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TheOptionsCourseWorkbook
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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With ofﬁces in North America, Europe, Aus-tralia, and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.
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TheOptionsCourseWorkbook
Second Edition
Step-by-Step Exercises andTests to Help You MasterThe Options Course
GEORGE A. FONTANILLS
John Wiley & Sons, Inc.
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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.
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For more information about Wiley products, visit our web site at www.wiley.com.
ISBN 0-471-69421-5
Printed in the United States of America.
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To our global communitythat we may strive to createa peaceful worldfor all our children.
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Contents
CHAPTER 1 Options Trading: A Primer
CHAPTER 2 The Big Picture
CHAPTER 3 Option Basics
CHAPTER 4 Basic Trading Strategies
CHAPTER 5 Introducing Vertical Spreads
CHAPTER 6 Demystifying Delta
CHAPTER 7 The Other Greeks
CHAPTER 8 Straddles, Strangles, and Synthetics
CHAPTER 9 Advanced Delta Neutral Strategies
CHAPTER 10 Trading Techniques for 
Range-Bound Markets
CHAPTER 11 Increasing Your Proﬁts 
with Adjustments
CHAPTER 12 Choosing the Right Broker
CHAPTER 13 Processing Your Trade 
CHAPTER 14 Margin and Risk 
CHAPTER 15 A Short Course in Economic Analyses
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CHAPTER 16 Mastering the Market 
CHAPTER 17 How to Spot Explosive Opportunities 
CHAPTER 18 Tools of the Trade
CHAPTER 19 Final Summary
CONTENTS
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194
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CHAPTER 1
OptionsTrading:A Primer
SUMMARY
Starting 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 un-derstood,  the  interrelation  of  these  three  issues  can  provide  the  edgeneeded  to  win  at  options  trading.  There  are,  however,  some  stepping-stones that need to be put in place before jumping headlong into the op-tions  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  experi-enced, 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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QUESTIONS AND EXERCISES
1. 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 read-
ily 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  trading 
options?
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  invest-
ment strategy?
A. Understanding your markets.
B. Having a good broker.
C. Deﬁning your risk in every trade.
D. Learning to paper trade ﬁrst.
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Options Trading: A Primer
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7. ______________  allows  a  trader  to  cultivate  a  matrix  of  strategies
with 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 ASSIGNMENT
The Internet is a great resource for new and experienced traders. Not onlycan traders place trades online, but there is a plethora of free options in-formation 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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VOCABULARY LIST
Bear
Broker
Bull
Call
Capital
Leverage
Paper trading
Put
Return
Risk
Delta neutral
Risk management
Stop loss
Trader
Go long
Go short
Investor
SOLUTIONS
1. 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 in-vestors 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
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Options Trading: A Primer
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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 readily
available 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 op-tions 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  trading 
options?Answer: D—All of the above (start small, learn to paper trade, inter-view  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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6. What  is  the  most  important  factor  for  building  a  low-stress  invest-
ment 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  strategies
with which to respond to market movement in any direction.Answer: A—Flexibility.Discussion: Though it is a good idea to narrow your choice of strate-gies, this doesn’t mean that a trader shouldn’t have a couple of strate-gies  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 profes-sion  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 op-tions  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.
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Options Trading: A Primer
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MEDIA ASSIGNMENT
Learning to use the Internet to further your understanding of the marketand options is a vital part of your trading education. The free Optionet-ics  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 informa-tion  about  costs,  services,  and  other  important  data  about  most  of  theoptions brokers available.
VOCABULARY DEFINITIONS
Bear: 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  for executing 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 obliga-tion, 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  try to make your initial investment grow in value. Capital also refers to ac-cumulated money or goods available for use in producing more moneyor goods.Delta neutral: Refers to an options position constructed so that the prof-itability of the position relies on the magnitude of the move—not the di-rectional  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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Investor: A person whose principal concern in the purchase of a secu-rity is the minimizing of long-term risk, compared to the speculator whois prepared to accept calculated risk in the hope of making better-than-average  proﬁts,  or  the  gambler  who  is  prepared  to  take  even  greaterrisks.  More  generally,  it  refers  to  people  who  invest  money  in  invest-ment products.Leverage: Enables a trader to buy or sell a security or derivative and re-ceive 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 obliga-tion,  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.
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CHAPTER 2
TheBigPicture
SUMMARY
Trading 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—in-cluding stocks, futures, and options—as well as the multitude of ways totrade  them.  Particular  attention  is  devoted  to  trading  instrument  proper-ties as well as speciﬁc examples.
Options are derivatives, meaning they derive their value from an un-derlying 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 dif-ferent 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 cre-ate  a  variety  of  different  limited  risk  strategies.  However,  like  most  en-deavors, 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.
9
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QUESTIONS AND EXERCISES
1. A stock is a unit of ownership in a company. The value of that unit of
ownership 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 as-sets 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.
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The Big Picture
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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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11. Name a few stock sectors.
____________________________________________________________
____________________________________________________________
12. What  is  the  difference  between  a  futures  contract  and  an  options
contract?
____________________________________________________________
____________________________________________________________
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  pri-marily  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.
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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  ener-gies. _________________ 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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22. By combining futures with ______________, you can create trades in
which 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.