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TheOptionsCourseWorkbook
Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.The Wiley Trading series features books by traders who have survivedthe market’s ever changing temperament and have prospered—some byreinventing systems, others by getting back to basics. Whether a novicetrader, professional, or somewhere in-between, these books will providethe advice and strategies needed to prosper today and well into the future.For a list of available titles, visit our web site at www.WileyFinance.com.
TheOptionsCourseWorkbookSecond EditionStep-by-Step Exercises andTests to Help You MasterThe Options Course
GEORGE A. FONTANILLS
John Wiley & Sons, Inc.
Copyright © 2005 by George A. Fontanills and Richard Cawood. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.No part of this publication may be reproduced, stored in a retrieval system, or transmittedin any form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc.,222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web atwww.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,201-748-6011, fax 201-748-6008.Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respectto the accuracy or completeness of the contents of this book and specifically disclaim anyimplied warranties of merchantability or fitness for a particular purpose. No warranty maybe created or extended by sales representatives or written sales materials. The advice andstrategies contained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any lossof profit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.For general information on our other products and services, or technical support, pleasecontact our Customer Care Department within the United States at 800-762-2974, outsidethe United States at 317-572-3993 or fax 317-572-4002.Wiley also publishes its books in a variety of electronic formats. Some content that appearsin print may not be available in electronic books.For more information about Wiley products, visit our web site at www.wiley.com.ISBN 0-471-69421-5Printed in the United States of America.10
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To our global communitythat we may strive to createa peaceful worldfor all our children.
Contents
CHAPTER 1
Options Trading: A Primer
1
CHAPTER 2
The Big Picture
9
CHAPTER 3
Option Basics
31
CHAPTER 4
Basic Trading Strategies
53
CHAPTER 5
Introducing Vertical Spreads
67
CHAPTER 6
Demystifying Delta
79
CHAPTER 7
The Other Greeks
87
CHAPTER 8
Straddles, Strangles, and Synthetics
100
CHAPTER 9
Advanced Delta Neutral Strategies
116
CHAPTER 10 Trading Techniques forRange-Bound Markets
129
CHAPTER 11 Increasing Your Profitswith Adjustments
141
CHAPTER 12 Choosing the Right Broker
149
CHAPTER 13 Processing Your Trade
159
CHAPTER 14 Margin and Risk
170
CHAPTER 15 A Short Course inEconomic Analyses
181vii
viii
CONTENTS
CHAPTER 16 Mastering the Market
188
CHAPTER 17 How to Spot Explosive Opportunities
194
CHAPTER 18 Tools of the Trade
212
CHAPTER 19 Final Summary
218
TheOptionsCourseWorkbook
CHAPTER 1
OptionsTrading:A Primer
SUMMARYStarting to trade options can be stressful and unsettling, but it doesn’t haveto be. By learning to trade options systematically and by fostering a patientapproach, a new trader can become successful. Options trading requiresan understanding of the characteristics of options and this takes time tomaster. Nonetheless, a person who is willing to study and work hard canachieve success.To become successful at trading options, you need to focus on threeimportant features of options: duration, direction, and magnitude. If understood, the interrelation of these three issues can provide the edgeneeded to win at options trading. There are, however, some steppingstones that need to be put in place before jumping headlong into the options game. Following the suggestions in this book will enable you togain the knowledge and skills necessary to trade profitably. Mainly, anew trader should start small, not placing too much capital in any onetrade initially. New traders should also paper trade strategies to get abetter feel for how each strategy works. Any trader, new or experienced, should define the risk before entering any trade. Only consistentrisk managers make it in the trading profession; so do your homeworkand follow the steps outlined in this book.
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THE OPTIONS COURSE WORKBOOK
QUESTIONS AND EXERCISES1. True or False: Just because someone is licensed to place a trade doesnot mean the person has the knowledge to invest your money wisely.2. What is the difference between an investor and a trader?____________________________________________________________________________________________________________________________________________________________________________________3. Successful options traders use only ________________ that are readily available and can be invested in a sound manner.A. Options.B. Funds.C. Futures.D. Stocks.4. It is critical to accurately assess your ______________ to determinethe style of investing that suits you best.A. Flexibility.B. Interest.C. Markets.D. Time constraints.5. How can you minimize your losses when you first begin tradingoptions?A. Start small.B. Learn to paper trade.C. Interview several brokers before picking the one most suited toyour needs.D. All of the above.6. What is the most important factor for building a low-stress investment strategy?A. Understanding your markets.B. Having a good broker.C. Defining your risk in every trade.D. Learning to paper trade first.
Options Trading: A Primer
3
7. ______________ allows a trader to cultivate a matrix of strategieswith which to respond to market movement in any direction.A. Flexibility.B. Specializing.C. Computer access.D. Confidence.8. Successful investors usually ______________ in just one or in a fewareas. This allows them to develop strategies that work in certainrecognizable market conditions.A. Specialize.B. Win.C. Go short.D. Systematically invest.9. To become a successful options trader you have to have______________.A. Lots of money to invest.B. Patience and persistence.C. A computer.D. A good sense of market direction.
MEDIA ASSIGNMENTThe Internet is a great resource for new and experienced traders. Not onlycan traders place trades online, but there is a plethora of free options information that can be easily accessed. For example, the Optionetics website has a wide range of information and numerous articles that can fosterprofitable trading for both new and experienced traders. Take the time tobecome familiar with the Optionetics site in order to benefit from thetools and information found there. This is also a great starting point tofind a broker. The site offers a section dedicated to providing in-depthinformation about the various options brokers out there. Take the time toreview this information so you’ll be prepared to open a brokerage accountwhen the time comes.
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THE OPTIONS COURSE WORKBOOK
VOCABULARY LISTBear
Leverage
Broker
Paper trading
Bull
Put
Call
Return
Capital
Risk
Delta neutral
Risk management
Go long
Stop loss
Go short
Trader
Investor
SOLUTIONS1. True or False: Just because someone is licensed to place a trade doesnot mean the person has the knowledge to invest your money wisely.Answer: True.Discussion: Unfortunately, obtaining a license to place a trade doesnot necessarily make someone a good trader. Like many things in life,sometimes book knowledge isn’t enough to create success. Whenlearning to drive a car, someone doesn’t just immediately move outonto the freeway after reading a book. Though having a license doesteach some important things, it isn’t a guarantee that the person willbe successful at trading.2. What is the difference between an investor and a trader?Answer: An investor takes a long-term, passive approach. A tradertakes a more active approach using various options strategies thattend to capitalize on shorter-term market movement.Discussion: As the term implies, an investor is investing his/hermoney into a company by buying stock in it. A trader isn’t necessarilyconcerned with ownership, just profits and short-term gains. Most investors are people who buy and hold stock or mutual funds; they aremore in step with the Warren Buffett approach to long-term security.A trader seeks profits in the short term, trading stocks and options
Options Trading: A Primer
5
with a clear eye on risk management and a friendly ear for volatility.Undoubtedly there are many who dabble somewhere in between.3. Successful options traders use only ______________ that are readilyavailable and can be invested in a sound manner.Answer: B—Funds.Discussion: Though Optionetics teaches traders how to use optionsto limit risk, there still is a chance that the capital used in trading options could all be lost. As a result, it is wise to only use money that isnot needed for bills or other important necessities in life. If you tradeusing capital you cannot afford to lose, it is very difficult to tradewithout letting your emotions get in the way.4. It is critical to accurately assess your ______________ to determinethe style of investing that suits you best.Answer: D—Time constraints.Discussion: If the capital you plan on using to trade options is alsoneeded for an important life event in the next year or two, it is unwiseto use it. Though quick profits can often be made trading options, westill need to trade with a long-term goal in mind. Even a successfuloptions trader might go through a losing streak, and if the capital isneeded during this down time, it can be a difficult situation.5. How can you minimize your losses when you first begin tradingoptions?Answer: D—All of the above (start small, learn to paper trade, interview several brokers before picking the one most suited to yourneeds).Discussion: All of these issues should be used when first starting totrade options. The nice thing about options is that it doesn’t take ahuge amount of capital to get started. Nonetheless, even if you have anice nest egg to begin with, start small. Try to learn how the strategieswork before taking a bigger leap. You may want to paper trade a newstrategy so you won’t lose capital during the learning process. Evenso, there eventually comes a time when the trader will not be able tolearn more until he or she trades with real capital. Using a brokerwho gets a trade a good fill and is easy to work with is crucial for thelong-term success of an options trader. With the number of brokersavailable, don’t be afraid to change brokers if the one you start withisn’t working out.
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THE OPTIONS COURSE WORKBOOK
6. What is the most important factor for building a low-stress investment strategy?Answer: C—Defining your risk in every trade.Discussion: Those who pay attention to Optionetics instructors andwriters will hear this all the time. Options were first developed tohelp traders limit risk, and Optionetics still believes this is the key.We need to know the risk of every trade before we enter it so that weare prepared for the worst and know what actions are needed to limitthis risk.7. ______________ allows a trader to cultivate a matrix of strategieswith which to respond to market movement in any direction.Answer: A—Flexibility.Discussion: Though it is a good idea to narrow your choice of strategies, this doesn’t mean that a trader shouldn’t have a couple of strategies for each type of market. One of the greatest advantages totrading options is their flexibility. You can make money in up, down,and sideways markets using options, so don’t limit yourself to justbullish strategies.8. Successful investors usually ______________ in just one or in a fewareas. This allows them to develop strategies that work in certainrecognizable market conditions.Answer: A—Specialize.Discussion: Specialization has become the thing to do in any profession in our day and age. It is no different when trading options.Though we need to have a wide base of knowledge about options andtrading, we do not need to become experts in every available optionsstrategy. As you learn about different options strategies, specialize inthe ones that best fit your risk tolerance and expertise.9. To become a successful options trader you have to have______________.Answer: B—Patience and persistence.Discussion: This is very important to remember. Too many newtraders expect to become millionaires overnight; this is unrealistic.Traders need to realize that where there is more possible reward,there is usually a higher degree of risk. Even the most successful options traders often lose money in individual trades. However, thesetraders have learned to limit their risk and have developed a soundplan that allows them to be patient and persistent.
Options Trading: A Primer
7
MEDIA ASSIGNMENTLearning to use the Internet to further your understanding of the marketand options is a vital part of your trading education. The free Optionetics web site has a plethora of information. Mainly, take the time tosearch for information dealing with the initial strategies you want tomaster. As you progress up the learning curve, read the daily articles togain an understanding of the markets. You can also read about variousoptions brokers on the Brokers Review link. This will provide information about costs, services, and other important data about most of theoptions brokers available.
VOCABULARY DEFINITIONSBear: An investor who believes that a security or the market is falling oris expected to fall.Broker: An individual or firm that charges a fee or commission forexecuting buy and sell orders submitted by another individual or firm.Bull: An investor who believes that a security or the market is rising or isexpected to rise.Call: An option contract that gives the holder the right, but not the obligation, to buy a specified amount of an underlying security at a specified pricewithin a specified time (e.g., if you buy an IBM January 85 call, you have theright to buy 100 shares of IBM at $85 each by the third Friday in January).Capital: The amount of money you have invested. When your investingobjective is capital preservation, your priority is to try not to lose anymoney. When your objective is capital growth, your priority is to tryto make your initial investment grow in value. Capital also refers to accumulated money or goods available for use in producing more moneyor goods.Delta neutral: Refers to an options position constructed so that the profitability of the position relies on the magnitude of the move—not the directional bias; it is relatively insensitive to the price movement of theunderlying instruments. A delta neutral trade is arranged by selecting acalculated ratio of short and long positions with a combined delta of zero.Go long: To buy securities, options, or futures with the intent to profitfrom a rise in the price of the assets.Go short: To sell securities, options, or futures with the intent to profitfrom a drop in the price of the assets.
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THE OPTIONS COURSE WORKBOOK
Investor: A person whose principal concern in the purchase of a security is the minimizing of long-term risk, compared to the speculator whois prepared to accept calculated risk in the hope of making better-thanaverage profits, or the gambler who is prepared to take even greaterrisks. More generally, it refers to people who invest money in investment products.Leverage: Enables a trader to buy or sell a security or derivative and receive fair value for it using borrowed capital to increase investment return.Paper trading: Simulating a trade without actually putting up the money,usually done for the purpose of gaining additional trading experience.Put: An option contract that gives the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specifiedprice within a specified time.Return: The income earned or a capital gain made on an investment.Risk: The potential financial loss inherent in an investment.Risk management: The process of managing trades by hedging risk.Stop-loss order: An order to sell when the price of the stock declines to,or below, a stated price. The purpose of this is to reduce the amount ofloss that might occur.Trader: Someone who buys and sells frequently with the objective ofshort-term profit.
CHAPTER 2
TheBigPicture
SUMMARYTrading stocks might be the best-known form of playing the markets, butmany individuals specialize in other lesser-known trading instruments.This chapter is designed to give the novice trader a comprehensive view oftrading by exploring the wide variety of different trading instruments—including stocks, futures, and options—as well as the multitude of ways totrade them. Particular attention is devoted to trading instrument properties as well as specific examples.Options are derivatives, meaning they derive their value from an underlying financial instrument. Though options can be entered using stockas the underlying security, indexes and futures also have options available.Futures and options can be used together, but they are two distinctly different instruments and require totally different types of trading accounts.However, both of these instruments provide increased leverage, whichmeans a trader can control a large amount of stock or other instrumentwith little initial capital outlay.Options are an extremely versatile instrument and can be used to create a variety of different limited risk strategies. However, like most endeavors, they require practice and discipline, as well as proper money andrisk management. In addition, traders must pay significant attention tovolatility issues if options are to be successfully utilized. Both historicaland implied volatility are important concepts to understand and should bestudied in depth to master the options trading game.
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THE OPTIONS COURSE WORKBOOK
QUESTIONS AND EXERCISES1. A stock is a unit of ownership in a company. The value of that unit ofownership is based on a number of factors, including:________________________________________________________________________________________________________________________2. Six people form a company together and decide that there will beonly six shareholders with only one share each. If this company’s assets total $90,000 and it has $15,000 in liabilities, how much is eachshare worth?A. $15,000.B. $12,500.C. $10,000.D. $7,500.3.
The computerized market, ______________, is also referred to as theover-the-counter (OTC) market.A. Securities and Exchange Commission.B. Chicago Board Options Exchange.C. Nasdaq.D. FOREX.
4. Supply and demand for a company’s shares helps to create______________.A. Momentum.B. Historical volatility.C. Liquidity.D. Time decay.5. If investors feel a company will beat Wall Street expectations, thenthe price of the shares will be ______________ as there will be morebuyers than sellers.A. Higher.B. Lower.C. Bid up.D. Offer down.
The Big Picture
11
6. If the majority of investors feel that the company’s earnings willdisappoint the Street, then the prices will be ______________.A. Higher.B. Lower.C. Bid up.D. Offer down.7. If there are more bidders (buyers), prices will ______________. Ifthere are more people offering (sellers), prices will ______________.A. Fall. Rise.B. Rise. Fall.C. Stay the same.D. Be impossible to predict.8. A company’s board of directors decides whether to declare______________ from time to time to be paid out and distributed toshareholders on a payable date.A. Better than expected earnings.B. Revised expected earnings.C. Cash flow.D. A dividend.9. What are the four unofficial size classifications of stocks?1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________4. _________________________________________________________10. The ______________, which reports the performance of 30 majorcompanies representing key industries, is the most widely quotedindicator of market performance.A. Standard & Poor’s Index.B. Amex Market Value Index.C. New York Stock Exchange Composite Index.D. Dow Jones Industrial Average.
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THE OPTIONS COURSE WORKBOOK
11. Name a few stock sectors.________________________________________________________________________________________________________________________12. What is the difference between a futures contract and an optionscontract?________________________________________________________________________________________________________________________13. ______________ were initially used by farmers and producers ofproducts to hedge themselves or lock in prices for a certain crop orproduct cycle.A. Options contracts.B. Futures contracts.C. Stock contracts.D. All of the above.14. True or False: Hedgers use futures trading to lock in prices andprotect themselves from market movement because they are primarily interested in actually receiving or selling the commoditiesthemselves.15. ______________ do not expect to take delivery of a product; they arein the futures market to try to make money on the price movement ofa futures contract.A. Producers.B. Speculators.C. Hedgers.D. Farmers.16. If you believe soybean prices will rise over the next three months,based on whatever information you may have, you could __________the corn futures three months out hoping to make a profit.A. Go long.B. Go short.C. Hedge.D. All of the above.
The Big Picture
13
17. If you believe corn prices will fall during this same period, youcould ______________ the corn futures contract three months outhoping to make a profit.A. Go long.B. Go short.C. Hedge.D. All of the above.18. Physical commodities are any bulk good traded on an exchange or inthe cash market; examples include grains, meats, metals, and energies. _________________ include debt instruments (such as bonds),currencies, and indexes.A. Index futures.B. ETFs.C. Financial commodities.D. HOLDRS.19. The value of ______________ primarily depends on interest rates.A. Bonds.B. Debt instruments.C. Eurodollars.D. All of the above.20. Typically, there is an inverse relationship between ______________and most foreign currencies.A. The U.S. dollar.B. Interest rates.C. Bonds.D. All of the above.21. A/an ______________ is an indicator that is used to measure andreport value changes in a specific group of stocks, commodities, ordifferent sectors of the marketplace.A. Bond.B. Moving average.C. Index.D. All of the above.
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THE OPTIONS COURSE WORKBOOK
22. By combining futures with ______________, you can create trades inwhich you limit your risk and maximize your potential profits.A. Options.B. HOLDRS.C. Futures contracts.D. All of the above.23. ______________ are contracts between two parties that convey tothe buyer a right, but not an obligation, to buy or sell a specificcommodity or stock at a specific price within a specific time periodfor a premium.A. Stocks.B. Futures.C. Options.D. All of the above.24. The price of an option is referred to as the ______________.A. Premium.B. Strike price.C. Bid-ask price.D. Price-earnings (P/E) ratio.25. The ______________ is defined as the price at which the stock orcommodity underlying a call or put option can be purchased or soldover the specified period.A. Premium.B. Strike price.C. Bid-ask price.D. Price-earnings (P/E) ratio.26. An option is no longer valid after its ______________.A. Payable date.B. Expiration date.C. Exercise date.D. Assignment date.27. True or False: Options are available on all stocks.
The Big Picture
15
28. Each stock option (call or put) represents ______________ shares ofa stock.A. 50.B. 100.C. 500.D. 1,000.29. True or False: Each futures contract has a set of unique specifications.30. You must be cautious trading indexes, for a few of them do not havemuch ______________.A. Diversification.B. Liquidity.C. Cash value.D. Flexibility.31. The most important factors for determining opportunity in a marketare ______________.A. Volume and cash flow.B. Volatility and cash flow.C. Liquidity and cash flow.D. Liquidity and volatility.32. ______________ gives you the opportunity to move in and out of amarket with ease.A. Volatility.B. Flexibility.C. An inexpensive option.D. Liquidity.33. ______________ measures the amount by which an underlying isexpected to fluctuate in a given period of time.A. Volatility.B. Delta.C. Theta.D. Liquidity.
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THE OPTIONS COURSE WORKBOOK
MEDIA ASSIGNMENTThere are numerous indexes and ETFs available for the options trader.This chapter provided examples of many of these securities, as well as anintroductory discussion of volatility. Take the time to look at daily andweekly price charts of various indexes and ETFs as well as their respective volatility levels. When we look at past movement, we are seeing historical volatility. However, by looking at a chart, we can also becomepretty good judges of what type of volatility is going to occur in the future.Use a charting program or the Optionetics web site to eyeball these indexes and ETFs to see which are the most and least volatile. Learninghow to view charts and access the plethora of information that is availabletakes time, so start by viewing the list of ETFs and indexes listed in thischapter of the main book.
VOCABULARY LISTAssets
Historic volatility
Assignment
Implied volatility
Bond
Liability
Capital gain
Liquidity
Commodity
Option premium
Dividend
Payable date
Exchange-traded fund (ETF)
Speculator
Exercise
Stock
Futures
Strike price
Hedgers
SOLUTIONS1. A stock is a unit of ownership in a company. The value of that unit ofownership is based on a number of factors, including:Answer: The total number of outstanding shares; the value ofthe equity of the company (what it owns less what it owes);the earnings the company produces now and is expected
The Big Picture
17
to produce in the future; and the demand for the shares of thecompany.Discussion: Stock ownership is a way to participate in the growth ofa company. It has limited liability, yet many millionaires have beencreated by their stock ownership. Fundamental analysis can helpbuy-and-hold investors find appropriate long-term stocks to own.However, short-term traders normally focus more on technical indicators that include price and volume and supply and demand issues.2. Six people form a company together and decide that there will beonly six shareholders with only one share each. If this company’s assets total $90,000 and it has $15,000 in liabilities, how much is eachshare worth?Answer: B—$12,500.Discussion: Because the balance sheet says the company is worth$75,000, each one of the six shares would be worth $12,500 ($75,000 ÷6 = $12,500). This is called book value, but book value is rarely what astock trades for in the stock market. Traders are buying future earnings, and this demand normally increases the stock price well aboveits book value.3. The computerized market, ______________, is also referred to as theover-the-counter (OTC) market.Answer: C—Nasdaq.Discussion: The Nasdaq is a computerized marketplace, with buyersand sellers brought together through a computer system. Supportersof the Nasdaq believe this is a much more efficient way to exchangethe buying and selling of shares. Whether this is true or not, the Nasdaq trades more volume on a daily basis than the New York Stock Exchange (NYSE). The Nasdaq is best-known for being a tech-ladenindex. This is because smaller technology companies have been ableto get listed on the Nasdaq more easily than on the NYSE.4. Supply and demand for a company’s shares helps to create______________.Answer: C—Liquidity.Discussion: Liquidity is important in the options market, as it helpslessen the spread between the bid and ask prices. It would be impossible to sell an option that is being held if there weren’t someone tobuy it from you. Market makers are there to help alleviate this problem, but illiquid stocks and options are still difficult to trade and are
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THE OPTIONS COURSE WORKBOOK
best left alone. In general, we don’t want to mess with stocks thathave a volume of less than 300,000 shares a day.5. If investors feel a company will beat Wall Street expectations, thenthe price of the shares will be ______________ as there will be morebuyers than sellers.Answer: C—Bid up.Discussion: The basic economic rule of supply and demand is useddaily in the stock market. When there is an abundance of buyers, thispushes the price higher until the stock price finds an equilibriumpoint. When there are more sellers than buyers, the stock price willfall until equilibrium is found to the downside. This is the definition ofthe free market system and has worked well for centuries. The stockmarket is a great discounter of news, which means expectationsdrive stock prices. Once an event takes place, the stock trades onwhat the expectations were more than the actual results.6. If the majority of investors feel that the company’s earnings willdisappoint the Street, then the prices will be ______________.Answer: D—Offer down.Discussion: Sometimes a stock will gain ground when announcedearnings are not good. This happens because expectations were evenworse than the actual news. When a stock disappoints, though, ittends to see its stock price offered down as traders jump in to sell onthe negative announcement. Sometimes a stock will announce fantastic earnings, but expectations were even higher, so the stock still seesa decline after the announcement.7. If there are more bidders (buyers), prices will ______________.If there are more people offering (sellers), prices will______________.Answer: B—Rise. Fall.Discussion: The price of an investment will react to the forces ofsupply and demand. If there are more buyers than sellers within themarket, and demand is strong, prices move higher. However, wheninvestors