an option increases without a corresponding change in the price of theunderlying  asset,  the  option’s  implied  volatility  will  have  increased  also.Overpricing and undervaluing an option’s premium can be caused by aninaccurate perception of the future movement in the price of an asset. Forexample, if implied volatility rises signiﬁcantly for no reason (and there isno increase in historical volatility), the option may be overpriced. Traderscan  take  advantage  of  changes  in  implied  volatility  by  applying  speciﬁcoption strategies.
Note: Since volatility is such a complex issue, my partner, Tom Gen-tile,  and  I  wrote  an  entire  book  on  the  subject  entitled  The  VolatilityCourse (John Wiley & Sons, 2002). If you are going to trade options, youowe it to yourself to develop a strong understanding of volatility.
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, an approach. If you have a consistent and methodical system,discipline leads to proﬁts in trading. On the one hand, it means taking aquick, predeﬁned loss because it is often better to exit a losing positionrather than letting the losses pile up. On the other hand, discipline is hold-ing your options position if you are winning, and not  adjusting an optionsposition when it is working in your favor.
It  also  entails  doing  a  signiﬁcant  amount  of  preparatory  work  be-fore market hours. This includes getting ready and situated before initi-ating a trade so that, in a focused state, you can monitor market eventsas 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  strate-gies, proﬁts can indeed ﬂow profusely. The consistent disciplined applica-tion of these strategies is essential to our success as professional traders.Plan your trade and trade your plan.
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Finally, as option traders, in order to improve in the discipline arenawe  must  identify  and  either  change  or  rid  ourselves  of  anything  in  ourmental  environment  that  doesn’t  contribute  to  the  strictest  execution  ofour well-planned trading approach. We have to stay focused on what weneed to learn and do the work that is necessary. Your belief in what is pos-sible will continue to evolve as a function of your propensity to adapt.
CONCLUSION
Almost every successful trader I know has an area of expertise. For some,it is trading futures. Others like trading commodities. Some traders spe-cialize in trading the Nasdaq 100 QQQs. My experience is mostly related tostock options. Initially, traders tend to explore a large number of differentvehicles and then narrow down their focus to a speciﬁc instrument and asmall number of winning strategies.
Hopefully, this chapter has provided you with a better idea of what ﬁ-nancial  instruments  are  available  for  trading  today  and  how  they  differfrom one another. We discussed a number of different underlying assetsincluding  stocks,  futures,  exchange-traded  funds,  indexes,  and  options.All can be used in creating and implementing options trading strategies.
At this point, the readers should also understand that a futures con-tract is signiﬁcantly different from an options contract. While both repre-sent  agreements  between  two  parties,  the  contracts  are  structured  inways that are considerably different from one another. From here, we fo-cus more on options and, in later chapters, discuss speciﬁc trading strate-gies that work in a variety of different market scenarios.
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CHAPTER 3
OptionBasics
A fter  I  was  introduced  to  the  futures  market  I  saw  how,  with  a
small amount of capital, I could increase my leverage and controlmuch  more  of  a  particular  commodity  using  less  money.  What  Idid not fully understand was the potential risk. Shortly into my futurestrading career, it became evident to me exactly what could happen to anaccount when one was on the wrong side of the futures market. This re-sulted in a temporary setback referred to by many in the business as amargin call, which requires a trader to provide additional money to thebroker as a guarantee to stay in the trade. Later that year, I returned tothe futures market with a more disciplined approach that included trad-ing options.
As a trader, I ﬁnd options to be the most effective way to maintain con-sistent  trading  proﬁts.  They  have  become  vitally  important  tools  in  mytrading toolbox. However, like any tool, they are most effective when usedproperly  and  dangerous  if  not  respected.  There’s  an  adage  among  savvytraders that says, “Options don’t lose money; people do.”
Most of my favorite trading strategies use put and call options to act asinsurance  policies  in  a  wide  variety  of  trading  scenarios.  You  probablyhave insurance on your car or house because it is the responsible and safething to do. Options provide the same kind of safety net for your trades.They  also  allow  you  to  control  more  shares  of  a  certain  stock  withouttying up a large amount of capital in your account.
In order to grasp the complex nature of trading options, it is importantto build a solid foundation in option basics. In Chapter 2, we started build-ing that foundation with a brief introduction to various ﬁnancial markets
42
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and  trading  instruments.  Now  let’s  continue  our  discussion,  but  narrowour focus to the fascinating world of options.
WHAT IS AN OPTION?
Outside in the world beyond ﬁnance, an option is merely a choice. Thereis an inﬁnite number of examples of options. Perhaps you are looking fora house to rent, but you are also interested in buying a house in the future.Let’s say I have a house for rent and would be willing to sell the house. A12-month lease agreement with an option to buy the house at $100,000 iswritten. As the seller, I may charge you $1,000 extra just for that 12-monthoption  to  buy  the  house.  You  now  have  12  months  in  which  to  decidewhether to buy the house for the agreed price. You have purchased a calloption, which gives you the right to buy the house for $100,000, althoughyou are in no way obligated to do so.
A variety of factors may help you decide whether to buy the house, in-cluding  appreciation  of  the  property,  transportation,  climate,  localschools, and the cost of repairs and general upkeep. Housing prices mayrise or fall during the lease period, which could also be a determining fac-tor in your decision. Once the lease is up, you lose the option to buy thehouse at the agreed price. If you decide to buy the house, you are exercis-ing your right granted by the terms of our contract. That’s basically how acall option works.
So,  in  the  options  market,  a  call  gives  the  owner  the  right  to  buy  astock (or index, futures contract, index, etc.) at a predetermined price fora speciﬁc period of time. The call owner could elect not to exercise theright and could let the option expire worthless. He or she might also sellthe call at a later point in time and close the position. Regardless of whatthe owner decides to do, the call option represents an option to its owner.Throughout the rest of this book, out discussion of options deals withthe types of contracts that are traded on the organized options exchanges.Each day, millions of these contracts are bought and sold. Each contractcan in turn be described using four factors:
1. The name of the underlying stock (or future, index, exchange-traded
fund, etc.).
2. The expiration date.3. The strike price.4. Whether it is a put or call.
Therefore, when discussing an option, the contract can be describedusing the four variables alone. For example, “IBM June 50 Call” describes
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the  call  option  on  shares  of  International  Business  Machines  (IBM)  thatexpires in June and has a strike price of 50. The QQQ October 30 Put is theput option contract on the Nasdaq 100 QQQ that expires in October andhas a strike price of 30. 
DETERMINANTS OF OPTION PRICES
Options are sometimes called “wasting assets” because they lose value astime passes. This makes sense because, all else being equal, an option tobuy or sell a stock that is valid for the next six months would be worthmore than the same option that has only one month left until expiration.You  have  the  right  to  exercise  that  option  for  ﬁve  months  longer!  How-ever, time is not the most important factor that will determine the value ofan options contract.
The price of the underlying security is the most important factor in de-termining the value of an option. This is often the ﬁrst thing new optionstraders learn. For example, they might buy calls on XYZ stock because theyexpect XYZ to move higher.
In order to really understand how option prices work, however, it isimportant  to  understand  that  the  value  of  a  contract  will  be  determinedlargely by the relationship between its strike price and the price of the un-derlying asset. It is the difference between the strike price and the price ofthe underlying asset that plays the most important role in determining thevalue of an option. This relationship is known as moneyness.
The  terms  in-the-money  (ITM),  at-the-money  (ATM),  and  out-of-the-money  (OTM)  are  used  with  reference  to  an  option’s  moneyness.  A  calloption is in-the-money if the strike price of the option is below where theunderlying  security  is  trading  and  out-of-the-money  if  the  strike  price  isabove the price of the underlying security. A put option is in-the-money ifthe  strike  price  is  greater  than  the  price  of  the  underlying  security  andout-of-the-money if the strike price is below the price of the underlying se-curity. A call or put option is at-the-money or near-the-money if the strikeprice is the same as or close to the price of the underlying security.
Price of Underlying Asset = 50
Strike Price
Call Option
Put Option
6055504540
OTMOTMATMITMITM
ITMITMATMOTMOTM
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As noted earlier, the amount of time left until an option expires willalso have an important inﬂuence on the value of an option. All else beingequal, the more time left until an option expires, the greater the worth. Astime  passes,  the  value  of  an  option  will  diminish.  The  phenomenon  isknown as time decay, and that is why options are often called wastingassets. It is important to understand the impact of time decay on a posi-tion. In fact, time is the second most important factor in determining anoption’s value.
The dividend is also one of the determinants of a stock option’s price.(Obviously, if the stock pays no dividend, or if we are dealing with a fu-tures contract or index, the question of a dividend makes no difference.)A dividend will lower the value of a call option. In addition, the larger thedividend, the lower the price of the corresponding call options. Therefore,stocks with high dividends will have low call option premiums.
Changes  in  interest  rates  can  also  have  an  impact  on  option  pricesthroughout  the  entire  market.  Higher  interest  rates  lead  to  somewhathigher option prices, and lower interest rates result in lower option premi-ums. The extent of the impact of interest rates on the value of an option issubject to debate; but it is considered one of the determinants throughoutmost of the options-trading community.
The volatility of the underlying asset will have considerable inﬂuenceon the price of an option. All else being equal, the greater an underlying as-set’s volatility, the higher the option premium. To understand why, considerbuying a call option on XYZ with a strike price of 50 and expiration in July(the XYZ July 50 call) during the month of January. If the stock has beentrading between $40 and $45 for the past six years, the odds of its price ris-ing above $50 by July are relatively slim. As a result, the XYZ July 50 calloption will not carry much value because the odds of the stock moving upto $50 are statistically small. Suppose, though, the stock has been tradingbetween $40 and $80 during the past six months and sometimes jumps $15in a single day. In that case, XYZ has exhibited relatively high volatility and,therefore,  the  stock  has  a  better  chance  of  rising  above  $50  by  July.  Thecall  option,  or  the  right  to  buy  the  stock  at  $50  a  share,  will  have  betterodds of being in-the-money at expiration and, as a result, will command ahigher price since the stock has been exhibiting higher levels of volatility. 
Understanding the Option Premium
New option traders are often confused about what an option’s premium isand what it represents. Let’s delve into the total concept of options pre-mium  and  hopefully  demystify  it  once  and  for  all.  The  meaning  of  theword premium takes on its own distinction within the options world. Itrepresents an option’s price, and is comparable to an insurance premium.
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If you are buying a put or a call option, you are paying the option writer aprice  for  this  privilege.  This  best  explains  why  so  often  the  terms  priceand premium are used interchangeably.
One  of  the  most  common  analogies  made  for  options  is  that  theyact  like  insurance  policies,  particularly  the  premium  concept.  For  ex-ample, as a writer of an option, you are offering a price guarantee to theoption buyer. Further, the writer plays the role of the insurer, assumingthe risk of a stock price move that would trigger a claim. And just likean insurance underwriter, the option writer charges a premium that isnonrefundable, whether the contract is ever exercised.
From the moment an option is ﬁrst opened, its premium is set by com-peting bids and offers in the open market. The price remains exposed toﬂuctuations  according  to  market  supply  and  demand  until  the  optionstops trading. Stock market investors are well aware that inﬂuences thatcannot be quantiﬁed or predicted may have a major impact on the marketprice of an asset.
These  inﬂuences  can  come  from  a  variety  of  areas  such  as  marketpsychology, breaking news events, and/or heightened interest in a particu-lar industry. And these are just three illustrations where unexpected shiftsin market valuations sometimes occur.
Although market forces set option prices, it does not follow that pre-miums  are  completely  random  or  arbitrary.  An  option  pricing  model  ap-plies  a  mathematical  formula  to  calculate  an  option’s  theoretical  valuebased on a range of real-life variables. Many trading professionals and op-tions strategists rely on such models as an essential guide to valuing theirpositions and managing risk.
However, if no pricing model can reliably predict how option priceswill behave, why should an individual investor care about the principlesof  theoretical  option  pricing?  The  primary  reason  is  that  understandingthe key price inﬂuences is the simplest method to establish realistic ex-pectations for how an option position is likely to behave under a varietyof conditions.
These models can serve as tools for interpreting market prices. Theymay explain price relationships between options, raise suspicions aboutsuspect prices, and indicate the market’s current outlook for this security.Floor traders often use the models as a decision-making guide, and theirvaluations play a role in the market prices you observe as an investor. In-vestors who are serious about achieving long-term success with optionsﬁnd it instrumental to understand the impact of the six principal variablesin the theoretical establishment of an option’s premium:
1. Price of