Jun

25

Staying in the Game

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“Stock option trading is hitting for average and not about hitting home runs”
% Drawdown % gain required to recoup losses
10 11.11
20 25.00
30 42.85
40 66.66
50 100
60 150
70 233
80 400
90 900
100 busted
You’ve got to pay to play. If you pay too much or too often, you‘re out. It’s that simple. This fact is in spades for stock option traders. One of the most important objectives in stock option trading is to be trading for the long haul. You do that by employing well defined and strict money management rules.

Trading stock options demands a strategy of cutting losses quickly and making sure that the trading system wins more than it loses. Some basic trading rules are:
1. More winning trades than losers;
2. Average profits are larger than average losses;
3. Compounding profits yield high annual returns
4. Trading account drawdown limits aren’t reached

First of all, trading account funds should be non-essential funds. Even then, the trader needs to conserve the trading account to enable a steady volume of trades. Most traders limit each trade to no more than 10% of the total trading account. If you have a $ 20,000 trading account balance, no trade will be more than $2,000.

The concept of drawdown is extremely important in providing the trader with exposure to the option market. Consider the chart.

As you can see from the chart, when a trading account reaches about 35% drawdown, required gains just to get back to the original balance start to go logarithmic and it becomes a difficult chore just to get back even. As a result of this fact, many stock option traders will put a drawdown limit of around 25%. Sometimes it can just be “bad luck” but when the win-loss ratio isn’t where it should be, more often there needs to be some adjustment to the system or to the trader’s psychology. Hitting a drawdown limit forces the trader to step back before winning trades only help claw back to the initial balance.

Along with setting up a drawdown limit, it’s important for stock option traders to also set up some trading rules to help conserve trading capital. For instance, a trader may establish trading policies like: no more that one trade per day; no trading when not feeling well; no trading if in a bad state of mind; or once hitting monthly goals, to stop trading for a week. A stock option trader must know the eccentricities of their own trading style and how best to accommodate their trading success.

Stock option trading is hitting for average and not about hitting home runs. It a trader can have a win-loss ratio in the sixty percent range and have an average profit at least twice of the average loss, we have a happy camper. Because trading is a matter of finding trades with a high probability of success, there will always be the variance from the average-both positive and negative. So, having losing trades is part of the territory of the option trader. If you are too much of a perfectionist and hate to lose, options trading will be a “voyage of self-discovery.” Its all about discipline, constant analysis and keeping above the trading account drawdown limit.

To learn more about options, take advantage of Options University to give you the education on everything you need to know about options-from basic to master.

Jun

23

If you don’t know Delta, You don’t Understand Options

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What do Greeks and stock options have in common? If you don’t know the answer to this question, you need some very important education about stock options.

Many “self-taught” stock option traders think that the game is to find a stock (the underlying) that is going to move up or down within a certain period of time and purchase an inexpensive call option or put option in hopes of capturing the movement. In general theory, if the stock (underlying) moves up or down, so will the stock option. While there is some truth in this theory, sadly it is only partially true. You see, a stock option trader may indeed correctly choose the stock, direction of movement and period of movement but not make any profit. That’s because inexpensive stock option premiums are usually out-of-the-money. That is, the stock price is higher (in the case of a call option) or lower (in the case of a put) and has not reached the option strike price. Even though, the underlying may move in the desired direction this does not necessarily mean the option will follow ; thus, debunking the common understanding of what stock options are supposed to do.

A stock option is a derivative of the underlying stock and not an exact surrogate. There are several key factors that decide how a stock option will relate to the underlying stock and this can be computed by using one of the many Stock Option Pricing models like the famous Black-Scholes model. I can see the reader’s eyes start to glaze over and the intellectual interest drain from the topic. But stop reading at your trading peril!! This is important stuff if you want to be successful at trading stock options.

The purpose of this article is not to talk about the complexities of stock option pricing models but to introduce the key concept of Delta. You see, Delta is one of the “Greeks” revealed in the process of valuing a stock option.
The most common Greeks are: Delta, Gamma, Vega and Theta. The most important for this discussion is Delta. What is Delta?

Delta measures the correlation of movement between the underlying stock and a corresponding option. When a stock option is out-of-the-money (OTM), it has a lower correlation to the underlying. This means that if the underlying stock moves $ 1 a corresponding out-of- the- money option will move only a percentage of the underlying. For example, an OTM option might only move about 30% or in our example the premium would only move about 30 cents. But an interesting thing happens when the option approaches in-the-money (ITM); its Delta rises. For example, when an option reaches at-the-money (ATM), its Delta might be as high as 70%. When the stock option moves high into-the-money, the stock option is usually at or very close to 100% Delta. At this point of high correlation, the option is a close surrogate for the stock. If the stock moves up $1, so will the option premium.

While it might be true that buying a cheap OTM option might provide a higher return on investment, the probabilities are much lower that an actual profit will be made. That’s because of Delta. That is why many seasoned stock option traders much prefer in-the-money options because they understand the higher probability of having success. Moreover, if an ITM stock expires, it will still have value whereas an OTM has zip.

Another important aspect of an option’s Delta is that it can define the probability of the option finishing in-the-money. For example, if a trader has an option with a Delta of .50, the option has a 50% probability of finishing in-the-money. Likewise, if a trader has an in-the-money option with a 95% Delta, the trader has an option that has a 95% chance of finishing in-the- money. This is extremely important for traders.

For more information and online educational courses on the tremendous capabilities of Stock Options, contact Options University at: www.optionsuniverstiy.com .

Jun

21

No Brainer

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It’s a no brainer. If you have an investing time horizon of less than two years, you are much better off using stock options. If you are a “buy and hold” investor, than you are basically looking for the long term average annual growth rate of about 12.5%-if you’re lucky. But if you are an active investor looking to optimize your investment dollars, there is no doubt that using the stock option strategy called “Stock Replacement” is a smarter and cheaper way to go. It’s smarter in that investment dollars are leveraged to optimize return and diversification and it is much less expensive because an investor can get the same affect of owning the stock but at a huge discount. Like I said, it’s a no brainer.

The Stock Replacement strategy holds that an investor/trader purchases either an in -the-money-call option (if the investor is bullish) or an in-the-money put (if the investor is bearish). The reason a trader purchases more expensive in-the-money stock options is that a trader wants the option to mimic, as closely as possible, the movement of the underlying stock. In other words, the educated trader wants what is called: “High Delta”.

If you are an “educated option trader”, you may recall that Delta is one of the famous Greeks, which measures the correlation between the movement of an option and its underlying stock. Many stock option traders may not have learned about the more sophisticated aspects of options and may not realize that just because the trader may have chosen an option that does what was hoped for, that doesn’t mean that the option will capture the same amount of movement as the underlying. For example, a trader may have purchased the cheaper out-of-the-money option but become confused when they find out that the underlying might have moved $1 but the option premium only moved 40 cents. This demonstrates that an out-of-the-money option would have a Delta of only 40% (.40). Whereas an in-the-money option will have a much higher Delta and more closely mimic the movement of the underlying. Let’s look at an example.

Suppose you purchased an out-of-the-money call option for a premium of $3.00 ($300 for one contract). The stock is currently at $ 105. If the stock moves up $3 to $108, the trader’s $3 OTM call option may move up just $1 (a Delta of .33). On the other hand, if a trader had purchased an in-the-money IBM call option for $10 premium per share, the ITM call option would have moved up perhaps $ 2.75 in sympathy with the underlying (Delta of .83) In other words, an ITM option call (or put) can be a close substitute for the underlying stock but at less than 10% the cost. To own 100 shares of IBM would cost about $10,500 and to own 100 shares under option would be about $1,050. While it’s true that a greater return can be made with a cheaper premium but the probability of it actually happening is much less than buying an ITM option. If a stock option has a Delta of .83 that means that the ITM option has an 83% chance of being in the money at expiration. For option traders who like to have a longer time horizon a long term option called LEAP (Long-term Equity Anticipation) can allow an option trader to hold an option for over two years!

For example, if an option trader thinks IBM will move up within the next two years, the option trader can own the rights to 100 shares of IBM for over two year for about $1400 (in-the-money call option expiring Jan 2010) Contrast this cost with the $10,500 it would take to purchase the stock outright. Just think of the other opportunities a trader could have with the capital saved by using LEAPS options. The option trader could diversify among other stocks or other types of investments. Indeed, if you have a time horizon of two years or less, it makes solid sense to look to options.

To find out about the wonders of stock options, contact Options University (www.optionsuniversity.com) about their many excellent online courses-from basics to advanced.

Jun

19

A Needle Through Your Psyche

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I saw it with my own eyes. A group of men-they looked like typical peasants from the countryside- parade through the open marketplace. What they were wearing shocked everybody. Or, they were high on something. This group of Peruvians-ranging from age 12 to about 70 years old all had large silver awls protruding through their tongues. I mean these needles were like 8 inches long and at least one quarter inch in diameter. When I saw them walking and trying to talk with no apparent pain, I was astonished. I stopped several of the men just to make sure it wasn’t some sort of trick. It wasn’t. They had indeed shoved these giant needles through their tongues. It made me flinch jus to think of it. But they had overcome any physical pain. Maybe I was so impressed because I am such a wimp when it comes to pain. Not physical pain so much as mental-like when I lose money when making a bad stock or stock option trade.

The unusual scene I saw in Huamachuco, Peru made me think that I needed to learn how to stick a needle through my trading psyche. When I got back home, I did a little research and the results have helped me a lot in my attempts to be become a better trader. You see, I’ve been trading long enough to understand that real success in stock or stock option trading is learning how to handle the pain of losing.

Psychologists have taken a recent interest in what makes a successful trader.
The following was taken from one of the latest studies done by the University of Minnesota concerning certain personality traits that seem to characterize successful traders.

1) Many successful traders show a certain amount of open mindedness. What this means is that they are open to new ideas and don’t close their minds off to possibilities if they can be shown to be beneficial. They may have a system that works for them but they are open to new ideas and will experiment if an idea sounds promising.

2) Conscientiousness is a quality most traders possess. They take the time to study their markets and will not trade if not adequately prepared. Moreover, when a trader establishes a system, they will follow it to the letter. Conscientious traders trade on a regular schedule and seldom vary their routine-both in trading and in life.
Conscientious traders like their trading logs to be a work of art and pride themselves in record keeping.

3) Personality types can be separated into introverts, extroverts and ambiverts. As trading is usually a solitary activity, one would think that introverted people would do best but that is not the case. Many traders come from a collaborative back-ground and like to link with other traders and to form networks of association and cooperation for the purposes of exchange of ideas and information. Even introverts are teaming up with coaches realizing that isolation is a choice and not a circumstance.

4) Helpfulness is a trait seen in most successful traders. They don’t mind sharing and helping others improve. They seem to sense that the odds are against them and survivors like to support one and another. Many successful traders turn to a teaching or coaching role to not only leverage their expertise but also to help others attain success. They know that trading is not for everyone and understand that a slew of successful traders are not going to be the result of their teachings. However, they do understand that for the proper students, they can make a very real difference.

5) Neurotic tendencies might be acceptable in some professions (linebackers and postal workers) but not in trading. Keeping a positive and winning outlook is a key quality for winners in any field-particularly in trading. But this doesn’t mean people with certain tendencies should be excluded. It can mean that by wanting to become a successful trader, the motivation will help to develop the techniques to over-come tendencies. Personality characteristics are not set in concrete. Moreover, over-coming shortcomings is what usually marks a winner.

Once I accepted that trading is as much a psychological challenge as it is intellectual, I have undertaken a study of myself and where I can improve to help forge a more successful trader. “Oh, how new age”, you might respond, but I spend most of my working time and a lot of my net worth trading and so why shouldn’t I look at all ways to improve? How about you?

Jun

18

Time decay in a sideways market

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There is something very seductive about using the prinicple of time decay to make profits. As many analysts are expecting a sidways moving market for the next fee years, a stock option trader might be well served by learning more about using a time decay strategy.

Every stock option trader is familiar with the extrinsic value-or time decay- of a stock option as it approaches expiration day. Check out the chart below:

As you can see, extrinsic value decreases to zero rapidly within the last month before expiration.
The basic strategy of capturing profits from time decay is to take a position of selling the front month and buying the back month. As the front month option (sold) extrinsic value goes to zero, the back month premium stays relatively flat. Profit is made in the arbitrage of the two premiums. Of course, there are devils in the details of this strategy (like is it better to use puts or calls and what are the best strike prices, etc) but it has proven to be a successful strategy for many investors.

Dr. Terry Allen (Terrystips.com) has been pushing his version and calls it the “36% solution” implying a conservative return of 36% annual return on his reccommendations. (But be sure to check out the SEC suit brought against him in 2006.) Eventhough a bit tarnishing, the suit does not diminish the strategy. He buys or sells LEAPS options for the Wilshire 2000 Index (IWM) for the back and buys or sells one month IWM options for the front. For example, Dr. Allan presents the follwing case:
Buy one-year call option for $7.80
Sell one-month call option for $1.80
Cost of spread: $6.00 ($600)

After one month, if the price of the stock remains at $70, the price of the option we bought for $7.80 will have fallen in value by about $.40, and is then worth $7.40. However, the option we sold to someone else would be worthless since the stock price is not higher than $70 and there is no time remaining for the option.
The spread that we purchased for $6.00 is now worth $7.40. We made a gain of $1.40, or about 23% on our investment in a single month (less commissions). At that point, we would sell another one month.

But there are some caveats to this strategy and is more complicated than Dr. Allen represents. For instance, what do you do if your position goed into the money? Or what about rolling the back ends? No doubt before attempting to use this interesting strategy, I recommend you take Options University’s
(www.optionsuniverstiy.com) “Advanced Options Course” designed by Ron Ianieri, a founder of OU and ex Market Maker in Dell otpions.

While the strategy has an elegant underlying strategy of taking advantage of the inherent time decay in expiring options, any stock option trader who may have an interest in employing this strategy needs to be aware of the more of the details and potential pitfalls.

Jun

17

Hedging with Delta

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Once again, Ron saves me money. I guess the hard reality is that there is a lot to learn about stock options and if a trader wants to use these marvelous investment tools, one needs to seek enlightenment in the form of learning from experts. Ron Ianieri of Options Universtiy is an expert and learned the ins and outs of options as a market maker trading Dell options. Like any real expert, Ron has that finger tip knowledge that comes from years of study and daily real world experience. Ron explains things in a practical manner and not in convoluted academic self-agradizing verbage. In the Advanced Course offered by Options University, I learned something that I want to share with all of us traders who feel uneasy in these volatile markets and are looking to hedge our long positions.

Before Ron (BR), I did some hedging but I had some concerns about the cost.
You see, BR hedging was done under a misconception. I thought that to hedge a long position, I needed to buy enough puts to cover the dollar value of the position. In otherwords, if you had a position with a current value of $100,000, you needed to purchase enough puts with the corresponding contracts to match the current value. For example, if you had purchased 200 shares of IBM at $100 per share and the current price is $115 per share, to hedge properly a trader needed to buy enough otpion contracts to cover 230 shares. So, I ended buying an additional contract to cover the 30 additional shares of “profit”. What was I thinking? Looking back it was only arrogance that kept me from doing the due dilligence to find out how to hedge. But, like many traders, my ego kept me ignorant and losing money.

Then I took the Options University Advanced Option Course and learned about Delta and how to use it when hedging a position. When I learned the truth, I felt like one of those Neanderthal brothers on T.V. commercials who are easily offended. I thought I had some idea but, indeed, I was ignorant.

You see, Delta is everything when it comes knowing how to hedge. One of the definitions of Delta is that of Hedge Ratio. Hedge ratio tells us how many calls we need to sell to become Delta neutral.

For example, say we were long 800 shares and we are looking at at selling calls to hedge our position. We check the OTM calls and choose a 40 Delta call. As we learn from the study of Delta, we know that a share of stock has a Delta of 100 (its price is 100% correlated with its movement). The 800 long Delta position from the stock, divided by the 40 Deltas of the call (the call will move about 40% of the underlying) will equal 20. That is how many calls we would need to sell – 20. Thus, if we sold 20 of the 40 Delta calls, we would have short 800 Deltas that would perfectly hedge our long 800 shares (with a Delta of 100) of stock. Of course, 20 calls represents 2000 shares but because of the 40% deltas of the short call options, we need 2.5 times as many shares to cover the position.

Bottomline, stock options are really fantastic but there is no doubt that extensive study should be done before using these elegant tools. If you really plan to get involved in trading stock options or using them to hedge, I strongly recommend taking the Basic and Advanced Stock options courses offered by Options University (www.optionsuniversity.com) before investing.

Jun

11

Volatility- The Essence of Stock Options

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The key to having a trade is that you, being the buyer, and me being the seller, have different volatility assumptions. What I think volatility is going to be versus what you think volatility is going to be makes the difference. Everything else we’re in total agreement with because those outputs are “hard numbers” processed by the Options Pricing Model. Current prices, selected strike price, days to expiration, interest rate and dividends are what they are. Just looking at the pricing model output based on these factors is the same for both buyer and seller. But what makes a trade is really the factor of perceived volatility. So, when we talk about volatility we are really talking about the essence of an option trade.

What is Volatility?
Basically, volatility is a measure of dispersion around the mean. A simple example would be comparing two stocks. Both have a current price of $40, however, the first stock has a price range of $15-$60 over a period of time and the second stock has a price range of $32-$52 over the same time period. The first stock is more volatile than the second stock; the range of past prices has a broader price range. Based upon historical movement, the price movement demonstrates the most probable price range. The potential outcome normally lies between the end points of the range for a certain time period.

When talking about volatility in the stock options market, there are basically four different types of volatility. The first is Historical Volatility. As Volatility has a direct link with price (higher volatility usually means higher prices) we try to predict future volatility (price) based a large part on the past history of a stock’s volatility. This leads us to extrapolate (guesstimate) the Future volatility for a specific time period in the future. This is where the art comes in. You may build your forecast on a set of assumptions different from mine. Once we input our forecast volatility into the pricing formula, the end result may be different. Differences make for perceived opportunities; you might think the option you are selling is correctly priced while the buyer feels it is under priced. However, just how much a difference in computed price may affect the actual trade is based on the individual cost-benefit perception. For example, there are times when I might feel that an option is over priced but I will buy it anyway because I think the profit potential will justify the purchase. However, for the most part, professional traders will stay away from overpriced options.

The third type of volatility is called implied volatility. We can actually figure out what your forecast volatility is by working your bid price. If you bid $3.00 and I put this into the model and solve for volatility, I can come up with your measure of volatility. This is the implied volatility as observed by your bid price. If the implied volatility for your bid is lower than mine, I am implying that I think there will be more future volatility and thus potential higher prices. Keep in mind that every time any of the variables change, so does the outcome of the pricing model.

The final volatility is future volatility. This is our “best guess” as to what we think the future volatility will be. The difference is that future volatility is not a product of the option pricing model.

Jun

9

Trumpification: Time and Volatility effects on Delta

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What is Position Delta?
The use of options allows a trader to be more than just a directional player in terms of the direction of the underlying. There are two other things that you can trade using options. One is volatility. A second is the passage of time and quite often traders, when trading volatility or time, don’t want to have a Delta. If a trader can’t go Delta neutral, then they never really will be able to isolate trading volatility or time.

First, what is Delta neutral? To get a good idea, let’s consider how we incorporate Delta as a hedge ratio. For instance, if I buy 400 shares of XYZ, each share has a Delta of 1 that’s going to give us a total Delta position of plus 400. In order to get Delta neutral, a trader needs to figure out a way of offsetting these 400 long Deltas. You could buy 8 puts with a delta of 50 for each contract (.5 Delta per option share), which would equal negative 400 deltas. This would give a Delta neutral position in that the 400 long Deltas would be offset by the 8 put contracts. Whenever you have a position where your Delta adds up to zero or close (plus or minus ten), you are Delta neutral. So, what does all this mean?

Ron Ianieri says: “Typically, a stock trader who’s been trading stock their whole life, the idea of being Delta neutral is tough because they don’t understand how they’re going to make money. How am I going to make money? If I’m not playing the stock going up or going down, how am I going to make money?” That is one of the beautiful things about options; the ability to make money in more than one way. It’s much more sophisticated than stock. It gives a trader many more opportunities than stock. The idea of a position being able to become Delta neutral allows us to eliminate the Delta factor from our position. At that moment in time, we now can isolate price and only trade volatility or only trade time, otherwise the effects of Delta will interfere with these two strategies.

Trumpification
Trumpification is a Delta affect where time and/or volatility create an affect where the in-the-money options increase their Deltas as time passes or as volatility decreases and the out-of-the-money options lose Delta as time passes and volatility decreases.

Trumpification is affected by two things; decrease in volatility or the passage of time. We know that in-the-money options have their Deltas increase as the option gets closer to expiration. Out-of-the-money options decrease in Delta as time goes by and/or volatility decreases.

Time affects the Deltas of in-the-money options and Delta increases as time goes on. Why? Because options are in-the-money now and with even less time to go they will be even further in-the-money because there will be even less of a chance for them to fall out which means there is more of a chance for them to stay in; thus a higher Delta.

Volatility is defined as the more an option moves, the better chance of that stock doing something to make an in-the-money option out-of-the-money. This is the reverse of the effects of time on Delta; higher volatility means lower Delta. As Ron Ianieri describes it in his Options Mastery Course (www.optionsuniversity.com), “with the volatility at 70 this stock is flapping around so much that there is now a higher percentage chance of this option making its way to being in-the-money. Because of the wild gyrations of the stock it’s got a better chance thus a higher Delta. If the stock is not moving as much the stock is probably not going to run up high enough to get this option in-the-money. If that’s true, then this option has less of a chance of becoming in-the-money when volatility decreases. Because it has less of a chance of being in-the-money its Delta must be lower. I know this sounds confusing, but read it over again and try to visualize what happens.

Jun

7

More about Volatility

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In the Options Mastery Course one reads : “As traders, we have to be able to determine for ourselves what the relative highs and lows for different stocks are going to be because obviously we don’t want to be buying an option that’s very high in terms of its volatility relative to what the stock normally trades at; nor do we want to be selling options when the range is very low. So we have to get an idea for ourselves of what the volatility ranges and measurements are”.

Measures of volatility are relative. For example a high volatility might be 30 while others might be high with a 90. High or low volatility is relative to the particular underlying stock. To derive what is high or low, we need to know what the mean or average for the particular underlying stock volatility is. To get the best idea of what monthly volatility is, we will look at the at-the-money strike price because it has the most attention and it’s the most accurately priced, but the second thing is it also has is the highest sensitivity to movements in volatility.

When we talk about measurements we talk about how we’re going to gauge whether present implied volatility is high or low. We do that by establishing a base volatility. The pros use a Volatility Cone-or Volcone Analyzer- to help measure historical volatility. Once a base volatility is determined, a comparative high or low volatility measure can be produced by establishing standard deviations based on the data. For example, if a current variance of implied volatility is over one standard deviation to the right that means that the current implied volatility is outside of the normal 68% expected range and is statistically “significant” to the upside.

Volatility Skew
Different options of different stocks trade at different volatilities from month to month and strike to strike. Even two options that are corresponding options (same strike and same month) have a call and its put that trade at two different volatilities. When this happens, it’s called “skew”, and in the real world of option trading there are many volatility skews.

The “vertical skew” (also called the volatility “smile”) demonstrates that as the strikes in the same month move away from the at-the-money strike (both into and out-of-the-money), volatility increases. Volatility is normally the lowest at-the-money. If you chart the volatilities, it resembles a smile with the low point at-the-money. Moreover, front months display a bigger smile, while the outer months seem to produce lesser smiles.

The “horizontal skew” (also called “tilt”) looks at what is happening to the same strike over different months. Same strike prices usually trade higher in the front month’s and decrease the further out you go. If the reverse happens, that is called a tilt inversion. This knowledge can become valuable when trading time spreads.

The last skew we’ll talk about today is the “put-call skew”. Theoretically, same month, same strike calls and puts should trade at the same price. However, in the real world, often the call price is trading higher than the corresponding put (positive skew). Likewise, put prices may be trading higher than the corresponding call (negative skew). Both of these situations can be important considerations when using different stock option strategies.

Jun

4

The Option Trader Blues

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“Traders can’t afford to get emotional in their trading”

“If it weren’t for bad luck, I’d have no luck at all”, go the famous blues lyrics about being a loser. Stock option traders define success or failure by the trading account balance. A trading account balance is a function of win-loss ratio and average gain over average loss. But there are times when probability turns its back on the trader. It’s going to happen and for perfectionists losing can be a difficult event and can make a trader feel like singing the blues.

From early childhood, we are taught that losing is a sign of personal weak-ness and failure. But to a trader, what is losing? Is it one trade; or more than 50%? Some traders actually have a win-loss ratio of over 70%, but most are below this ratio. Nobody-except a storyteller- has a ratio in the 90’s. Losing trades are a part of the territory-even for the best. The sooner a trader understands this, the better. Many high achievers take losing very personally, but in the option trading theatre of probability, losing is part of the process. Having the affliction of expecting perfection takes a heavy toll on the ego of option traders.

Traders can’t afford to get emotional in their trading. That’s why we develop a disciplined trading system. It’s mechanical and the less art, the better. When the system isn’t producing the way it reasonably should, (less than 55% win-loss over at least 100 trades), then the system needs to be modified. But to have a “system” means applying the rules of the system consistently. In this way the system is tested and not the trader’s “abilities”. If you want to hear “he’s a great trader” then your ego will kick your butt every time you lose and when that happens things can start to unravel. Beating yourself up is no fun and it usually only makes things worse.

Successful option traders cut losses immediately, review the reasons for the loss as part of a learning process, and move on. They understand that if they follow a strict regimen and the system is just average, they will come out winners-if they keep trading options mechanically and understand it’s a number’s game. Drawdown limits become the deciding factor not whether a limited number of trades are winners or losers.

If you find that trading is getting you down, first analyze if it’s your ego and requirement for being right. Are you trading to prove that you are better than others or to make money? This internal monologue needs to be squelched. Making money by trading options is a mechanical, analytical skill combined with the patience to stay the course. Effective traders are like anybody else with the exception that they learn to control their egos and care not if using a checklist and a set of pre-determined rules make them money. If over the long haul (trading year) traders see high double digit or triple digit returns for the year, traders understand that it was not due to their intelligence or “special abilities” but their ability to stay disciplined and keep the big picture always in mind: “it’s not about me but about my ability to consistently apply my trading system”.

To learn more about options, take advantage of Options University to give you the education on everything you need to know about options-from basic to master.

Jun

2

What do They Know, Anyway?

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Another B.S. statistic! I put off trading options for years because I read someplace that over 80% of all options expire worthless. Expire worthless… something we’re all afraid of. You don’t want your tombstone to say: “Here lays so and so….he expired worthless.” But seriously, many a potential stock option trader may have been scared away from the wonders of trading stock options by the 80% statistic by not fully understanding what that dismal statistic (some say it’s as high as 90%!) really means. As the old saying goes, “there are statistics and then there are damn statistics”. In the case, the famous 80% is a damn statistics. Here’s why.
Option contract and open interest
An option contract is where one person buys (long) and another sells (writes); this transaction constitutes one contract. If the buyer and seller close out their positions, there is one less contract. If one original buyer sells their original position to another person, then the original contract would still be open; thus the name “open interest”.
The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or a negative number. Most traders interpret that if open interest is increasing, more money is coming into the market for that instrument and usually means or verifies increasing prices. Conversely, if open interest is decreasing, it means that money is exiting the investment vehicle and usually means decreasing prices. Open interest and price is one way to confirm a trend. The following table is a well known description of the relationship of price, open interest and trend.
Price Open Interest Interpretation
Rising Rising Market is Strong
Rising Falling Market is Weakening
Falling Rising Market is Weak
Falling Falling Market is Strengthening
But how does that tie into the mysterious 80% worthlessness of stock options?
The myth
It has to do with two things: First, it has a lot to do with how options are pur-
chased. Most stock option traders seem to prefer buying out of the money calls if they think a stock is going to make an impending upward move in price. Out-of- the-money calls are cheaper than in-the-money calls. However, not all stock option traders trade that way. As in-the-money options have intrinsic value, they are normally closed out and not left to expire as they will have intrinsic value. However, as most options are purchased out-of-the-money they are normally left to expire because as they approach expiration, they quickly lose premium value which has only time value and no intrinsic value.
Secondly, many sophisticated stock option traders and portfolio managers use stock option puts for hedging purposes. They purchase out-of -the-money puts and if not exercised, they expire worthless. It’s not uncommon that thousands of put options are used for hedged positions. Thus, given the open interest of out of the money calls and hedged puts, 80% of stock options expiring in a state or worthlessness might be accurate but it doesn’t mean that 80% of stock option traders lose money.
To learn more about options, take advantage of Options University to give you the education on everything you need to know about options-from basic to master.

May

31

A Naked Kamikaze

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Don’t go naked. It’s not that you’ll catch a cold but you might have to buy stock you don’t want to buy. To a stock option trader, going naked is buying or selling (writing) an option contract without owning the underlying stock. But you already knew that. And chances are you also know that most stock option traders will tell you to never sell naked puts. I say most because I have used selling naked puts successfully for years. I don’t recommend it because for many traders it would indeed be the wrong thing to do. But for some, it could work out well. It did for me.

Here’s my story. I used to own a medium sized company which had the advantage of having a large line of credit which we rarely used. At the time, we paid about 8% interest. As I was in charge of managing our money, I was always looking for ways to optimize our assets. One day it hit me. I have this line of credit, which I fortunately don’t need, but I wondered if there was a way I could use it in a productive manner for the company. As a desk bound executive, I had the capability to trade stocks and options because a computer was always an arms length away.

I had this mysterious friend who somehow made a good living for he and his family by no obvious means. Once I broached the subject and he muttered something about stock options. I prodded him and he explained a strategy that provided him with a steady stream of income. It got my interest and I offered to pay him if he would show me how to do it. He obliged and in ten minutes I was out the door shaking my head. He was nuts because he was defying a common taboo of selling naked puts. Soon, I became focused on the unused LOC because the bank had informed us that they wanted to close out our credit line because we weren’t using it. So, I started to do some paper naked put option selling just to see if my nutty friend was right. Within a short period of time, I was pleasantly surprised. I just needed to focus on stocks that I wouldn’t mind owning if I were somehow forced to cover. Then it hit me. This line of credit was like having a huge margin account. It cost me 8% per year on any balances and yet I figured that I could fairly regularly make 5%-7% on out-of-the-money naked put options on stocks I wouldn’t mind owning if I had to.

The way I do it is the following: I look for out-of-the-money put options that have a time value that if divided by the stock price would yield at least 5%. For example, let’s say a stock has a current price of $40 and has an out-of-the-money put option with a strike price of $38 for a premium of $2. The time premium is $2 so if we divide the time premium by the strike price, we get a return of 5.6% exclusive of the costs of the round trip commission. All that is needed is for the stock to stay neutral or move up until the option month expires. If you do that repeatedly, you can have some nice annualized returns. The key is to have the cash to cover the purchase of the stock if required to do so.

So, I decided to tap my company’s credit line for about 20% for trading activities. “Getting naked” became part of my everyday routine and low and behold after the first year I had managed to capture a total return of over 35% net all transaction costs. I was forced to cover only there times in the year. Within several months, I was able to recoup the LOC cost by liquidating the stocks once they reached breakeven. Over the past six years, I have accumulated almost as much money by going naked in my office as we make from one of our smaller divisions.

It might not be a good thing to do, but I, for one, don’t hold to selling naked puts as something bad. Just be sure you have a big wardrobe in the closet if you need it.

To learn more about options, take advantage of Options University to give you the education on everything you need to know about options-from basic to master.

May

28

Should you use an Option advisory Newsletter?

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It’s seductive. But is it too good to be true? Make triple digit returns on your horizontal money. Yeah, right. Are there really stock option traders who sign up for newsletters that promise high returns just by following instructions? Is there any entity watching over the hawkers of easy money newsletters? Or, are the promised returns for real? Investment newsletters cater to the do-it-yourself investor who is knowledgeable and confident enough to invest without a professional investment adviser, but too busy to track all of the potential investments himself. Most investment newsletter subscriptions cost between $100 and $300 a year. But trading stock options are not as simple as trading stocks. Stock options have so many uses and strategies that to be a good “do-it-yourselfer” probably means that you have too much free time or you have a real talent. But there are many stock option traders that think they know what they are doing but are really in over their heads. If you don’t believe me, just try reading some of the stock option trading blogs. Trading options is rarely about trading option calls or puts. Its much more about spreads, front and back months, analyzing deltas and understanding the differences between eagles, butterflies and other esoteric strategies. Not only is it understanding about the underlying stocks but also about the derivatives of derivatives. Let’s face it, its not for everybody. In it’s complexities lays the beauty of stock options for those who understand it.

Maybe the guys and gals who write the newsletters understand options and how to trade them and maybe they don’t. It should be easy to find out by having the authors of stock option trading newsletters provide an audited trade journal with all suggested trade results to substantiate their claims. The closest things I could find for some third party evaluations was the Hulburt Financial Digest.

Since 1980, Mark Hulbert has been monitoring the performance of investment newsletters and publishing the information in the Hulbert Financial Digest which is considered to be the preeminent source for advice on investment newsletters. Each year, Hulbert publishes a list of the top ten newsletters, ranked by performance. But before you start huting for inexpensive ways to make “big bucks”, you need to ask yourself some fundamental questions:

1. Do you want to learn about trading or are you more concerned about building wealth? If you’re not interested about learning the compexities of trading stock options, then you should be seeking third party confirmation of newsletter returns. Also, you need to make sure that you understand enough about trading options to enter and exit trades properly.
2. If you are interested in learning about options, you need a newsletter that is going to discuss the strategy and methodology of each trade and support if you have any questions.
3. Maybe a newsletter isnt the best way to go. It might be better if you hiried a trading mentor or contracted a service such as the Options University Strategist program which is a real time investment advisory service with trading analysis presented on a trade by trade basis. You learn and you earn. It costs more, but if the returns on capital and knowledge gained is worth it-it’s just the cost of doing business.

May

26

In Your Face

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“Favored stocks usually underperform and the out-of- favor stocks out- perform the market.”

They don’t know squat. Their recommendations are bogus and history proves it-market analysts have a lousy record. In his book, Contrarian Investment Strategies: The Next Generation, David Dreman drags the Wall Street analysts through the mud as he discloses why being a contrarian makes a lot of sense. John Bogle, chairman of the Vanguard Group, trumpets the study that showed that 90% of fund managers underperformed the market in every 10 year period since records began in the 1960s. As further testament to the “false gurus”, all the “smart money” was out of the market in ´87 but the “dumb money” stayed in and reaped the benefits when the market came roaring back.

Contrarians postulate that analyst recommendations help set up the overconfidence and emotion that makes it possible to make investments that take advantage of the positive affects of surprise. The basic premise is that the favored stocks usually underperform and the out-of- favor stocks out- perform the market. As a matter of fact, if a contrarian investor sees that 70% of Wall Street experts are bullish-a contrarian investor knows the market is topping out. Conversely, if the experts are 70% bearish, it’s a good time to invest. For those familiar with the technical tool-Relative Strength Index (RSI) – it does basically the same thing in that a buy signal is given when a stock is over-sold and a sell signal is generated when a stock is over- bought.

A contrarian investor looks for stocks that are solid but out-of-favor. Being solid can be defined as having a low price-to-earnings ratio, a favorable price-to-cash flow and a favorable price to book value. As option investors look closely at the underlying stock, contrarian fundamental investment strategies can be a very valid strategy.

Dreman goes on to list a series of 21 rules and 3 strategies for a contrarian investor to apply to their investing system. The three strategies are:
1. Look for stocks with a lower than industry price to earnings ratio.
2. Look for stocks with a lower than industry price to cash flow
3. Look for stocks with a lower than industry price to book value.
He also recommends that an investor in a contrarian stock should exit when any of the above criteria move back into the normal range.

Bottom line, contrarian investing is dedicated to using the consensus opinion of analysts and gurus as a contrarian indicator. Favored stocks and investments are to be avoided. A guru bullish fever is a signal to sell stocks and investments. Excessive Guru bearishness is a time to buy stocks and options. Additionally, according to Dreman, investors should look for “value stocks” which are for some reason off the radar or out of favor. These stocks have the powerful element of surprise which can have an explosive impact on price movement and is a powerful attraction for the mob chasing alpha.

As a stock option trader or stock investor, a contrarian point of view can form part of an effective investing strategy. However, a trader must be aware that a stock option with a thin market is something to be concerned about.

To learn more about options, take advantage of Options University to give you the education on everything you need to know about options-from basic to master.

May

24

Option Entrails

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“Even a losing trade can be “money well spent”.

It was the scene of a crime. There was no blood, but the damage had been done. I had repeated the same error I had done on several past option trades. Like a crime scene investigator, I put back the pieces of what had happened. The “vic”-me-had been overcome by the fear of being wrong- but it wouldn’t happen again.

“Live and learn”-if your smart enough. Unfortunately most would-be option traders learn mainly after getting hit over the head or slapped in the face; a reduced investing account balance and bruised ego act as a surrogate for a bloody nose and a knee in the groin. For an ill-prepared option trader, lessons can be costly and limited to just a few. Usually the last lesson is when you understand that you are over your head and don’t know what your doing. You put your tail between your legs and head back toward mutual funds and conservative buy-and- hold stocks investing.

Here’s your first lesson about stock options: get educated about stock options before you trade options. Sounds obvious, but only about 10% of stock option traders have taken professionally prepared courses on the subject. An industry cliché is that about 80% of all options expire worthless. Another cliché touts that only about 10% of option traders are successful. Is there a correlation here?

Learning about investing never stops. Once you understand the theory, your practical trading experience will be a life-long mentor-if you document and analyze. An excellent tool to help keep your eye on the ball and continuously improve is the trading journal.

Once a trade has been completed, not only should you analyze the technical aspects of a trade but also your state of mine. What were you thinking? What would you do differently next time? Make your experience count. But just merely writing it down doesn’t count if you don’t take the time to analyze it.
date of trade symbol # contracts open price total $ close price total $ fees net profit/loss$ %

Trade comments: This is the time to pull out your trading journal and make use of this valuable tool.

When you take the time to write things out and analyze after each option trade has been closed out, you’ll constantly improve and even a losing trade can be “money well spent”. The act of writing forces you to concentrate on what you are writing. Just thinking is not as effective. In the trade comments, make note of the things that happened and what to do next time you encounter the same or similar trade opportunities. By doing some introspective self-analysis of what you were thinking and feeling at the time, option traders will see how important it is to stay balanced, disciplined and detached. Self –analysis is very important part of an effective trading system and is very much worth the time it takes to do it properly.
On weekends and non-trading days, review your journal and look for patterns in your trading that may be causing losses or successes. Once patterns are identified, you’re really climbing the learning curve.
Most traders evolve and as they do, so does their system. Constant analysis should be a very important part of a traders discipline and the Trader’s Journal should be an integral part of your trading system.
To learn more about options, take advantage of Options University to give you the education on everything you need to know about options-from b

May

21

Through The Looking Glass

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By Greg Loehr

The following article appeared in this Month’s “Options Strategist” newsletter provided to members of the Options University. Greg is one of our pro trader-analysts and he presents a market strategy appropriate for the current period. Indeed, there is nothing like learning from the pros….a benefit of being part of the Options University student body.

SPX 1200 is upon us. This level was pointed out to me many months ago by a colleague who is skilled in technical analysis as a level to which the market would return before making any major moves to the downside.

How right he was in this call, at least to the move up to 1200, and I only wish that I had heeded it more than I did. Now many more technicians are calling this level one of major market resistance. Not only does this level match a Fibonacci retracement level from the low in March 2009, it also coincides with the market low in July 2008 just before the market completely imploded. These technicians join the growing throng of market analysts who continue to call this an overbought market and have done so for quite some time now.

Regardless of what you think of the technical analysis and the other market-watchers, if a lot of people think this is an important level, then it becomes an important level. I’ll be the last to say whether the market goes higher or lower, but if I had to pick up or down from here, I’d pick down only because of my colleague’s prescient call.

Trying to pick the top in the market is tough work, and plenty of people have been trying. In the Live Trading Labs we’ve been putting some trades to work that don’t hurt too bad if we’re wrong on direction, and I’ve discussed such trades in this column before. So it’s always best to wait for the tide to turn before jumping on the correction that everyone is looking for.

But what if the tide DOESN’T turn? With everyone looking at this level and thinking it’s a top, the contrarian in me thinks that more upside could be coming. Maybe there’s far too much bearishness for the market to go lower.

If the market moves above this so-called resistance level, it could force those who are short the market to close positions, thus fueling a rally because anyone short the market would need to buy stock. There’s also a ton of cash sitting on the sidelines (according to analysts) and these investors fell they have been missing the boat – and they have. So for this group, a move higher could also trigger them into the market, again providing fuel for a continued rally.

But, as I say, I’m not predicting one way or the other. But I am preparing for both. So how could we trade the market either way if there’s a move higher through resistance, or a move lower and a much called-for correction?

Market lower

Again, the rally stays in force until the rally is over. Don’t jump the gun. But if the market starts to sell off and the mainstream media starts to focus on bad news, the sell off will be accompanied very predictably with higher volatility. As of April 26 the VIX is trading at 17, and during the short sell off in February the VIX got up to 27. Buying June or July puts on the DIA’s, SPY’s or DJX can be profitable from both the downward move in the market and the spike in the volatility.

Market higher

A look at the monthly SPX chart shows a market that has been moving vertically on the chart for 12 out of the last 14 months. This is the same thing one sees on any chart for a stock that’s had a big move. Those who have sat on the sidelines and missed the big move are forced into the market because they’re tired of missing the move. And those who have shorted a big move are forced back in to close losing positions and this drives the stock straight up. And while no market goes up forever, you might be surprised at how long it can go on. So instead of trying to pick the top, just identify whether the trend is intact or has reversed, and then place the trade.

If the market breaks through resistance, I’m not sure what to think of the volatility. Conventional wisdom says that volatility will drop, but that really depends on the speed of the move. I’d approach a breakout by buying some ATM or near-ATM calls, but would be quick to spread them off into vertical spreads if the volatility starts to cave in. I wouldn’t be surprised to find any such move to be a fast one, so always hedge your risk by spreading it off where you can.

Only time will tell if this record rally is failing, but just be patient and let the market tell you which way the train is going rather than jumping in front of the train.

May

19

Seller Risk & Reward

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The seller of a time spread buys the nearer month option and sells the outer-month option in a one-to-one ratio. To profit from the sale of the time spread, the seller must look for two things.

The first is a decrease in implied volatility. As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher Vega in the out month option. This will cause the spread to contract or lose value and will be profitable for the time spread seller.

The second thing a seller should look for is a movement in stock. A time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread. As long as the stock moves in either direction away from the strike, the seller’s position could be profitable if time decay does not outperform the stock movement.

Time, unfortunately, never works in favor of the time-spread seller. The nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value, which produces a loss for the time spread seller.

Increases in implied volatility are also detrimental to the potential profits of the time- spread seller. When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long). This is due to the out month option’s higher Vega which creates an expansion in the spread and increases its value resulting in a negative for the spread seller.

The seller, in theory, has an unlimited loss potential. The maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility. As the seller, you will be long the front month call and short the out-month call.

The out month call will be more sensitive to movements in implied volatility due to a higher Vega or volatility sensitivity component. If implied volatility increases, then the seller’s short, out month option will increase more in value than will the seller’s long, front month option. This will cause the spread to widen or increase in value – a negative for the seller.

The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short. If volatility does not decrease or the stock does not move away from the strike significantly before the seller’s long option expires, (s)he will be left short a naked or un-hedged option and a loss on the position.

If the seller can wait out the position, the lost extrinsic value of the short option is retainable. This option also has a limited life and must shed its extrinsic value, no matter how much, by its expiration. The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.

Once the long option expires leaving the seller short a now naked call, stock price movement in the wrong direction is a substantial risk and under the circumstances described above, a big problem.

While the seller can wait out an implied volatility movement that created an increase in extrinsic value, they will probably not be able to wait out a large, negative stock movement creating an increase in intrinsic value. In that case, the seller must take action to prevent substantial losses once the front month expires. Attention to the implied volatility in the farther out option when the nearer month option expires can save the seller from a large loss.

May

17

Getting Out or Rolling the Position

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The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence.

Looking at the closing out of a vertical call spread, we find there are three possible outcomes. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In order to close out the spread, an investor would just let it expire. Both options finish out of the money so there is no residual position left over.

If the spread finishes fully in-the-money (at maximum value), meaning both options in-the-money, both options are exercised. You will exercise your long call and your short call will be assigned. They cancel each other out leaving you with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.

Investors encounter a difficult scenario when a stock closes in between the two strikes of the spread. This creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money. When both options expire in-the-money, they are both exercised. One creates a long stock option, the other a short position canceling each other out. This is not the case here. The option that is in-the-money leaves a residual stock position. Since the other option is out-of-the-money, it cannot offset the residual stock position created by the expiring in-the-money option.

Two actions are possible in this scenario. One involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. This may be the best thing to do in order to avoid naked, unlimited risk.

If you only trade out of the in-the-money option, you run the risk that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. This risk is short-lived because you are doing this late on expiration day of the expiring month. If this happens, you will be naked in the residual stock position.

If there is still time, you can always trade out of the option, but that is very risky. If the stock is at a relatively safe distance from the out-of-the-money option, you may want to just close out the in-the-money option and let it expire worthless.

The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option.

Remember, this takes place at the very end of the day on expiration day. These options only have minutes of life left. The risk is somewhat mitigated, but still there nonetheless.

The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, it is best to trade out of the spread entirely.

As stated before, if the stock closes either with the spread fully in-the-money or out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position.

We discussed how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.

If you have 10 July 50 calls and you exercise them, you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.

May

14

Answers to Test Your Options Knowledge

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1) Call options give buyers the:
b) Right to buy stock
Long options always give the buyer some type of right. You will never incur an obligation by purchasing an option. Call options give buyers the right, not the obligation, to buy stock. If you buy a call, you can purchase 100 shares of the underlying stock at any time for the strike price.

2) Put options give buyers the:
d) Right to sell stock
Put buyers have the right, not the obligation, to sell stock. The put owner can sell 100 shares of stock and receive the strike price at any time through expiration.

3) Option sellers:
d) Both b and c
Option sellers receive a premium for accepting an obligation. The seller of a call has the potential obligation to sell shares of stock for the strike price while the put seller has the potential obligation to buy shares of stock for the strike price.

4) One option contract generally controls how many shares of stock?
d) 100
When options are first issued, they generally control 100 shares of stock.

5) You bought an Intel $25 call. The “$25” figure is called the:
c) Strike price or exercise price
The price at which you are contracting to trade shares of stock is the exercise price. It is also called the strike price because that’s where the deal was “struck.”

6) The intrinsic value of an option represents the:
b) Immediate benefit
For call options, the intrinsic value is found by taking the stock price minus the strike price, assuming it is a positive amount. For put options, we take the strike price minus the stock price, assuming it is positive. With the stock at $55, a $50 call has $55 – $50 = $5 of intrinsic value. A $60 call has no intrinsic value since $55 – $60 = negative $5. Likewise, a $50 put has no intrinsic value since $50 – $55 = negative $5. The intrinsic value represents the amount of “immediate benefit” to the owner. If the stock is $55, the $50 call owner is better off by $5 since he can pay $50 for the stock rather than $55. The $60 put holder can sell his stock for $5 more than the current market price of $55 so he is better off by $5 as well. Whenever you are trying to figure out the intrinsic value, think if there is an immediate benefit in owning that option. If there is, it has intrinsic value. The intrinsic value is also the amount that the option is in-the-money.

7) You are long an ABC $40 call. How much will it cost to exercise the call?
c) $4,000
Each contract controls 100 shares of stock and you have the right to buy it for $40 per share. Therefore, it will cost 100 shares * $40 per share = $4,000 to exercise the call. In return, you will receive 100 shares of ABC.

8) If you are “long” options:
a) You are not required to ever buy or sell the stock
If you are long options, whether calls or puts, you have rights. This means you are not required to ever buy or sell stock. You can buy or sell stock if you choose. It is your option to do so.

9) Which of the following is true?
b) Long positions exercise, short positions get assigned
Long positions have the rights. It is the long position that decides whether or not to exercise. If the long position exercises then the short position must oblige. The short position has the obligation.

10) XYZ is trading for $74. The XYZ $70 call is trading for $4.50. What are the intrinsic and time values?
a) $4 intrinsic, 50 cents time
There is an immediate advantage in owning this call since it gives the buyer the right to pay $70 for a stock that is trading for $74. Specifically, there is a $4 advantage so that is the intrinsic value. The remaining 50 cents of value is due to time.

11) ABC is trading for $107. The ABC $110 call is trading for $4. What are the intrinsic and time values?
c) $0 intrinsic, $4 time
There is no immediate benefit in holding this call since it gives the buyer the right to pay $110 for a stock that is currently trading for $107. Therefore, there is no intrinsic value to this option. However, this does not mean the option has no value. Because time remains on the option, the stock does have a chance of rising above $110. All of this option’s value is due to the fact that time remains on the option.

12) An option is bidding $3 and asking $3.20. What does this mean?
d) Both a and c
The bid represents the highest price that someone is willing to pay. In other words, it represents the highest bidder. The asking price represents the lowest price at which someone will sell. Because someone is willing to pay $3, this means we can sell to that person if we wish to sell this option. Likewise, because someone is willing to sell for $3.20, we can buy the option for this price.

13) The bid and ask represent the:
c) Highest bidder and lowest offer.

14) Microsoft is trading for $29 and the $30 put is trading for $2.50. This put is:
a) $1 in-the-money
Put options give the holder the right to sell stock. Because this put allows the holder to sell for $30 when the stock is trading for $29, there is a $1 immediate benefit in holding this put. Therefore, this put is $1 in-the-money.

15) ABC stock is trading for $47. You just purchased an ABC $45 call for $3. If the stock remains at $47 at expiration, what is the amount, if any, you will lose on this option?
b) $1
This call has $2 intrinsic value and $1 time value. If the stock is $47 at expiration, this option will be worth the $2 intrinsic value so the most you could lose is the $1 time value. Remember, the key to this question is that the stock remains at $47 at expiration. It is true that the most you could ever lose on this (or any) option is the amount paid, or $3 in this example. But the question is assuming the stock remains at $47. The only way you could lose more than the $1 time value is if the stock’s price falls below $47.

16) If you wish to exercise an option, you must:
d) Submit exercise instructions
You are free to exercise an equity option at any time and the OCC guarantees the performance so there’s no need to find a buyer or seller. The only thing you must do is submit exercise instructions to your broker which is done with a simple phone call.

17) The OCC:
b) Is the buyer to every seller and seller to every buyer
The OCC acts as a middleman to every transaction. If you buy an option, you are really buying it from the OCC. If you sell an option, you are selling it to the OCC.

18) Options trade in units called:
a) Contracts
Options trade in units called “contracts” because that’s what they are – contracts between two people to buy and sell shares of stock. Stock trades in “shares” while options trade in “contracts.”

19) The last trading day for options is:
c) The third Friday of the expiration month
The last trading day is the third Friday of the expiration month. Technically, options expire on Saturday following the third Friday but the last “trading” day is the third Friday.

20) Because a portion of an option’s value declines over time, options are referred to as:
b) Wasting assets
A wasting asset is one whose price declines with the passage of time. Some options decline very little while others decline much more and much faster. Regardless, all options are classified as a wasting asset.

21) Which “style” are all equity options?
d) American
All equity options are American style, which means you can exercise them at any time prior to expiration. Bermudan and Asian options are actually styles too but they fall under the category of exotic options.

22) If you sell a put option, you have:
a) The potential obligation to buy stock
Put sellers have the potential obligations to buy stock. They must buy the stock only if the long put holder decides to exercise.

23) If you sell a call option, you have:
b) The potential obligation to sell stock
Call sellers have to sell stock only if the long call holder exercises.

24) If you sell an option, you collect a premium. What happens to that premium if you are assigned?
c) You keep the premium regardless of whether you’re assigned or not
Option sellers always keep the premium regardless of what happens. That is their fee for accepting some type of obligation (risk).

25) If you buy or sell an option, you can escape your obligations by:
d) Entering a reversing trade
You can always get out of an option contract by entering a reversing trade of the same month and strike. If you originally purchased an ABC $50 call you would enter a reversing trade by selling an ABC $50 call.

May

12

Test your Options Knowledge

Filed Under Option Trading Articles | Leave a Comment

1) Call options give buyers the:
a) Obligation to buy stock
b) Right to buy stock
c) Obligation to sell stock
d) Right to sell stock

2) Put options give buyers the:
a) Obligation to buy stock
b) Right to buy stock
c) Obligation to sell stock
d) Right to sell stock

3) Option sellers:
a) Have rights
b) Receive premiums
c) Have obligations
d) Both b and c

4) One option contract generally controls how many shares of stock?
a) 25
b) 50
c) 75
d) 100

5) You bought an Intel $25 call. The “$25” figure is called the:
a) Contract value
b) Moneyness
c) Strike price or exercise price
d) Intrinsic value

6) The intrinsic value of an option represents the:
a) Time value
b) Immediate benefit
c) Contract value
d) Strike price

7) You are long an ABC $40 call. How much will it cost to exercise the call?
a) $40
b) $400
c) $4,000
d) $40,000

8) If you are “long” options:
a) You are not required to ever buy or sell the stock
b) You are required to buy or sell the stock if assigned
c) You are obligated to buy stock at some time
d) You receive premiums

9) Which of the following is true?
a) Long positions get assigned, short positions exercise
b) Long positions exercise, short positions get assigned
c) Long and short positions can exercise
d) Long and short positions can get assigned

10) XYZ is trading for $74. The XYZ $70 call is trading for $4.50. What are the intrinsic and time values?
a) $4 intrinsic, 50 cents time
b) $4.50 intrinsic, $0 time
c) 50 cents intrinsic, $4 time
d) $0 intrinsic, $4.50 time

11) ABC is trading for $107. The ABC $110 call is trading for $4. What are the intrinsic and time values?
a) $1 intrinsic, $3 time
b) $3 intrinsic, $1 time
c) $0 intrinsic, $4 time
d) $4 intrinsic, $0 time

12) An option is bidding $3 and asking $3.20. What does this mean?
a) The highest price that someone will pay is $3 and the lowest price at which someone will sell is $3.20.
b) The highest price that someone will pay is $3.20 and the lowest price at which someone will sell is $3.
c) You can currently buy the option for $3.20 and sell it for $3
d) Both a and c

13) The bid and ask represent the:
a) Lowest bidder and highest offer
b) Highest bidder and highest offer
c) Highest bidder and lowest offer
d) Lowest bidder and lowest offer

14) Microsoft is trading for $29 and the $30 put is trading for $2.50. This put is:
a) $1 in-the-money
b) $1 out-of-the-money
c) $2.50 in-the-money
d) $2.50 out-of-the-money

15) ABC stock is trading for $47. You just purchased an ABC $45 call for $3. If the stock remains at $47 at expiration, what is the amount, if any, you will lose on this option?
a) $0
b) $1
c) $2
d) $3

16) If you wish to exercise an option, you must:
a) Find a buyer or seller
b) Do so only at expiration
c) Submit assignment instructions
d) Submit exercise instructions

17) The OCC:
a) Guarantees an option’s profit
b) Is the buyer to every seller and seller to every buyer
c) Acts as a mediator for disputes
d) Requires you to become a member before trading options

18) Options trade in units called:
a) Contracts
b) Shares
c) Round lots
d) OCC units

19) The last trading day for options is:
a) The second Thursday of the expiration month
b) The second Friday of the expiration month
c) The third Friday of the expiration month
d) Saturday following the third Friday

20) Because a portion of an option’s value declines over time, options are referred to as:
a) Physical delivery assets
b) Wasting assets
c) Linear assets
d) Cash delivery assets

21) Which “style” are all equity options?
a) Bermudan
b) Asian
c) European
d) American

22) If you sell a put option, you have:
a) The potential obligation to buy stock
b) The potential obligation to sell stock
c) The right to buy stock
d) The right to sell stock

23) If you sell a call option, you have:
a) The potential obligation to buy stock
b) The potential obligation to sell stock
c) The right to buy stock
d) The right to sell stock

24) If you sell an option, you collect a premium. What happens to that premium if you are assigned?
a) You only keep the premium if you are assigned
b) Option sellers do not receive the premium
c) You keep the premium regardless of whether you’re assigned or not
d) You only keep the premium if you are not assigned

25) If you buy or sell an option, you can escape your obligations by:
a) Entering a reversing trade in a different month
b) Entering a reversing trade at a different strike
c) Entering the same trade again
d) Entering a reversing trade

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