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want  to  buy  your  house  from  you  one  year  from  today.  I  am  willing  topay  you  the  appraised  value  today  plus  another  10  percent  on  top  ofthat.  (If  you  don’t  take  10  percent,  maybe  I  offer  15  percent  or  25  per-cent.) Once you agree on the price and I pay you a deposit (known as thepremium),  I  will  have  an  option  contract  to  purchase  an  asset  (yourhouse) at an agreed-to time (one year from today) at an agreed-to price.For this I pay you a premium. This is a simple example of a call option.The buyer (me) will have a right to buy the asset (your house) from theseller of the option (you), who will have an obligation to deliver the op-tion (sell the house) to the option buyer.
If you want the right to sell an asset, you can employ the use of a putoption. A good analogy can be the purchase of auto insurance, which pro-vides the right to sell your car (the asset) to the seller of the put (the in-surance company) if the value goes down due to an accident. Let’s say youpurchase a policy that values your car at $25,000 and you pay $1,000 forone  year’s  coverage.  What  you  have  done  is  purchased  the  right  to  sellyour car (the asset) for $25,000 for a one-year period in exchange for thepremium of $1,000. If nothing happens in the year, your option will “expireworthless” and you will have to buy another put option (next year’s insur-ance policy).
These  relatively  simple  analogies  are  the  initial  steps  to  managingtrading risk and leveraging your capital more effectively. In this book, youcan  learn  how  to  use  these  amazing  trading  instruments  in  the  volatilemarkets of the twenty-ﬁrst century.
I have been fortunate to work with some of this country’s best traders.This  has  enabled  me  to  pass  on  an  abundance  of  knowledge  geared  tohelp  people  become  successful  traders.  This  information  comes  fromyears  of  experience  spanning  from  my  ﬁrst  days  as  a  novice  traderthrough my experience running a ﬂoor trading operation at the AmericanStock Exchange and in the Chicago futures pits.
It  is  my  sincere  hope  that  you  can  learn  to  develop  moneymakingtrading acumen by reading this book. Most importantly, you will be able toavoid many of the costly errors commonly made in trading and investingand  ascend  your  own  learning  curve  in  leaps  and  bounds.  I  have  conﬁ-dence that you will gain signiﬁcant insight into the world of investing bystudying the strategies in this book. By applying this knowledge to stocks,futures, and options markets, I have no doubt that you will ﬁnd trading alucrative endeavor.
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CHAPTER 1
OptionsTrading:A Primer
T rading is an elusive beast to the uninitiated, ﬁlled with mystery and
complexity.  Although  trillions  of  dollars’  worth  of  stocks,  futures,and  options  change  hands  every  day,  learning  to  trade  is  a  compli-cated puzzle that takes patience and perseverance to navigate effectively.Perhaps  you  have  a  friend  who  has  made  money  or  know  other  friendswho have lost money playing the markets. Learning to trade can be the be-ginning of an exciting new career, especially if you master combining op-tions with futures and stocks.
Many years of teaching and trading have taught me that the most suc-cessful investors are those who do not think of trading as work, but as play.Obviously, a love affair with anything you do will increase your chances ofsuccess dramatically. Perhaps that’s why I like to call what I do “grown-upNintendo.” Making money is just a natural consequence of my daily play.
My  systematic  approach  to  trading  emphasizes  risk  management.  Iknow  how  to  spot  optimal  moneymaking  opportunities  to  increase  mychances  of  high  returns  from  low-risk  investments.  I  share  this  tradingknowledge  with  individuals  throughout  the  world  through  seminars  andvarious innovative products designed to foster a strong foundation in op-tions trading in the stock and futures markets.
Stock, futures, and options trading provide investors with the best op-portunity  to  ﬁnd  rewards  that  satisfy  almost  anyone’s  ﬁnancial  objectives.My investment philosophy is to make money any way we can, in any marketwe can. It’s a matter of working with a matrix of trading strategies, develop-ing a feel for how to trade proﬁtably, and learning the tricks of the trade.
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What separates those investors who make consistent returns year af-ter year from those who can’t ever seem to make a winning investment?Vision. Simply put, the winning investor has the vision to systematicallyspot good opportunities, while the losing investor simply never developedthis insight. Can this vision be developed? Some say that a great investorhas an innate sense that drives his or her ability to make money. However,I  believe  that  although  there  may  be  a  few  individuals  with  this  innatesense,  most  great  investors  learn  by  trial  and  error  until  they  ﬁnd  whatworks best for them.
For example, many people refer to Warren Buffett as the greatest in-vestor  of  all  time.  He  appears  to  have  a  knack  for  turning  anything  hetouches into gold. Is it because he is just so much smarter than everyoneelse, or has he developed a methodology over the years that works for himon a consistent basis? For someone as successful as he is, I would have tosay that he has both innate skill and a formula for success. This formulafor  success  can  be  developed  by  anyone.  The  problem  is  that  most  in-vestors don’t have the persistence and drive necessary to achieve success.First and foremost, you have to learn how to invest and trade the rightway. Typically, most new investors lose money when they ﬁrst begin dueto  their  lack  of  understanding  of  what  it  really  takes  to  succeed.  Manymay listen to their stock or commodity broker from the outset and neverdevelop  an  understanding  of  the  markets.  Many  more  lose  money  untilthey realize their main error is taking someone else’s investment advice. Aword of caution: Just because someone is licensed to take an order andexecute a trade does not mean that  person has the  knowledge to investyour money wisely. Gaining the right kind of knowledge, however, is criti-cal to trading success. Although there is risk in virtually all investmentsand trades, you can mitigate risks by learning how to protect yourself us-ing innovative option strategies. Once you learn how to manage risk, therewards come more easily.
If you intend to enter the markets, you’ll need to decide what kind ofinvesting/trading you want to engage in. Keep in mind that there is a bigdifference between investing and trading. An investor is an individual whotakes a long-term perspective. For example, if you have $5,000 to investand you place all the money in a mutual fund—a pool of investments man-aged  by  a  professional  manager—then  you  are  taking  a  passive  role  forthe  long  term.  If  you  choose  to  set  up  an  individual  retirement  account(IRA), you will more than likely keep it until retirement.
A  trader,  on  the  other  hand,  takes  a  more  active  role.  Traders  maymake  investments  that  last  for  seconds,  minutes,  hours,  weeks,  or  evenyears,  always  looking  for  an  opportunity  to  move  the  money  around  tocapture  a  greater  return.  Typical  traders  actively  make  investment  deci-sions  on  a  continuous  basis,  never  allowing  anyone  else  to  control  the
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funds. As a trader, you need to focus on strategies that provide the bestchance to create proﬁtable trades. Combining stocks or futures with op-tions provides you with extra leverage; but this extra leverage is a double-edged  sword.  Options  give  you  the  chance  to  make  a  very  high  returnusing  smaller  amounts  of  cash  than  futures  or  stocks  require,  but  thisleverage also creates an opportunity for you to lose money just as fast.
The losing traders are those who do not respect risk. To survive in thisbusiness  and  have  the  opportunity  to  enjoy  the  fruits  of  your  labor,  youmust develop a very healthy respect for risk. Before entering any invest-ment, you should ask yourself four questions:
1. How much proﬁt can I make?2. What is the maximum loss I can take?3. At what point will I get out if I am wrong?4. When should I take proﬁts?
As you make the transition to becoming a motivated, knowledgeable,and successful trader, you will have to undertake a realistic examinationof your personal goals, habits, dreams, and dislikes. This step is of utmostimportance. Many individuals believe that they will enjoy a certain profes-sion, but then give up before the opportunity to achieve success appears.You must have a good understanding as to why you want to partici-pate in any endeavor. Why are you taking the time to learn a new profes-sion?  What  are  your  goals?  What  are  your  strengths?  What  are  yourweaknesses? Before you can become a serious and successful trader, youneed to search for these answers. Make a list and add to it every day asmore things become apparent. Try to be honest with yourself. Keep yourhighest goals in mind and work toward them one step at a time using yourlist of attributes to strengthen your willpower to succeed.
The three primary reasons for developing trading savvy are:
1. To  achieve  more  wealth. The  number  one  reason  that  most  peoplewant to become traders in the stock, futures, and options markets isto attain ﬁnancial rewards. Stories about the large sums of money tobe made and the successes of the rich and famous inspire a desire toachieve the same level of ﬁnancial success. Just as it is a business’sobjective  to  produce  more  cash  ﬂow  to  pump  up  the  bottom  line,  atrader’s objective is to make more money from money. That is how atrader  monitors  progress.  Although  “money  doesn’t  buy  happiness,”having plenty of money sure helps. However, there is no need to makehaving  money  your  sole  goal  in  life;  as  far  as  I’m  concerned,  thatwould undermine your development as a well-rounded individual.
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2. To improve family life. The ultimate goal, other than trading just tomake money, is to create a better life for yourself and your family. Thesuccess I have been fortunate enough to achieve through hard workhas allowed me to help my family and friends ﬁnancially when theyneeded it; I have found this ability to help others very enjoyable. Onceyou have achieved a ﬁnancial level where you can live each day with-out  worrying  about  which  bills  need  to  be  paid,  you  will  have  morefreedom to discover your true purpose in life. As an added bonus, youcan also afford the time and energy to help others, which will makeyour life as an investor even more fulﬁlling.
3. To gain greater autonomy in the workplace or be your own boss. Thethird most common reason is the desire to break away from a day-to-day job that has been emotionally and/or ﬁnancially unfulﬁlling. Thisis the main reason I started trading; I needed more than what real es-tate offered. As I like to ask my seminar students, “How many of youare here to try to get out of a real job?” More often than not, it’s betterto describe the day-to-day grind most people subject themselves to asan unreal job, since many cannot believe they have to go through themotions each day. In essence, it has become a nightmare.
Whether you enjoy what you are doing today and just want to supple-ment your income, or you are looking to become your own boss, there isno better profession than that of a trader. For example, I travel extensivelyand  live  in  various  locations.  With  a  small  laptop  computer,  Internet  ac-cess, and a cell phone, I can conduct my business from almost anywhere,which maximizes my freedom. For me, trading is a dream come true.
THE ROAD TO SUCCESSFUL TRADING
Achieving trading success is not easy. In fact, just getting started can be anoverwhelming process. The road to wealth can take many paths. To deter-mine your optimal trading approach, start by making an honest assessmentof  your  ﬁnancial  capabilities.  Successful  traders  only  use  funds  that  arereadily available and can be invested in a sound manner. It is also critical toaccurately  assess  your  time  constraints  to  determine  the  style  of  tradingthat suits you best. If you want to trade aggressively, you can do so usingvarious  short-term  strategies.  If  you  want  to  take  a  hands-off  approach,you can structure trades to meet that time frame. All of these choices areless difﬁcult to make if you respect the following trading guidelines.
1. Gain the knowledge to succeed over the long run.2. Start with acceptable trading capital.
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3. Establish a systematic approach to the markets.4. Be alert for trading opportunities at all times.5. Develop the ﬁne art of patience.6. Build a strong respect for risk.7. Develop a delta neutral trading approach.8. Reduce your stress level.
Gain the Knowledge to Succeed over the Long Run
You have to have knowledge to succeed. Most new investors and tradersenter  this  ﬁeld  expecting  to  immediately  become  successful.  However,many have spent tens of thousands of dollars and many years in collegelearning  a  speciﬁc  profession  and  still  do  not  make  much  money.  To  besuccessful, you need to start your journey on the right path, which will in-crease  your  chance  of  reaching  your  ﬁnal  destination:  ﬁnancial  security.To accomplish this goal, learn as much as you can about low-risk tradingtechniques and increase your knowledge base systematically.
Successful traders have an arsenal of trading tools that allows them tobe competitive in the markets. I have used the word arsenal purposely. Ibelieve that as an investor or trader, you need to recognize that each andevery day in the marketplace is a battle. You must be ready to strategicallylaunch  an  attack  using  all  the  resources  in  your  arsenal.  Your  ﬁrstweapon—knowledge—will enable you to make fast and accurate decisionsregarding the probability of success in a speciﬁc investment. Is it incongru-ous to suggest that trading is war and also that to trade successfully onemust reduce one’s level of stress? I believe not. The most composed andwell-armed  opponents  win  wars.  The  same  is  true  for  traders.  In  mostcases,  winners  will  be  more  comfortable  (less  stressed)  regarding  theirability  to  win.  Knowledge  fosters  conﬁdence.  If  you  are  well  armed,  youwill be conﬁdent as you go off to ﬁght the battle of the markets. Increasedconﬁdence leads to lower stress and higher proﬁts.
Start with Acceptable Trading Capital
Many investors start with less than $10,000 in their trading accounts. How-ever, it is important to realize that the less you have in your account, themore cautious you have to be. Perhaps the toughest problem is to estab-lish a sufﬁcient capital base to invest effectively. If you begin investing ortrading with very little capital, you will assure yourself of failure. Makingmoney in the markets requires a learning curve, and incurring loss is partof the trading process. When it comes to trading, “you have to pay to play.”You  don’t  need  to  be  a  millionaire,  but  trading  does  require  a  certain
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amount  of  capital  to  get  started.  In  many  cases,  the  brokerage  ﬁrm  youchoose will determine how much is required to put you in the game. How-ever, no matter how much you begin with, it is a good idea to start outby trading conservatively. If you invest smartly, you can make very goodreturns and your ﬁnancial goals will be realized.
Establish a Systematic Approach to the Markets
The third key to successful moneymaking in the markets is to develop asystematic  approach  that  combines  all  the  weapons  in  your  arsenal  tocompete effectively in the marketplace. Then, and only then, will you beable to reduce your stress enough to believe in the plan and stick with it. Asystematic approach diffuses the inherent madness of the marketplace,allowing you to make insightful trading decisions.
Be Alert for Trading Opportunities at All Times
By opening your receptivity to opportunity, you will be able to ﬁnd manymore promising trades than you thought possible. Where do you ﬁnd op-portunities?  Everywhere.  When  you  begin  to  train  yourself  to  automati-cally look for trading opportunities in everything you do, you are on yourway to being an up-and-coming successful trader.
Develop the Fine Art of Patience
Patience is one of the most difﬁcult aspects of trading and investing andextremely  hard  to  teach.  I  have  to  work  at  applying  patience  conscien-tiously each and every day, even after years of trading.
As a professional trader and investor, I have the opportunity to sit infront  of  computers  all  day  long,  day  after  day.  This  is  another  double-edged sword. Yes, I have the ability to look for promising trading opportu-nities  because  I  have  lots  of  information  in  front  of  me;  however,  I  alsohave the opportunity to second-guess great trades due to ﬂuctuations inthe  market  that  may  be  unimportant.  Therefore,  I  have  learned  that  thebest investments are those in which I have thoroughly studied the risk andreward and have developed a time frame for the trade to work. For exam-ple, if I place a trade with options six months out, I try to stay with thetrade for that period of time. This takes patience. Of course, if I reach mymaximum proﬁt level before that time, I take that proﬁt and get out.
Do not feel that you are at a disadvantage if you cannot trade and in-vest full-time. This allows you to avoid the “noise” in the market that oc-curs  each  and  every  trading  day.  Many  of  my  successful  students  makemore money by not watching the markets too closely.
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Build a Strong Respect for Risk
You must respect risk if you are to survive as an investor or a trader. Be-fore  you  ever  place  an  order  with  your  broker,  make  sure  you  calculatethe maximum potential risk and reward as well as the breakeven(s) of thetrade. This will help you stay in the game so you can achieve your goals.Risk graphs, which are explored in later chapters, are important tools forassessing risk and reward.
Develop a Delta Neutral Trading Approach
Delta neutral trading is composed of strategies in which a trade is createdby selecting a calculated ratio of short and long positions that balance outto an overall position delta of zero. The term delta refers to the degree ofchange in an option’s price in relation to changes in the price of the under-lying security. The delta neutral trading approach reduces risk and maxi-mizes  the  potential  return.  Effectively  applying  these  strategies  in  yourown personal trading approach generally requires four steps:
1. Test  your  trading  systems  by  paper  trading. Paper  trading  is  theprocess of simulating a trade without actually putting your money onthe line. To become a savvy delta neutral options trader, you will needto  practice  strategies  by  placing  trades  on  paper  rather  than  withcash. Although it may not feel the same as putting your money on theline,  it  will  help  you  to  develop  practical  experience  that  will  fosterconﬁdence  in  your  abilities.  This  will  come  in  very  handy  in  the  fu-ture. Since there is no substitute for personal experience, you shouldtest all ideas and your ability to implement them properly prior to us-ing real money.
2. Discuss  opening  a  brokerage  account  with  several  brokers. Makesure you have a broker who is knowledgeable and fairly priced. Bro-kers can be assets or liabilities. Make certain your broker is an assetwho will help make you richer, not “broker.” Do not sacriﬁce serviceby selecting the broker with the lowest cost. Shop around for the rightperson or ﬁrm to represent your interests. Your broker will play a cru-cial role in your development as a successful trader. Take your time,and if you are not satisﬁed, ﬁnd someone else.
3. Open  a  brokerage  account. It’s  best  to  consider  a  brokerage  ﬁrmthat specializes in stocks, futures, and options. Then you can easilyplace  trades  in  any  market  using  the  same  ﬁrm.  When  it  comes  totrading, ﬂexibility and precision are equally important. Today, someonline brokers specialize in options. We provide examples in laterchapters.
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4. Start small. Any mistakes you make early in your trading career willobviously cost you money. If you start with small trades in the begin-ning,  you  will  be  able  to  gain  the  knowledge,  experience,  and  conﬁ-dence necessary to move on to bigger trades. The bottom line is that amistake made in a small trade means a smaller loss of capital, whichcan help keep you in the game.
Reduce Your Stress Level
Successful traders have to ﬁnd ways to reduce the stress commonly asso-ciated  with  trading.  I  reconstructed  my  trading  style  after  experiencingmore stress than I had thought I could ever handle. In a typical trading daywith the S&P 500 (Standard & Poor’s 500 Index, which represents the 500largest companies in the United States), I found myself buying close to thehigh  of  the  day.  Immediately  the  market  started  to  tumble  so  fast  that  Iwas down 100 points even before I got my buy ﬁlled (i.e., before my orderwas executed). I ﬁnally was able to regain my composure just enough topick up the phone in a panic to sell as fast as possible. By then the markethad  tumbled  almost  200  points.  Worst  of  all,  I  had  purchased  too  manycontracts for the money I had in my account; and, to top it all off, it wasmy ﬁrst trade ever in the S&P.
That was the point in my trading career that I experienced the panicand  stress  of  losing  more  than  40  percent  of  my  account  in  three  min-utes—more than one month’s pay as an accountant. I did not trade againfor more than two months while I tried to ﬁgure out whether I could reallydo this for a living. Luckily, I did start trading again; however, I reducedmy trading size to one contract position at a time for more than a year.
Many professional ﬂoor traders and off-ﬂoor traders have had simi-lar experiences. However, these kinds of stressful events must be over-come and used as lessons that needed to be learned. Simply put, stressproduces  incomplete  knowledge  access.  Stress,  by  its  nature,  causeshumans to become tense in not only their physical being but also theirmental  state.  For  years,  physicians  have  made  the  public  aware  thatstress  can  lead  to  many  illnesses  including  hardening  of  the  arterieswith the possibility of a heart attack or other ailments. Reducing stresscan lead to bigger rewards and can be accomplished by building a low-stress trading plan.
To create your own plan, follow this three-point outline:
1. Deﬁne your risk.2. Develop a ﬂexible investment plan.3. Build your knowledge base systematically.
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Deﬁne Your Risk As a trader you have the ability to make large proﬁtswith the risk of potentially large losses. This is no secret. Unfortunately,that  old  maxim  “cut  your  losses  and  let  your  proﬁts  run”  is  easier  saidthan  done.  By  deﬁning  your  risk,  you  are  assured  that  you  cannot  losemore money than the amount you have established as being the maximumposition loss. You will also be able to develop strategies that create the po-tential for large rewards by predeﬁning your acceptable risk parametersand by applying strategies that combine stocks and options on stocks, orfutures and options on futures.
Develop a Flexible Investment Plan The second step in reducingrisk and stress is to develop an investment plan that is ﬂexible. Flexibilityallows a trader to cultivate a matrix of strategies with which to respond tomarket movement in any direction. Erratic market movement can changeyour position dramatically in seconds. Each price move (tick) rearrangeseveryone’s  assumptions  about  what  the  market  is  about  to  do.  This  dy-namic environment borders on schizophrenia, where the bulls and bearsdo  battle  trying  to  outmaneuver  each  other.  This,  in  turn,  creates  prof-itable opportunities for the knowledgeable investor with a smart and ﬂex-ible  investment  plan  and  creates  nightmares  for  the  uninitiated  traderwithout a plan, only a hunch as to where the market appears to be going.Investors and traders have to be entrepreneurial by nature to survive. Oneof the greatest attributes of entrepreneurs in any industry is the ability torecognize a roadblock and change direction when one is reached. Tradersmust also exhibit this ﬂexibility if they are to survive in the marketplace.
Build Your Knowledge Base Systematically The third step to cre-ating a successful investment plan is to systematically build a solid base ofinnovative strategies from which to invest wisely. Most investors start thesame way. They read a few books, open a small account, and lose every-thing very quickly. However, there is one way to differentiate the winnersfrom the losers. Winners persist at learning as much as they can by start-ing slowly and collecting tools to beat the market consistently. Successfuloptions traders ﬁrst learn to walk, then to run. Usually traders begin withsimplistic strategies such as going long or shorting the market, and usingstops  to  limit  losses.  Some  just  listen  to  their  brokers  and  follow  theirtrading ideas. Once initiated, traders accelerate their learning at the righttime to become successful.
Successful traders usually specialize in one area or just a few areas.This  specialization  allows  the  trader  to  develop  strategies  that  consis-tently  work  in  certain  recognizable  market  conditions.  A  successful  in-vestor realizes that, in all likelihood, these situations will reoccur and thesame  strategies  can  be  used  proﬁtably  over  and  over  again.  At  my  alma
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mater, Harvard Business School, the same systematic approach is used. Inever realized what the school was attempting to accomplish until aftergraduation when I had time to apply this approach to the real world—allthose case studies on businesses I had no interest in fostered my ability tolearn how to think in any environment. This systematic building of knowl-edge will enable you to quickly get up and running as a successful traderin the marketplace.
CONCLUSION
Options, the most ﬂexible ﬁnancial instrument that exists today, provideunique  investment  opportunities  to  knowledgeable  traders  on  a  regularbasis. However, the entire options arena can be a very complex and con-fusing place in which to venture, especially for the novice trader. The pri-mary  reason  for  this  complexity  is  the  fact  that  options  trading  is  amultidimensional process; and each dimension needs to be understood inorder to trade successfully.
Prior  to  initiating  an  options  position,  there  are  three  main  issues  toconsider:  direction,  duration,  and  magnitude.  Direction  refers  to  whetherthe underlying security will move up, down, or sideways. Duration refers tohow  long  it  will  take  for  the  anticipated  move  to  take  place.  Magnituderefers to how big the subsequent move will be. In order to make a proﬁt, theoptions trader must be correct in all three of these categories. This is the