Date
Position
Num
OptSym
Expire
Strike
Type
Entry
Bid/Ask
Model
IV %
Vol
OI
Days
04-29-05
Bought
6
OOOGK
JUL05
37
Call
0.5
0.45/0.55
0.575
19.1
1095
3617
77
Gamma
Vega
67.472
$33.34 $–4.55
Entry Debit(Cost)
$300.00
Profit
Max Profit
Max Risk
Delta (Shares)
$–30.00 $Unlimited $–300.00 177.86
Downside Breakeven37.50
Upside Breakeven37.50
Max Profit/Max RiskUnlimited%
Theta
Max Profit/CostUnlimited%
FIGURE 16.1 QQQQ Option Trade Speciﬁcs (Source: www.Optionetics.comPlatinum)
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exit points will be. Setting exit points ahead of time helps keep the emotion out of the decision-making process. In this example, let’s set ourprofit goal at double. At this point, we would sell half of the options sothat we would then have a risk-free trade. We also need an exit point incase of a loss. We might decide that we don’t want to lose more than halfthe value of the option, which in this case would be if the option is onlyworth $0.25. If neither of these events occurs, we will exit the trade with30 days left until expiration.By looking at this data we can see that our maximum risk is $300, thetotal debit to enter the trade. The breakeven is easy to figure—it is thestrike price used plus the debit of $0.50 per contract. Using the exits wedecided on earlier, we would sell half the contracts if the options can besold for $1.00 each. If the Qs fall, we would get out once the contracts areworth just $0.25. Figure 16.2 shows the risk profile of our paper trade.There are two ways we can see how this trade would have fared. Onewould be to go forward one day at a time in Platinum to see if our exitpoints are reached. The other would be to forward the Platinum date tothe point where we are 30 days from expiration and then view the backdata from entry point until this point in time.Looking at the data from April 29 to June 15, we see that our firstprofit exit would have been reached on May 18 with the closing price for
FIGURE 16.2 QQQQ July Long Call Risk Proﬁle (Source: www.Optionetics.comPlatinum)
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the Qs at $37.20. At the close of trading that day, we could have sold threeof the July 37 options for $1.15 each, or $345. This would bring in morethan we paid to enter the trade by $45, which ensures that a loss cannotoccur. On June 2, the Qs rose to 38.66, which pushed our profit up to $660total as the remaining three contracts were now worth 2.05. This wouldhave been a point to close the trade and take profits. Whenever you canmake 200 percent return, take it. Of course, if we would have held all ourcontracts until this point, we would have made 400 percent, but we wantto take out as much risk as possible.This was an example of a winning trade, but we often learn more fromour losses than from our wins. When paper trading, we welcome lossesthat teach us important lessons. However you decide to go about papertrading is fine; just make sure you learn the strategies by using paper trading to avoid large losses of capital at the beginning of your trading career.
TYPES OF ORDERSOne of the most stressful functions of the new trader is actually to placethat first trade. Picking up the phone or turning to the broker’s web pageis, without a doubt, a time of considerable angst. After all, you are tryingsomething totally new. There is a seemingly endless number of choices,you are on your own, and if you mess it up, it could conceivably cost you alot of money—your money.As you gain experience, you will settle into a style of order placingthat works for you and your broker, often forgetting that there are manyother ways that might possibly solve a particular problem. However, to getstarted you need to understand the basics of how to place a trade, as wellas some of the available options that even the more experienced tradermay have forgotten.To place a trade, you need to communicate several things to your broker. Although we offer a list—the particular order of which is only suggested, not mandatory—you will soon find an order structure that worksbest for you and your broker. The following list is designed around asingle asset (stock, call, or put) but will work just as well for any of theOptionetics-style combination (or hedge) trades.To place a trade, you’ll need to give your broker the following information:• Whether you want to buy (go long) or sell (go short) the security.• The underlying stock (and possibly ticker symbol).• The actual vehicle (stock, ETF, HOLDR, call, or put).
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• If an option, the particular month and strike (and possibly the appropriate symbol).• The number of shares or contracts.• The type of order (market, limit—and if so, what limit).• Whether you are opening a position (initially setting up the position—long or short) or closing a position (selling an existing long positionor buying back an existing short position).Some brokers and most web sites require you to provide the exactticker symbol for your transaction. Other brokers will accept an order using a plain English description of your transaction. Using the coded description (which you can search for on Optionetics.com) is just too easyto mess up, especially for a beginning trader or a semiactive trader (onewho attempts to remember the code from last week or month). For instance, “AEQFI” and “AEQRI” appear to be almost identical (at least withmy handwriting!) and in fact are both options for Adobe Systems, Inc.(ADBE). However, the “FI” is the descriptor for the June 45 call, whilethe “RI” is the descriptor for the June 45 put—both fine options, buthardly interchangeable. If you are using a broker who cannot look up thesymbols for you (or remember them—they, after all, do this many, manytimes per day), then be very careful that you in fact have the correct symbol—it is your money that is on the line, and no one cares more about itthan you do.For our purposes here, we assume that you have researched and decided on just the appropriate type of trade. The question now is how toput the trade on. There is a major decision to make: Do you want to putit on as a market order or a limit order, and, if the latter, what type oflimit order?Market orders are generally not the preferred way to trade. By placinga market order, you are assured of getting the trade filled immediately, butat whatever price the floor chooses to charge you! You are, in effect, handing them a blank check. In reality, if you are trading a stock or option witha lot of activity, the price that the broker gives you on the phone and theprice the stock is trading at by the time the order reaches the floor (a fewseconds or minutes later) will not be much different. However, thinlytraded stocks and options may find a fairly large swing. Also, if your broker happened to give you a bad quote or you didn’t hear it correctly andyou place a market order expecting a similar price, you may be quite disappointed. You would choose a market order only if you absolutely, positively had to have the trade consummated right now, no matter what.Therefore, under most circumstances, the limit order is the preferred wayto trade.Limit orders come in many forms, but the basic concept is that you
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only want the trade filled if it meets your requirements (primarily a pricethat you have set). This protects you in several ways, not the least beingthat it protects you from the floor traders (manipulating the prices just asyour trade reaches the floor) and from yourself (making an error in calculation, reading, hearing, or whatever). In a limit order, you will typicallygive the broker a price for the trade. If it is a debit trade (you are payingmoney out of your account), that price is the maximum price you will pay;if the trade is a credit trade (you are receiving money into your account),that price is the minimum amount you will accept. Note: If the stock ismoving rapidly, you can always set a limit outside the bid-ask spread.For instance, if the stock is moving up, and you want to be sure tobuy it, you can set a buy price of $55, even if the bid-ask quote is$49–$50. Your broker should be able to get the stock (or option) even ifit is moving, but you are protected from finding that the price is $60 or$70 by the time your order is filled. If the stock price does jump up to$70 by the time your order hits the floor, your order will not be filled. Butin that case, not getting filled is probably a good thing, especially if itwas trading at $50 only moments ago.When setting exit points, you can often use different order types tomake sure you can easily exit at these points. Brokers use various ordertypes, so let’s go through them and discuss how they are used. In additionto previously discussed market and limit orders, the following order typesare commonly used:• Fill or kill: The broker is instructed to fill the order immediately orelse kill (cancel) the order.• Day order: This is the most common type of order for options. Itkeeps your order in the system until the market close, and if it isnot filled, it is cancelled. In order to place the order for the nextday, a new order would need to be placed as either a day order orgood-till-cancelled (GTC) order. Many brokers only allow day orderson options.• Good till cancelled (GTC): Unlike a day order, a GTC order stays inthe system until filled or for a specified amount of time. Most brokersallow GTC orders to remain in the system for 30 to 60 days.The list that follows details other types of trades that can be placedwith your broker. Some orders may have broker deadlines for submission(i.e., buy on close). Check with your broker for specific details.• At-the-opening order: This type of order provides the trader withthe price at the open of trading. Perhaps you expect a large gain in thestock price after the open and you want to make sure to get the initial
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price of the option before it starts heading higher. This type of orderdoes not have to be filled, but it won’t be filled at a price other thanthe opening price.• Buy on close: This type of order provides the trader with the closingprice for an option. This is useful on expiration day when the ownerof an option might want to wait until the last possible moment to buyback an option that is in-the-money.• Buy on opening: This is the buy side of the at-the-opening order.• Cancel former order: If you have previously placed a limit orderthat hasn’t yet been filled and you now want to cancel it, you wouldplace a cancel former order.• Exercise: If you are long an option and you either want the stock (ifyou are long the call) or you want to sell stock you own (if you arelong the put), you would exercise your option. You would choose toexercise the option as opposed to either buying the stock and sellingthe call or selling the stock and selling the put if there was no timevalue in the option (typically if the option is deep in-the-money). Youwill then get the strike price of the option (buying or selling) no matter where the stock is presently trading, and with no slippage for thespread between the bid and ask prices. The exercise of the optiontakes place after the market has closed for the day—it doesn’t happenimmediately.• Market-if-touched (MIT): This type of order automatically becomes a market order if the specified price is reached. If a stock isfalling and you want in at a certain price, you could place a MIT order.However, if the stock falls through your price, your order might notget filled at the market price you had hoped for. Remember, once acertain price is reached, the order becomes a regular market order.• Buy stop order: Set a price, usually lower than the current price,and if the market price falls to that specified price, the order becomesa market buy order. This is the same as the market-if-touched order,but specifically to repurchase a short position.• Sell on opening: This is the sell side of the at-the-opening order.• Sell stop order: Set a price lower (as protection) or higher (to capture a profit) than the current price, and if the market price reachesthat price, the order becomes a market sell order. This is the same asthe market-if-touched order, but specifically to sell your position.Placing an order is not a simple process, especially for the beginner.The variations are many, and the consequences of being wrong are great.This is why, when asked by new traders about the type of broker to get, Istrongly recommend a full-service broker. In the beginning of a trading career, it is very helpful to have someone who is willing to take the time to
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walk the novice trader through the intricacies of the system, generallyprotecting traders from themselves. Even after many years of trading,many professional traders find full-service brokers very helpful, especiallywhen they are trying to do anything out of the ordinary, something new, orsomething that they haven’t done in some time. Also, not all brokers allowall types of orders for options, so if you have a particular order you expectto use more often, make sure it is available at the brokerage you choose towork with.
THE IMPORTANCE OF LIQUIDITY ANDMULTIPLE LISTINGA final but very important factor to consider when evaluating index options is liquidity. How liquid are the options? Some indexes have optionsbut not much activity. Others, however, such as the S&P 500, S&P 100, andsome of the PHLX sector index options do trade actively. In general, themore volume and open interest associated with an index option, the better it is as a trading vehicle.Simply looking at the volume and open interest statistics can help todetermine whether the options contract is actively traded. Open interestis the number of contracts that have been opened but not yet closed out.For example, if I sell five calls to establish a covered call, open interest inthat contract will increase by five. Open interest will also change due toexercise and assignment. If I am assigned my five calls, then open interestwill decline by five. Or if I close out my covered call trade, open interestwill fall by five contracts.Looking at an options chain or an options quote will provide openinterest information. If open interest is zero, the contract does not seemuch trading activity. If the open interest across all of the contracts ofan underlying asset is zero or close to zero, it has low volume and notmuch liquidity.In general, we are looking for actively traded options and high liquidity for trading spreads and other advanced strategies. This means lookingfor contracts that not only have steady volume and high open interest, butalso are listed on multiple exchanges. Multiple listing means that marketmakers will be competing for orders and the spreads will therefore bemore favorable for the trader. In short, when looking at an index contract,the strategist wants to see (1) steady volume, (2) open interest, and (3)multiple listing on competing exchanges. Not all index contracts will havethose three characteristics, but the ones that do are superior from a liquidity standpoint.
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FINAL SUMMARYTrading options is not for everyone; but, for the person who is diligent andwilling to learn, it can be a very profitable endeavor. Of course, there is alearning curve, so it is important to study and test ideas and strategies togain an understanding of the options trading field. Paper trading is a keyaspect of the learning curve and will continue to be important throughoutyour option trading career. Even seasoned traders still test new ideas before putting real money into the market.Given the predetermined life of an option, the strategies you use willoften require two things: a careful eye and the ability to make quick decisions without regret. Inevitably, there will be costly errors in judgment,but that’s also part of the learning process. These errors will be less costlyif they are made in paper trades. There is a big difference between tradingwith your own money and trading on paper. Bottom line, one of the mostimportant factors in mastering trading is investing enough time into theart of paper trading.Besides gaining knowledge, there are some things that need to bedone before trading options. First, a relationship must be establishedwith a broker who can handle option trades. Whatever broker is chosenshould cater to your needs and provide the services you desire. Even ifyou plan on trading mostly through the Web, it still is important to havea broker who understands options trading. The Optionetics free website has a section specifically designed to help you choose an appropriate broker.Decades ago, stock traders had to create their own charts of stocks ororder from a chart service. With the advent of the computer, there aremany advanced charting tools available for low cost, sometimes free. Acomputer is almost a necessity for trading in this day and age, but a computer can be purchased relatively inexpensively. Software programs thatspecialize in helping both stock and option traders can be had for littlecapital as well, especially considering the time they can save a trader. Theone problem is that there are so many companies pushing trading software that it can become overwhelming trying to choose the one bestsuited for your needs. Don’t buy any software that won’t provide somesort of trial first so you can see how well it works for you.The Internet is an amazing thing, and it is hard to imagine that we everlived without it. There are a multitude of web sites that provide free trading information, including our own web sites: www.optionetics.com andwww.profitstrategies.com. The learning curve has been cut down substantially by the depth of easy-to-get information available on the Internet.We get a lot of enjoyment and satisfaction from trading and fromteaching others. After writing four books on stocks and options, writing
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one on index trading provided some very interesting challenges and opportunities. On the one hand, we wanted to avoid too much overlap withour other books. For that reason, we tried to minimize the discussion ofthe stock market and options trading basics. At the same time, we alsowanted to provide readers with new material that can deliver positivereal-world results. The chapters on indicators, system trading, and indexstrategies were designed to answer that call.Readers who have made it this far through the book have clearly increased their odds of success. I have never met a trader who has given it100 percent effort and failed. Taking the time to read this material shows areal commitment and dedication to success. Congratulations!It takes some of us more time than others to become proficient attrading, but by using a disciplined approach and the strategies outlined inthis book, it is possible to develop a winning system. The first step isknowledge and, after reading these 16 chapters, any reader will have developed a very solid knowledge base pertaining to index option trading. Itwon’t hurt to reread some of the strategy rules and guidelines, as well askeep the book on your trading desk as a reference.To summarize and conclude, let’s try to tie things down by reviewinga few key points. First, the index market is clearly an exciting market fortraders. It offers opportunities to trade a variety of different instruments, including gold, bonds, the stock market, sectors, and specific industry groups. There are two tools for doing so: exchange-traded fundsand indexes.However, not all index products are created equal. Some have options, some do not. As a general rule, the strategist will want to focus onthose products that have options contracts with the greatest amount ofliquidity or those that reflect a market or industry group where thetrader has special knowledge or skill. As a first step, readers are encouraged to develop a list of a dozen or so indexes that might be used astrading vehicles. In addition, as we saw in Chapter 15, understanding themethodology and components of the index can help make sense of itsdaily moves.Specific markets and sectors will sometimes chop around sideways,but more often develop into bullish and bearish trends. There is always abull market somewhere and always a bear market somewhere. Consequently, the index trader wants to develop a variety of different tradingstrategies that can deliver profits regardless of the current market environment. Chapters 5, 6, and 7 explained a variety of different options trading strategies that can be used in the index market.Catalysts and technical indicators can help with the timing of indextrading strategies. A catalyst is an event that triggers a response in the financial markets. For index traders, examples include economic reports,
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changes in energy prices, and interest rate announcements from the Federal Reserve. You may want to review the list of fundamental catalysts inChapter 8.A variety of technical indicators can also help index traders get anedge. Some reflect the internal action of the market. Examples includevolume, market breadth, and the new high–new low index. Seasonal patterns and sentiment analysis are also helpful timing tools. Chapter 10 provides an explanation of the variety of different technical indicators used inthe index market.Some traders prefer using systems, however. A trading system canprovide a clear set of rules for when to enter and exit the market. The keyin developing a winning system is in the software, the data, and the backtesting. Chapter 9 provides some insightful examples, along with guidelines for building and backtesting trading systems.Sector trading is another approach to the index market. Rather thanfocusing on the market as a whole, this type of trading uses a combinationof fundamental and technical analysis to find opportunities within specificsectors or industry groups. Chapter 11 provides examples of the indexproducts used to trade sectors.Regardless of the approach or the market, volatility is an important element when trading options. Volatility, discussed at length in Chapter 12,measures the speed of the price movement of an investment or asset. Inaddition, implied volatility is a component of an options premium. It tellsus whether options are cheap or expensive, which can help us identify thebest trading strategy for a specific situation.Risk management and adjustments go hand in hand. An adjustmentcan help salvage a losing position or protect gains from a winning trade.Meanwhile, risk management is often overlooked, but vital to the longterm success of an index trader. In that respect, diversification and assetallocation can help manage risk and reduce the stress related to trading. Acomplete discussion of using adjustments and risk management is covered in Chapters 13 and 14.Equipped with an understanding of the variety of index products; theoptions strategies for different trends and volatility situations; indicatorsand systems; and adjustments and risk management, readers are now in aposition to begin looking at potential trading opportunities in the indexmarket. Importantly, however, new traders will want to start small. Additionally, we highly recommend paper trading the index markets to getsome practical experience. In addition, understanding order entry and therole of the brokerage firm in handling the trade is equally important, asdiscussed earlier in this final chapter.Now it’s time to get started. Even if you are not ready to put realmoney to use yet, take the time to paper trade to see if trading options is
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something you enjoy and at which you could be successful. Starting smallcan keep new traders in the game, even if they make mistakes early intheir trading careers.Trading options is fun and profitable. For us, it’s hard to imagine amore enjoyable way to make a living. We enjoy it and we also enjoy seeingothers succeed. In that respect, we hope this book has been helpful. Stopby our message boards at www.optionetics.com and let us know.
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APPENDIX A
Important Tablesand Lists
INDEXES CLASSIFIED BY MARKET CAPITALIZATIONMarket capitalization refers to the total dollar value of all outstandingshares and is a measure of corporate size. Below is a list of indexes thathave been created to gauge the performance of U.S. stocks based on market capitalization.• S&P 500 (large-cap): The S&P 500 is one of the primary market indexes to gauge the health of the U.S. stock market. It is comprised of500 leading companies, as determined by S&P, and includes large-capnames.• S&P 100 (large-cap): The S&P 100 is the top 100 large-cap nameslisted in the S&P 500 index.• S&P MidCap 400 (mid-cap): S&P’s MidCap 400 covers approximately 7 percent of the U.S. stocks and is a commonly used benchmark to monitor performance of mid-cap mutual funds. There are 400names in this index, selected by S&P analysts and economists.• S&P SmallCap 600 (small-cap): S&P’s SmallCap 600 covers approximately 7 percent of the U.S. stocks and is used as a benchmarkto monitor performance of small-cap mutual funds. There are 600names in this index, selected by S&P analysts and economists.• S&P Composite 1500 (large-cap, mid-cap, and small-cap):S&P’s Composite 1500 combines the S&P 500, the S&P MidCap 400,and the S&P SmallCap 600, covering leading companies in each ofthe three primary capitalization sizes. It represents approximately357
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90 percent of the U.S. stocks and gauges the broadest market exposure of the four listed indexes.• Russell 3000 Index (large-cap, mid-cap and small-cap): TheRussell 3000 Index includes the top 3,000 U.S. equities by market capitalization, resulting in an index that includes large-cap, mid-cap, andsmall-cap names. The average capitalization of stocks in this index is$4.8 billion while the median capitalization is just under $1 billion (asof July 2005).• Russell 1000 Index (large-cap, mid-cap, and small-cap): TheRussell 1000 Index includes the largest 1,000 stocks by market capitalization from the Russell 3000 Index, resulting in an index that includespredominantly large-cap and mid-cap names. The average capitalization of stocks in this index is $13 billion while the median capitalizationis $4.6 billion. The smallest capitalization for stocks included in the listis $1.8 billion—the high end for small-cap stocks (as of July 2005).• Russell 2000 Index (small-cap): The Russell 2000 Index includesthe smallest 2,000 stocks by market capitalization from the Russell3000 Index, resulting in an index that includes predominantly smallcap names. The average capitalization of stocks in this index is $665million while the median capitalization is $540 million. The largestcapitalization for stocks included in the list is $1.8 billion—the highend for small-cap stocks (as of July 2005). This index is also a widelyused benchmark for small-cap fund performance.• Russell Microcap Index (micro-cap): The Russell Microcap Indexuses the smallest companies from the Russell 2000 Index plus thenext 1,000 publicly traded companies by market capitalization to construct this index. The average capitalization of stocks in this index is$217 million while the median capitalization is $183 million. Thelargest capitalization for stocks included in the list is $540 million andthe smallest is approximately $55 million (as of July 2005).
INDEXES CLASSIFIED BY INDUSTRY SECTORSIndexes have been created to reflect the performance of different sectorsof the market place, such as financial, utilities, health care, and so on.Most sectors have at least one representative index. The following list details a variety of sector indexes constructed by various exchanges. Wehave included indexes from the AMEX and PHLX in this list.• AMEX Airline Index (XAL): An equal-dollar-weighted indexcomprised of major U.S. airlines. Currently 10 companies are listedin this index.
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• AMEX Biotech Index (BTK): An equal-dollar-weighted index comprised of companies that provide biotechnology research and products or firms that provide services to them. Currently 17 companiesare listed in this index.• AMEX Disk Drive Index (DDX): An equal-dollar-weighted indexcomprised of companies that design and manufacture storage devicesfor computers or related software. Currently 10 companies are listedin this index.• AMEX Gold Bugs Index (HUI): A modified equal-dollar-weightedindex comprised of companies that are involved in gold mining anddo not significantly protect their interests through hedging techniques. Currently 15 companies are listed in this index.• AMEX Gold Miners Index (GDM): A modified market capitalization–weighted index comprised of companies that are involved in goldand silver mining. Currently 39 companies are listed in this index.• AMEX Oil Index (XOI): A price-weighted index comprised ofcompanies that are involved in oil exploration, production, and development of petroleum. Currently 13 companies are listed in thisindex.• AMEX Natural Gas Index (XNG): An equal-dollar-weighted indexcomprised of companies that are involved in natural gas explorationand production and in pipeline transport and transmission. Currently15 companies are listed in this index.• AMEX Pharmaceutical Index (DRG): A market capitalization–weighted index comprised of companies that are involved in the pharmaceutical industry. Currently 15 companies are listed in this index.• AMEX Securities Broker/Dealer Index (XBD): An equal-dollarweighted index comprised of companies that provide securities brokerage services, market making U.S. Treasury dealer functions, andother security-related activities. Currently 12 companies are listed inthis index.