primary reason that many people lose money when trading options. Theydo not accurately understand the three dimensions of an options position.
The ﬁrst step in taking your options trading to another level is to un-derstand  and  comprehend  the  interrelation  of  direction,  duration,  andmagnitude.  Additionally,  the  trader  must  use  these  three  different  vari-ables in order to provide an edge in the market. It is imperative to be ableto combine and exploit these three variables in order to give yourself anadvantage; otherwise your trading will become no more than an exercisein giving your money away to other traders.
Many times it is necessary to work with combinations of options inorder to give yourself an edge in the market as opposed to just buying acall or a put. This is where understanding spreads, straddles, and variousoption  combinations  is  helpful.  There  are  a  few  general  rules  that  I  al-ways follow when looking for and constructing option positions. The ﬁrstis that when I am going to bet on the future direction of a security, I wantto give myself enough time to be right. That means I will usually chooselong-term  equity  anticipation  securities  (LEAPS)  for  directional  trades.LEAPS is a name given to options with expiration dates further than ninemonths  away.  The  second  rule  is  in  regard  to  magnitude  or  volatility.
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When  combining  different  options  together,  I  want  to  be  a  seller  of  ex-pensive  options  (high  volatility)  and  a  buyer  of  cheap  options  (lowvolatility).  The  third  rule  is  that  I  want  to  make  time  my  friend  as  op-posed to my enemy by purchasing options that have plenty of time left toexpiration  and  selling  shorter-term  options.  This  allows  me  to  take  ad-vantage  of  the  time  decay  characteristic  of  an  option.  These  guidelinesare a brief summary of the issues that need to be understood when build-ing trades that give you a competitive edge in the market.
To the beginner, these issues may seem complex and convoluted; butwith  a  little  bit  of  practice  everything  should  become  quite  clear.  If  youtake the time to understand the concepts of direction, duration, and mag-nitude, you’ll soon be able to start experimenting with a variety of differ-ent  options  strategies.  For  example,  if  you  want  to  be  bullish  on  aparticular stock, then you can take a longer-term perspective by placing abull call spread using LEAPS. For shorter-term trades, you can take advan-tage of time decay by using credit spreads, calendar spreads, or butterﬂystrategies. Increased comprehension of these basic concepts will enableyou  to  combine  short-  and  long-term  strategies  together  to  help  you  be-come an even more proﬁcient trader.
As you build experience as a trader, you will become more conﬁdent inyour ability to make money. After a few successes, traders are more moti-vated  to  develop  the  perseverance  necessary  to  stay  with  the  winningtrades and exit losing positions quickly. In the long run, you have a muchbetter chance of becoming successful when you start by acquiring a solidfoundation of the option basics. In addition, keep a journal of every tradeyou make—especially your paper trades—as a road map of where you’vebeen and where you want to go on your journey to trading victory. Remem-ber, patience and persistence are the keys to trading options successfully.
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CHAPTER 2
TheBigPicture
I n this book, our discussion of trading involves a variety of different in-
vestment vehicles in addition to options: stocks, futures, commodities,exchange-traded  funds  (ETFs),  and  indexes.  These  ﬁnancial  instru-ments  can  be  assembled  in  an  inﬁnite  number  of  combinations.  My  owntrading  focuses  on  stocks  and  options.  Yet,  an  appreciation  of  all  thesetools can help build an integrated understanding of what is happening dayto day in the ﬁnancial marketplace. So, let’s take a closer look at the funda-mental  components  of  each  investment  vehicle  to  see  how  one  differsfrom the other.
Note: The  word  “market”  can  be  used  to  describe  the  overall  stockmarket or to refer to individual markets such as a speciﬁc stock, futures,or market sector.
STOCKS
Those of you just starting in the ﬁeld of investment have most likely heardabout  one  popular  ﬁnancial  instrument:  the  stock.  In  fact,  thousands  ofstocks are traded on the U.S. stock exchanges every day. But what exactlyis a stock? Basically, a stock is a unit of ownership in a company. The valueof that unit of ownership is based on a number of factors, including the to-tal number of outstanding shares, the value of the equity of the company(what it owns less what it owes), the earnings the company produces nowand is expected to produce in the future, as well as investor demand forthe shares of the company.
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For example, let’s say you and I form a company together and decidethat  there  will  be  only  two  shareholders  (owners)  with  only  one  shareeach. If our company has only one asset of $10,000 and we have no liabili-ties (we don’t owe any money), our shares should be worth $5,000 each($10,000 ÷ 2 = $5,000). If the company were sold today, together we wouldhave a net worth of $10,000 (assets = $10,000; liabilities = 0).
However, if it is projected that our company will make $100,000 thisyear, $200,000 next year, and so on, then the value goes up on a cash ﬂowbasis  as  we  will  have  earnings.  Investors  would  say  that  we  have  only$10,000 in net worth now, but they see this growing dramatically over thenext  ﬁve  years.  Therefore,  they  value  us  at  $1  million—in  this  case,  10times next year’s projected earnings. This is very similar to how stocks arevalued in the stock market.
Stocks  are  traded  on  organized  stock  exchanges  like  the  New  YorkStock Exchange (NYSE) and through computerized markets, such as theNational  Association  of  Securities  Dealers  Automated  Quotations  (NAS-DAQ) system. Share prices move due to a variety of factors including as-sets,  expected  future  earnings,  and  the  supply  of  and  demand  for  theshares of the company. Accurately determining the supply of and demandfor a company’s stock is very important to ﬁnding good investments. Thisis what creates momentum, which can be either positive or negative forthe price of the stock.
For example, scores of analysts from brokerage ﬁrms follow certainindustries and companies. They have their own methods for determiningthe value of a company and its price per share. They typically issue earn-ings estimates and reports to advise their clients. Analyst, or Wall Street,expectation will drive the value of the shares before the actual earningsreport is issued. If more investors feel the company will beat analyst pre-dictions, then the price of the shares will be bid up as there will be morebuyers than sellers. If the majority of investors feels that the company’searnings will disappoint “the street,” then the price will decline (also re-ferred to as “offered down”). As stated earlier, the stock market is similarto an auction. If there are more bidders (buyers), prices will rise. This isreferred  to  as  “bidding  up.”  If  there  are  more  people  offering  (sellers),prices will fall.
For example, let’s say Citigroup (C) is expected by analysts to reportearnings of $1 per share. If news starts to leak out that the earnings will be$1.25 per share, the share price will jump up in anticipation of the better-than-expected earnings. Then if Citigroup reports only $.75 per share, thestock  price  will  theoretically  fall  dramatically,  as  the  actual  earnings  donot  meet  initial  expectations  and  are  well  below  the  revised  expectedearnings. The investors who bought the stock in anticipation of the better-than-expected  earnings  will  sell  it  at  any  price  to  get  out.  This  happens
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quite  often  in  the  market  and  causes  sharp  declines  in  the  value  ofcompanies. It is not uncommon to see shares decline in price 25 to 50 per-cent in one day. Conversely, it is also common to see shares rise in valuein a similar fashion.
Dividends
American companies may periodically declare cash and/or dividends on aquarterly  or  yearly  basis.  Dividends  are  provided  to  the  shareholders—otherwise referred to as stockholders—as an income stream that they canrely on. This is quite similar to a bank paying interest on certiﬁcates of de-posit  (CDs)  or  savings  accounts.  There  are  a  number  of  companies  thatboast  that  they  have  never  missed  a  dividend  or  have  always  increaseddividends.
Companies  that  distribute  their  income  as  dividends  are  usually  inmature industries. You typically will not ﬁnd fast-growing companies dis-tributing dividends, as they may need the capital for future expansion andmay  feel  they  can  reinvest  the  funds  at  a  higher  rate  of  return  than  thestockholders.  As  a  stock  trader,  you  need  to  know  how  this  process  af-fects your long or short investment. Basically, a company’s board of direc-tors  will  decide  whether  to  declare  a  dividend,  which  is  paid  out  anddistributed to shareholders on a date set by the company. Also, some com-panies will declare a special dividend from time to time. This dividend ispaid out and distributed to shareholders on a date set by the company,referred to as a payable date.
In  order  to  qualify  for  a  dividend,  you  must  be  a  shareholder  onrecord as of the record date (the date you are “recorded” as the owner ofthe shares) of the dividend. You can also sell the stock as soon as the nextday after the payable date and still receive the dividend.
A beginner may think this is a proﬁtable way to buy and sell shares:Buy the shares a few days before the record date and sell them on the dayafter the payable date. However, before you run out and open a stock bro-kerage  account  in  order  to  implement  this  tactic,  you  may  want  to  con-sider that, in most cases, the stock prices will be trading lower on the daythat the dividend is payable. That’s because on the dividend payable date(i.e., the date on which you get paid the dividend), the stock should tradeat its regular price minus the dividend.
Let’s consider an example. If IBM (IBM) declared a $1 per share divi-dend payable on June 30, and closed at $90 on June 29, then on June 30,IBM would open at $89. As a stock trader, it is important to be aware ofdividends and how they can affect a stock. You can ﬁnd stocks declaringdividends by looking in the newspaper ﬁnancial pages or at various ﬁnan-cial web sites.
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Market Capitalization
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Market capitalization is deﬁned as the total dollar value of a stock’s out-standing shares and is computed by multiplying the number of outstand-ing  shares  by  the  current  market  price.  Thus,  market  capitalization  is  ameasure  of  corporate  size.  With  approximately  8,500  stocks  available  totrade on U.S. stock exchanges, many traders judge a company by its size,which can be a determinant in price and risk. In fact, there are four unofﬁ-cial size classiﬁcations for U.S. stocks: blue chips, mid-caps, small caps,and micro-caps.
1. Blue-chip stocks. Blue chip is a term derived from poker, where bluechips in a card game hold the most value. Hence, blue-chip stocks arethose stocks that have the most market capitalization in the market-place (more than $5 billion). Typically they enjoy solid value and goodsecurity, with a record of continuous dividend payments and other de-sirable investment attributes.
2. Mid-cap stocks. Mid-caps usually have a bigger growth potential thanblue-chip stocks but they are not as heavily capitalized ($500 millionto $5 billion).
3. Small-cap stocks. Small caps can be potentially difﬁcult to trade be-cause  they  do  not  have  the  beneﬁt  of  high  liquidity  (valued  at  $150million to $500 million). However, these stocks, although quite risky,are usually relatively inexpensive and big gains are possible.
4. Micro-cap stocks. Micro-caps, also known as penny stocks, are stockspriced  at  less  than  $2  per  share  with  a  market  capitalization  of  lessthan $150 million.
Some traders like to trade riskier stocks because they have the poten-tial for big price moves; others prefer the longer-term stability of blue-chipstocks. In general, deciding which stocks to trade depends on your timeavailability, stress threshold, and account size.
Common versus Preferred Stock
Ofﬁcially, there are two kinds of stocks: common and preferred. A com-pany  initially  sells  common  stock  to  investors  who  intend  to  makemoney by purchasing the shares at a lower price and selling them at ahigher  price.  This  proﬁt  is  referred  to  as  capital  gains.  However,  if  thecompany falters, the price of the stock may plummet and shareholdersmay end up holding stock that is practically worthless. Common stock-holders  also  have  the  opportunity  to  earn  quarterly  dividend  payments
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as the company makes proﬁts. For example, if a company announces a$1 dividend on each share and you own 1,000 shares, you can collect ahealthy dividend of $1,000.
In  contrast,  preferred  stockholders  receive  guaranteed  dividendsprior to common stockholders, but the amount never changes even if thecompany triples its earnings. Also, the price of preferred stock increasesat  a  slower  rate  than  that  of  common  stock.  However,  if  the  companyloses  money,  preferred  stockholders  have  a  better  chance  of  receivingsome of their investment back. All in all, common stocks are riskier thanpreferred stocks, but offer bigger rewards if the company does well. (SeeTable 2.1 for a comparison.)
Stock Classiﬁcations
Another  way  to  classify  a  stock  is  by  the  nature  of  its  objectives  (seeTable 2.2). The correct classiﬁcation often is derived by looking at what astock does with its proﬁts. For example, if a company reinvests its proﬁtsto promote further growth, then it is known as a growth stock. A growthstock  is  a  company  whose  earnings  and/or  revenues  are  expected  togrow more rapidly than the average earnings of the overall stock market.Generally, growth stocks are extremely well managed companies in ex-panding  industries  that  consistently  show  strong  earnings.  Their  objec-tive is to continue delivering the performance their investors expect bydeveloping new products and services and bringing them to market in atimely fashion.
If  a  stock  regularly  pays  dividends  to  its  shareholders,  then  it  is  re-garded  as  an  income stock.  Usually  only  large,  fully  established  compa-nies can afford to pay dividends to their shareholders. Although incomestocks  are  fundamentally  sound  companies,  they  are  often  consideredconservative  investments.  Growth  stocks  are  more  risky  than  incomestocks but have a greater potential for big price moves. Don’t be lured intoan income stock simply because it pays a high dividend. During the late1990s,  many  utility  companies  paid  high  dividends.  Then  problems  sur-faced  in  the  industry  and  stocks  in  the  utility  sector  became  extremelyvolatile.  Many  suffered  large  percentage  drops  in  their  share  prices.Therefore,  even  though  these  companies  paid  hefty  dividends,  manyshareholders suffered losses due to the drop in the stock price.
Additionally,  there  has  been  a  surge  in  the  popularity  of  socially  re-sponsible or “green” stocks. Socially conscious investing entails investingin companies (or green mutual funds) that are socially and environmen-tally  responsible  and  follow  ethical  business  practices.  Green  investorsseek to use the power of their money to foster social, environmental, andeconomic changes that will improve conditions on the earth.
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TABLE 2.1 Comparison of Common and Preferred Stock
Common Shares
Preferred Shares
• Common shares offer larger 
potential rewards than preferred shares; shareholders share the rise in stock price more quickly than preferred shares.
• If a common stock declines in price, shareholders share these losses and the value of their shares may drop dramatically.
• Although shareholders of common 
stock are eligible to receive dividends, companies are not obligated to distribute a portion of the proﬁts back to the shareholders (i.e., they do not offer investors guaranteed performance results).
• Preferred shares are a hybrid between bonds and common stock. Due to their hybrid nature, the price of preferred shares does not act like the ﬁrm’s bonds or the common stock. The more bondlike a preferred stock is, the more it will mirror the bond pricing; the more like common stock it is, the more closely it followsthe price changes of the common stock.
• The particular features of any one 
preferred stock are spelled out in the legalese of the issuance, as determined by management and approved by the common stockholders.
• Features of preferred shares may or may not include such criteria as:• Guaranteed dividends at regular 
intervals—cumulative or noncumulative.
• Limited dividend amount 
regardless of company’s proﬁts.• Voting inferiority (or superiority) to common stock depending on the speciﬁc agreement.
• Possible convertibility into common
stock or bonds.
Stock Sectors
Stock market activity is reported each day by certain indexes, which re-ﬂect the general health of the economy. Everyone has seen the Dow JonesIndustrial Average (DJIA) mentioned on the nightly news as a key indica-tor of the day’s trading performance. But what is the DJIA and how did itget started? In 1884, Charles Dow surveyed the average closing prices ofnine  railroad  stocks  and  two  manufacturing  companies,  which,  in  hisopinion,  represented  the  general  trends  in  the  national  economy.  Heprinted  the  results  in  his  newspaper,  a  forerunner  of  today’s  Wall  StreetJournal. Over the next 12 years, he honed that list until he ﬁnally settled
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TABLE 2.2 Types of Stocks
Stock Type 
Characteristic
Examples
Cisco (CSCO)Dell Inc. (DELL)Home Depot (HD)Charles Schwab (SCH)
Growth stocks—aggressive
• Rarely pay out dividends to their shareholders because they prefer to reinvest their proﬁts into future growth.• Two kinds of growth stocks: 
established growth and emerging growth. Established growth stocks have seen several years of successful expansion. In contrast, emerging growth stocks are the up-and-comers that are currently experiencing dramatic expansion, yet have limited previous growth experience. Both offer investors the potential to make dramatic gains or suffer heavy losses depending on market performance.
Income stocks— • Solid companies that offer conservative
slow, but steady growth.• Regularly pay out dividends 
to their shareholders.
ExxonMobil (XOM)3M (MMM)Bank of America 
(BAC)
• Do not offer dramatic returns.
Duke Energy (DUK)
Cyclical stocks
• Fluctuate in relation to the 
Turnaround stocks—aggressive
Green stocks—vary
economy, seasons, or events. 
• Provide an excellent gauge 
for the strength of the economy.
• Stocks that have suffered 
severe losses that are due for a turnaround—investors have to know when a stock has reached rock bottom and just what can make it turn around.• Offer explosive growth 
opportunities.
• No guarantees and high risk.• Warren Buffett’s favorite stock 
picking method.
• Environmentally friendly and socially conscious stocks.• Spawned the concepts of 
socially “conscious investing” and “corporate accountability.”• If saving the rain forests is high on your priority list of things to do, green stock investing is deﬁnitely worth checking out at www.greenmoneyjournal.com.
PPG Industries (PPG)Weyerhaeuser (WY)Alcoa (AA)
Blockbuster (BBI)LSI Logic (LSI)Rite Aid Corp. (RAD)
Canon (CAJ)Timberland (TBL)Whole Foods Market
(WFMI)
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on 12 industrial stocks. In 1896, Charles Dow began to publish this list andthe overall average every day.
Today’s  DJIA  reﬂects  the  performance  of  30  major  companies  repre-senting key manufacturing, technology, energy, ﬁnancial, and service indus-tries worth approximately 25 percent of the total value of all stocks listedon the New York Stock Exchange. It is widely regarded as an accurate as-sessment of the daily trends in the American economy. However, many in-vestors believe the DJIA is too narrow with only 30 stocks in the index. TheStandard & Poor’s 500 Index (S&P 500) is followed very widely these daysas  it  represents  a  more  diversiﬁed  portfolio  of  500  different  companies.However, if you track the performance of the DJIA to the S&P 500 you willﬁnd that they are highly correlated (prices move very similarly).
While  the  Dow  Jones  Industrial  Average  and  the  S&P  500  track  theperformance  of  the  stock  market  as  a  whole,  some  indexes  are  used  totrack sectors. In fact, there is a wide variety of stock sectors from whichto choose. The following list is a general outline of the most popular ones.
Sector Index
Symbol
MS Consumer Products IndexDow Jones Utility AveragePHLX Bank Sector IndexDJ Transportation AverageAMEX Oil IndexPHLX Defense Sector IndexMS Cyclical IndexAMEX Natural Gas IndexAMEX Pharmaceutical IndexMS Commodity-Related IndexMS Retail Store IndexPHLX Box-Maker IndexAMEX Broker/Dealer IndexPHLX Oil Service IndexAMEX Networking IndexPHLX Street.com Internet IndexAMEX Biotechnology IndexMS Oil Service IndexGSTI Computer Software IndexGSTI Computer Hardware IndexCBOE Internet IndexPHLX Semiconductor IndexPHLX Gold Mining IndexAMEX Airline IndexAMEX Disk Drive Index
$CMR$DUX$BKX$DTX$XOI$DFX$CYC$XNG$DRG$CRX$MVR$BMX$XBD$OSX$NWX$DOT$BTK$MGO$GSO$GHA$INX$SOX$XAU$XAL$DDX
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Instead of using indexes, some traders watch the performance of indi-vidual stocks to gauge trends in an industry or sector. Some sectors andgauges follow. For example, Intel (INTC) is often considered a gauge forthe semiconductor group.
• Technology:
Computers (e.g., Dell, Hewlett-Packard).
Internet-related (e.g., Amazon.com, Yahoo!).
Software-related (e.g., Microsoft, Adobe).
Semiconductors (e.g. Intel, Applied Materials).
• Health-related:
Pharmaceuticals (e.g., Merck, Pﬁzer).
Biotech (e.g., Amgen, Biogen).
• Defense industry (e.g., Boeing, Lockheed Martin).• Retailers:
Clothing (e.g., Gap, Wal-Mart).
Sportswear (e.g., Nike, Reebok).
Automakers (e.g., General Motors, Ford).
• Transportation (e.g., Delta Air Lines, Continental).• Financial services (e.g., Citigroup, J. P. Morgan).
This list is not meant to be an exhaustive list; rather, it is meant to re-ﬂect the diverse range of ﬁelds and individual stocks within each sector.This  may  very  well  be  why  many  prospective  investors  shy  away  frommaking their own investment decisions. The plethora of opportunities canbe overwhelming to many people.
The IPO System
The equities market generates wealth in several different ways. As privatecompanies expand, they come to a point where they need more capital toﬁnance further growth. Many times the solution to this problem is to offerstock in the company to the public through an initial public offering (IPO).To do this the company hires the services of a brokerage ﬁrm to under-write its stock, which means the brokerage will buy all the shares the com-pany  is  offering  for  sale.  The  brokerage  then  charges  a  commission  formanaging  the  IPO  and  generates  cash  by  selling  the  shares  to  investors.The commission is usually about 10 percent of the total value of all shares.
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There is a misconception among many people who believe a com-pany  makes  money  every  time  a  share  of  its  stock  is  traded  after  itsIPO, but that simply is not true. Companies get the IPO money, and thatis it. From that point on, the money derived from the buying and sellingof a company’s stock is passed back and forth between the actual buy-ers and sellers.
The IPO is an avenue provided by the stock market for a companyto  fund  expansion.  If  the  expansion  succeeds  and  the  company  pros-pers,  it  will  hire  more  people  and  buy  more  raw  materials  from  othercompanies. This process contributes to the expansion of the economyas a whole, generating wealth that would not have existed without thestock market.
Investors who proﬁt from a successful IPO also create wealth for theoverall  economy.  If  they  buy  low  and  sell  high,  they  have  made  a  proﬁtthat improves their standard of living and their ability to buy goods andservices. They also use stock proﬁts to start small businesses, reinvest inthe  stock  market,  or  add  to  their  savings.  This  process  of  putting  stockproﬁts back into the economy helps the economy grow over the long termand is a vital component of economic prosperity.
If a company increases its proﬁts year after year, its stock price willrise. The increase in price is the result of the law of supply and demand.When  the  company  went  public  it  issued  a  limited  number  of  shares,called  a  ﬂoat  or  the  number  of  shares  outstanding.  As  the  demand  forthese  shares  increases,  the  supply  decreases.  In  this  situation,  the  pricewill rise.
Companies deﬁnitely beneﬁt when their stocks are in great demand. Acompany’s market capitalization, the value of all shares of its stock, willgo up. Market capitalization is computed by multiplying the current stockprice by the number of outstanding shares. The equities market is a pow-erful mechanism of the capitalist system. It has an enormous inﬂuence onthe business cycle, because it creates wealth and stimulates investment inthe future.
This is also why it should be no surprise that the stock market is sosensitive to economic news such as an interest rate change. The economyis a ﬂuid system, one that evolves through predictable ups and downs. In-vestors will buy stocks when it appears that companies will be able to usethe capitalist system to improve their earnings. They will sell stocks whenit seems that economic woes are on the horizon.
This buying and selling is prompted by economic news that providesthe clues to the direction the economy is taking. All that said, the IPO mar-ket is one of capitalism’s greatest gifts because it provides a mechanismfor companies to expand and create wealth in the future.
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