THE ULTIMATE GUIDE TO
TRADING OPTIONS
BY
TRADING ADVANTAGE
1
WHAT’S IN THIS GUIDE?
Winning. That’s what this guide is all about. We’ll expose the secrets, tips and techniques used by some
of the BEST options traders in the game to help put the odds in your favor and win this zero-sum game.
We’ll reveal:
Secret formulas and systems to make quick returns
The habits needed to achieve options trading success
Major mistakes made by rookie options traders and how to avoid them
Some of the most powerful options trading strategies on earth
What separates the winners from the losers
And much more…
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ABOUT THE AUTHORS
Larry Levin
PRESIDENT & FOUNDER, TRADING ADVANTAGE
Starting over 25 years ago as a runner at the
CME group, the world’s largest and most
diverse futures exchange, Larry Levin quickly
climbed the ranks to become one of the
most successful traders in the S&P 500 pit.
At the height of his trading career, Larry
averaged between 2500-3000 S&P contracts
per day.
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ABOUT THE AUTHORS
Scott Bauer
SENIOR OPTIONS INSTRUCTOR, TRADING ADVANTAGE
A respected market commentator seen on
CNBC and other major financial networks,
Scott Bauer has 20 plus years of professional
equity and index options experience
including over ten years as a Chicago Board
Options Exchange (CBOE) market maker
and a trader for Goldman Sachs. Scott
graduated from the University of Illinois
Business School and has taught classes both
at his alma mater and at the CBOE.
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ABOUT THE AUTHORS
Michael Shorr
OPTIONS INSTRUCTOR, TRADING ADVANTAGE
Michael Shorr is a veteran derivatives trader
of the CME, CBOT, and CBOE. He has broad
market knowledge ranging from agricultural
to treasury markets. Michael has taught
options theory classes for a number of years
and possesses an entertaining and relatable
teaching style.
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TABLE OF CONTENTS
Introduction
6
Mechanics Of Options Trading
7
The 25 Greatest Secrets, Tips and Techniques
Top Secrets from Legendary Traders that Will Transform Your Options Trading
The “Magic” 3-Step Formula that Rookie Traders are Using to Beat Wall Street
The Key to Turning Your Portfolio into an Income Generating Machine
Seven Habits of Highly Successful Options Traders
The Three Deadly Sins of Options Trading
A Go-To Strategy for the Next Market Crash
The K.I.S.S. Strategy
11
15
20
24
29
33
37
Next steps
41
Glossary of Terms
43
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INTRODUCTION
Welcome to the world of options trading...
You have decided to embark on a journey
that can potentially provide enormous
financial rewards for the educated and
disciplined.
While many investors are afraid to use
options and think they’re risky, options can
be an extremely powerful tool in your trading
arsenal. In fact, options are the most versatile
financial instrument at your disposal.
While options may appear complicated and
difficult to master to the novice, they are an
indispensable tool for the professional
traders that must generate positive income
to pay their bills.
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By utilizing the power of options, you can
potentially:
Trade market direction with less exposure
and significantly lower margin
requirements
Generate income from stocks or
instruments you already own
Hedge your existing market exposure
and/or tail risk
Potentially profit from changes in implied
volatility
Potentially profit from nothing more than
the passage of time
So how do you become a profiting options
trader? First, let’s take a look into the
mechanics of options trading.
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THE MECHANICS OF OPTIONS TRADING
Before we dive into the secrets, tips and
techniques, we should first cover some basic
terminology and concepts to make sure
we’re all on the same page.
An option is a contract to buy or sell
underlying instrument or underlying interest.
Owning stock options is not the same as
owning shares of stock.
There are two types of Options: CALLS and
PUTS. Call options give the owner the right
to buy the underlying asset; put options give
the owner the right to sell the underlying
asset.
If you own an option, you have the right, but
not the obligation to control your stock at a
specified price, (STRIKE PRICE), until a
specified time, (EXPIRATION DATE). If an
option is not exercised before the expiration
date, it will expire, or cease to exist.
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BASIC TERMS YOU NEED TO KNOW
The STRIKE PRICE, or EXERCISE PRICE, is
the price at which the underlying asset may
be purchased or sold. Equity (stock) option
strike prices are listed in increments of 0.50,
1, 2.5, 5, or 10 points, depending on the
price level of the stock.
The EXPIRATION DATE is the date the
option expires. A stock option expires at the
market's close on the 3rd Friday of the
expiration month.
There are two definitions of options
PREMIUM. The first refers to the price of the
option. The second definition and the one we
will generally use is the extrinsic (time) value
of the option above and beyond any intrinsic
value of an option. In either definition, an
option's PREMIUM is determined by many
factors, including the current price of the
asset, the strike price of the option, the time
remaining until expiration, interest rates,
dividends and volatility.
All listed options can be traded with at least
four expiration dates, and usually more.
Some stocks and indices have options that
trade as far out in the future as two years
(LEAPS).
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An option's premium is on a per-share basis
and represents 100 shares of the underlying
asset. If the premium of an option is 6, the
total premium for that option is 600 (6 x 100).
Purchasing an option creates a debit to your
trading account in the amount of the
premium paid. There are no margin
requirements when you purchase options
because your risk is limited to the premium,
the price of the option.
Selling an option creates a credit to your
trading account in the amount of the
premium collected. However, because option
sellers have an obligation to either buy or sell
the underlying equity if their option is
exercised by an option owner, selling an
option requires a substantial margin.
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How do options offer an investor
LEVERAGE? Option buyers can pay a small
premium for market exposure as compared
to the actual price of the asset to which it is
attached. Investors can see large returns
from even small, favorable percentage moves
in the underlying equity. Option buyers also
know their RISK. The maximum loss would be
the premium amount paid for that option.
However, an option seller potentially has
unlimited risk.
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Trading stock options, especially in today's
volatile market, can offer an investor the
following advantages:
Protection from a decline in the overall
market or in the price of a long underlying
security.
The ability to purchase stock at a lower
price or sell stock at a higher price.
The ability to create additional income
against a long OR a short position.
Profit potential from a move in the price
of a stock, regardless of direction.
Now that we’ve got the basics covered, let’s
look at top secrets from legendary traders
and how you can begin to deploy these
secrets today to catapult your own options
trading.
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TOP SECRETS FROM LEGENDARY TRADERS
THAT WILL TRANSFORM YOUR OPTIONS TRADING
Throughout history, certain men and women
have achieved great success in financial
markets. These successes were not due to
luck and were certainly not a fluke. Many of
the most legendary traders achieved such
status due to the consistency with which they
were able to beat the market.
While traders tend to have their own styles,
habits and methodologies, the most
successful traders share a number of
traits-and secrets-that have helped them
reach the top of an extremely competitive
field.
Top Secret #1
FIND YOUR OWN STYLE
No two traders are exactly the same. Traders
may have completely different goals and
objectives and may trade all different kinds of
markets. While some traders may utilize a
very technical approach, others may be more
reliant on market fundamentals. Some may
trade options as a standalone instrument
while others may use options in conjunction
with stock, futures or other instruments.
Whatever the case may be - find your own
way.
So what are the top secrets of these trading
superstars?
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Top Secret #2
Top Secret #3
Many traders that have tremendous potential
all too often are out of the game too fast
because they are not properly capitalized. It
is imperative to determine your trading goals
and objectives. For example, a trader looking
to make a full-time living from trading is
going to need a substantially larger account
than a trader who is simply looking to build
wealth over a period of time. The products
traded will also have a significant impact on
the amount of capital required. For someone
looking to day-trade, stocks will require more
capital than futures or forex.
The ability to lose like a professional is key to
your trading success. No one has a crystal
ball - NO ONE. The difference between a
novice trader that loses money consistently
and a professional trader that makes money
consistently is how they take losses. Novice
traders tend to hold onto losing positions,
and find themselves hoping and praying for
the market to reverse course. Professional
traders, on the other hand, understand that
taking losses is part of the game, and do so
with grace and objectivity.
BE PROPERLY CAPITALIZED FOR YOUR OBJECTIVES
LEARN TO LOVE LOSING
Whichever path you choose, make sure you
are working with adequate capital to endure
the inevitable draw-downs that are part of
trading.
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Top Secret #4
Top Secret #5
Trading is a psychological game. While
methodology and strategy are important,
without the right psychological mindset you
are destined for failure. The emotions of fear
and greed must be overcome to be
successful in this endeavor. Top traders not
only take losses like professionals, but they
are happy to do so. They understand that by
taking a loss, they are protecting their capital
from further losses that can take them out of
the game. On the other hand, professional
traders know when to take profits. They have
an uncanny ability to let their profits run, but
do not get overly greedy in the process,
allowing a big winner to turn into a small
winner, or worse yet, a loser. Top traders
remain objective at all times, and do not
allow emotion to dictate trading decisions.
Trading for a living is a business and should
be treated accordingly. To be a successful
full-time trader, we recommend viewing your
trading as a business that can provide a very
good livelihood for you and your family. This
means putting in the time to perform market
research, doing technical analysis and
structuring positions with care and attention
to detail.
CONQUER YOUR OWN HUMAN NATURE
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TREAT TRADING LIKE A BUSINESS
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Top Secret #6
ALWAYS STRIVE TO GET BETTER
Top traders are always, ALWAYS looking for
ways to improve. Markets can and do
change, and as traders one must be able to
adapt strategies accordingly. Trading is a
life-long journey, a journey with no end. In
trading, just as in any other field or
occupation, the best are always looking for
ways to get better. The best never sit on
their heels, and never allow themselves to
become content and complacent. By always
looking for ways to sharpen your skills, you
can help ensure you stay at the top of your
trading game.
business that can potentially provide
enormous financial benefits while allowing
you to live life on your own terms.
While there is no “Holy Grail” when it comes
to trading, these simple guidelines from
some of the world’s best traders can get you
a step ahead. By putting in the time and
effort, and with a willingness to be a life-long
learner, you can catapult your trading into a
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The “Magic” 3-Step Formula Rookie
Traders Are Using to Beat Wall Street
You don’t have to trade on Wall Street to win
like a Wall Street trader. More and more of
today’s investors are putting their money into
their own hands. These investors, having
chosen to take control of their own destiny,
could now also be referred to as traders. In
fact, there are traders out there right now
that are beating Wall Street as we speak.
Many of these traders come from
non-financial backgrounds, and some have
had very limited experience in trading
altogether.
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So How Are They Beating Wall Street?
Today’s financial markets have become more
complex, more efficient and more
competitive. The market is still, at its core, an
auction. It is a market of buyers and
sellers-nothing more and nothing less.
Acknowledging this fact, and removing a lot
of the common “noise” surrounding trading,
is a great start.
There are three key steps that even novice
traders are taking right now to beat Wall
Street.
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Step #1
Know thy market. Successful traders do not
generally go out and trade multiple financial
instruments. Have you ever seen a successful
S&P pit trader who was also a pro stock
trader? Not likely. How about a successful
stock trader that also killed it in the grain
markets? Again, not likely.
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Today’s financial markets can lead to
information overload. Most successful traders
focus on a single product or arena to work in.
For example, a treasury trader may trade
bonds, 10 year notes and five year notes. Or
an energy trader may focus on crude oil and
natural gas futures. The point is this: When
you begin to spread yourself out, you may
dilute your trading abilities. Focus on one
market or one area. Become intimately
familiar with it. Feel like you know what it’s
going to do before it does. Study your craft,
and put all of your efforts into mastery of this
single product or space.
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Step #2
Understand Risk. When it comes to trading
and investing, the name of the game is risk.
One way to think of trading is simply a
transfer of risk from one party to another. For
example, if you sell a cash secured put on
stock XYZ, you have just assumed the risk of
that stock falling below the strike price, in
which case you will have to take delivery of
the shares. On the other hand, the person
that purchased the put from you has
effectively just transferred his risk of the
stock moving lower to you.
Risk Mitigation and Risk Acceptance
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Traders are out there beating Wall Street and
other professional traders right now have a
deep understanding of risk. They have risk
management protocols in place, and they
adhere to these protocols under even the
most difficult of circumstances. For the
layperson, it’s sometimes referred to as
discipline.
Risk is part of trading and investing, any way
you slice it. Most people lose money trading
because they have no concept of proper risk
management.
The first step on the road to making
money is not losing money!
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Step #3
Know the costs of doing business.
Unfortunately for the public, Wall Street and
other financial markets are set up in such a
way that makes it extremely difficult for the
average trader or investor to turn a profit.
Markets and exchanges are in the game for
the same reason as you are; to make money.
If you are trading stocks, find a reliable
discount broker and negotiate your
commissions and fees. If you are trading
futures, go to a discount broker or even
directly to an Futures Commission Merchant ,
or FCM, to get the lowest rates possible.
Commissions, data feeds, memberships – all
of these costs of trading can add up quickly.
In fact, many traders are able to make money
in the market, but end up net losers overall
after factoring in all of these costs.
Traders currently beating Wall Street
understand this, and take whatever steps are
necessary to gain an edge.
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continued...
Track your expenses, and always strive for
ways to lower them.
Commissions and fees can turn a winner
into a loser
Make sure that any potential market
opportunities are large enough to cover the
costs of doing business. Do not turn into a
“commission generator” for your brokerage
or clearing firm
By following these three simple steps,
you will gain an advantage over the
majority of market participants.
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THE KEY TO TURNING YOUR PORTFOLIO
INTO AN INCOME GENERATING MACHINE
Many traders and investors do not realize
how to utilize the power of their portfolios.
When you think of your portfolio, you may
think of a basket of stocks you have held for
years, or perhaps mutual funds you may have
owned since the Reagan Administration was
still in office.
You may have been told that “buy and hold”
is the way to invest for the future…
In reality, your portfolio can be used for so
much more. When used with proper risk
management and sound investment
strategies, your portfolio can give you the
ammunition you need to potentially generate
returns in any market condition. Up, down,
sideways-it doesn’t matter.
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How does this relate to trading options? Let
me dig deeper…
You see, when you own stocks for example,
you own an asset that fluctuates in price. The
stock may also pay you dividends. Many
stocks, however, also have listed options
contracts. These options contracts can be
purchased to hedge your position, to play
earnings, or to try to generate additional
income.
Markets may trend higher, they may trend
lower, or they may simply stay in a sideways
trading range. Many stocks spend a great
deal of time within a certain range. Why not
take advantage of that?
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The covered call write strategy is one widely
used and simple strategy to learn. Using this
strategy, you will write one out-of-the-money
(OTM) call option for every 100 shares of
stock you are long. An OTM has no intrinsic
value, but only possesses extrinsic or time
value. When were are talking about call
options, an OTM has a strike price that is
higher than the market price of an underlying
asset.
Selling these calls may accomplish two things:
First of all, the sale of out-of-the-money calls
may provide a hedge against your position.
Let’s look at an example: Suppose that you
are long 500 shares of stock XYZ which is
currently trading at $40 per share. The stock
has stalled out a bit, and you believe it may
remain around $40 for the next few months.
You decide to sell five of the front month
$42.5 call options on the stock for $.40 each,
therefore collecting a total premium of $2.00
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not including any transaction costs.
If the stock price drops, the calls will lose
value and in the process partially offset your
losses on the share price. In this case, each
call for 100 shares was sold for $.40, so the
breakeven on the position would be $39.60
per share.
If the stock goes sideways, the calls may lose
value through the power of time decay. In
this case you are neither making nor losing
money on the stock itself, but now you are
potentially profiting as the short calls lose
value as they approach expiration. Assuming
the short calls expire worthless, you would
then keep the entire $2.00 premium collected
as profit.
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If the stock price rises, you may still
potentially make money. Your long stock
position would gain in value as the share
price goes up, however, your short calls may
also be increasing in value. The key is where
the stock is at expiration. If the stock price is
below the strike price of $42.50 at expiration,
the calls will still expire worthless. In this
case, you have now potentially made money
on the stock itself and the short calls.
Iron condors consist of a short call spread
and a short put spread with the idea being
that the market will remain between the two
spreads, allowing all options to expire
worthless.
Iron condors can provide a very wide
potential profit zone, and can possibly make
money in two ways. The first way is through
time decay. The second way is through a
drop in implied volatility.
Range-bound = Opportunity
In addition to covered call writing, there are
numerous other ways to potentially profit in
markets that are consolidating or moving
sideways and you don’t need to own the
stock or contract to take advantage. Let’s
talk briefly about another popular strategy
that anyone can learn: The iron condor.
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Let’s look at a simple example:
You own 1000 shares of stock WWW. You
have owned the shares for years, and the
company pays a decent dividend. The stock
has, however, traded in a relatively tight
range for several years now, oscillating
between $35 and $40 per share.
In addition to earning dividends on your
shares, you decide to use iron condors on the
stock to try to generate additional income.
With WWW currently trading at $37 per
share, you initiate the following position:
Sell 10 of the front month $41/$45 call
spreads for a premium of $.50 each.
Sell 10 of the front month $34/$30 put
spreads for a premium of $.50 each.
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You have collected a total of $10 in option
premium.
If WWW simply stays between the short
strike process of $34 and $41, all options will
expire worthless and you keep the entire $10
credit collected (Not including applicable
transaction costs). This equates to $1000 in
gross income that was generated.
On the other hand, if the share price rises
and is above the short call strike of $41 at
expiration, you may lose your shares of the
stock upon assignment (you’d be assigned a
short position in the stock at $41 thus
offsetting your existing long stock position).
In this case, you would have made another
dollar on the stock price going higher, and
you would still keep the $10 of option
premium collected.
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In another scenario, if the stock price falls,
you will be losing money on your long stock
position and potentially losing money on the
short put spreads. If WWW is below the short
put strike of $34 at expiration, you will be
assigned an additional long position from
$34. In this case, the call spreads sold would
expire worthless, and you would still keep the
total option premium collected. You now,
however, have a larger underlying position in
the stock itself and therefore have more
exposure.
Your portfolio does not have to be treated as
a passive source of wealth building. Quite to
the contrary, by using various options
strategies, you have the potential to turn
your existing portfolio into an income
generation machine that can potentially build
your wealth with greater speed or provide an
additional source of income.
The Point is This:
By using cash and/or securities already in
your portfolio, you have the potential to
generate some serious additional income.
Of course, trade selection and potential
stocks or contracts with which to utilize such
strategies should be carefully considered.
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SEVEN HABITS OF HIGHLY
SUCCESSFUL OPTIONS TRADERS
While options may seem perplexing to
traders who are new to the game, once you
have a deep understanding of options and
options pricing, you will have a very powerful
weapon in your trading arsenal. In fact,
options are one of the most, if not the most,
versatile financial instruments at your
disposal.
Like any other financial instrument, trading
and using options successfully requires
knowledge, perseverance and good trading
habits.
It is these solid trading habits that separate
the novices from the professionals, and the
winners from the losers. While some of these
habits apply specifically to options traders,
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many of the habits of highly successful
options traders can also be applied to trading
in other instruments as well. Here we will
briefly discuss seven habits of highly
successful options traders:
Habit #1
HIGHLY SUCCESSFUL OPTIONS TRADERS UNDERSTAND
HOW OPTIONS ARE PRICED, AND CONSISTENTLY PUT
THAT KNOWLEDGE TO USE
This allows successful options traders to
avoid paying too much for an option, or
selling an option for too little. In fact, option
pricing theories are the basis for options
trading, and without habitually putting these
theories to work, you will be giving up a
great deal of “edge.” Highly successful
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options traders understand the importance of
having an edge, and will seek out any and all
opportunities to gain one.
trading decisions on potential changes in
implied volatility.
Habit #2
HIGHLY SUCCESSFUL OPTIONS TRADERS FOCUS ON
RISK MANAGEMENT
HIGHLY SUCCESSFUL OPTIONS TRADERS FOCUS ON
VOLATILITY
Successful options traders understand that
volatility is the name of the game. While
options can be used to trade directionally or
for premium collection strategies, pros
understand that options derive a great deal
of their value from volatility — both historical
and implied. Successful options traders
understand how implied volatility affects
options, and structure their trades and
strategies accordingly. In order to be
successful in trading options, you must
always consider volatility and how it may
potentially affect your position. Successful
options traders always consider this key
component and base
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Habit #3
If you do not have a solid understanding of
risk management and employ concrete risk
management techniques in your trading, you
are likely going to be out of the game before
long. Highly successful options traders place
an emphasis on risk, and have parameters in
place for trade risk and overall account
management. These risk management habits
help pros cut losing positions short, while
maximizing winning positions. Highly
successful options traders understand that
the first step to making money consistently is
not losing money.
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Habit #4
Habit #5
These traders will only put their capital at risk
in positions that they feel have a high
probability of success. They also have a
thorough understanding of percentages and
other basic mathematics involved in options
trading. For example, successful options
traders understand that if an option or asset
loses 25 percent of its value, it will have to
see a gain of 33 percent to break even. The
most successful options traders focus on
putting the odds and probabilities in their
favor as much as possible. This is why you will
not likely see a professional options trader
buying extremely deep out-of-the-money
options that have little statistical chance of
making a profit.
Highly successful options traders understand
and accept that losing is a part of winning.
These successful traders strive to remain
focused and objective at all times, and do not
allow themselves to get attached to a
position or become greedy. They understand
that periods of losses can and do occur, and
that even in the best of times, profits can be
fleeting.
HIGHLY SUCCESSFUL OPTIONS TRADERS THINK IN
TERMS OF ODDS AND PROBABILITIES
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HIGHLY SUCCESSFUL OPTIONS TRADERS DO NOT ALLOW
THE POWER OF EMOTION TO CONSUME THEM
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Habit #6
HIGHLY SUCCESSFUL OPTIONS TRADERS NEVER STOP
LEARNING
Markets can and do change over time, and
successful options traders are constantly
looking for ways to improve their trading
skills. They are life-long students of the
market, and they take complete responsibility
for their ability to learn and grow as trader.
They habitually read books, confer with other
traders and stay in touch with the markets in
which they trade.
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Habit #7
HIGHLY SUCCESSFUL OPTIONS TRADERS HAVE A LIFE
OUTSIDE OF MARKET HOURS
The most successful traders realize and
understand that trading is simply a means to
an end. Even the most successful traders
require a break now and then to recharge
mentally and emotionally, and spending some
time away from the trading screen allows
them to do just that. This keeps them sharp
and focused during market hours and may
potentially allow them to achieve a higher
level of success. Trading options for a living is
a job, and like any other job one must
distance themselves at times to regain
perspective.
The most successful options traders
understand the importance of employing
these habits each and every day.
Fortunately, numerous studies have shown
that adopting habits does not take long.
Start practicing the habits of highly successful
options traders today, and before long these
habits will become ingrained and second
nature.
While there is no “Holy Grail” to options
trading, by constantly adopting the habits of
highly successful options traders you can
greatly increase your odds of success.
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THE THREE DEADLY SINS OF OPTIONS TRADING
Trading options, just like trading any other
type of financial instrument, involves a
number of potential pitfalls that can quickly
drain your account.
Knowing some of the possible traps traders
commonly fall into, and how to avoid them,
can give you an edge in your trading and
potentially give you more staying power in
the markets.
Through our 20 years of trading education,
we’ve identified three deadly sins of options
trading and ways to keep your trading free
from evil…
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Sin #1
BUYING OPTIONS AND LETTING THEM EXPIRE
WORTHLESS
This one is really a no-brainer. When you
purchase an option, whether it is to hedge,
play market direction, or get long volatility,
you should still draw a line in the sand. Just
because your risk is limited on an options
purchase to the premium paid, does not
mean you have to sacrifice that entire
premium! Many novice options traders make
this simple, yet significant, mistake. Because
of the defined-risk nature of long options,
they consider it to be a “set and forget” type
of trade and willingly lose all the money they
paid for the option in many cases. Let’s look
at a quick example:
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Investor Joe believes that the price of crude
oil is about to rise. Crude oil futures are
currently trading at $50 per barrel. Joe does
not want to buy a futures contract, and
decides to purchase the front month
at-the-money $50 call for a premium of 350,
or $3500. Joe makes his purchase and
watches as the days go by while oil trades
sideways right around the $50 level. Joe’s
option has four weeks until expiration. Two
weeks after his purchase, with no real bullish
market movement to speak of, Joe’s $50 call
has lost half its value and is now only worth
175 or $1750.
Many novice options traders will hold the call
until its value declines to zero!
Don’t be that guy… Decide how much room
you are willing to give the trade and then
stick to it.
A simple rule of thumb is to cut losses
once a long option has lost 50 percent of
its value.
Obviously, Joe’s market forecast was
incorrect…
Joe could take his loss at this point, and
move on to the next trade, or he can
continue to hold the call option.
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Sin #2
BUYING DEEP OUT-OF-THE-MONEY OPTIONS
Let’s make this one easy to understand –
trades are trades and lottery tickets are
lottery tickets…
Many novice options traders believe they can
possibly turn a profit by purchasing very
cheap, deep out-of-the-money options. Do
people win the lottery? Yes… have you or I
ever won it? Probably not…
And to be clear, out-of-the-money options
may be very useful for trading directional
moves or for volatility plays. You want to
make sure, however, that the options are not
so far out-of-the-money as to make the
probability of the trade working almost
non-existent.
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While deep out-of-the-money options may
represent less monetary risk due to their
smaller premiums, these options also have a
statistically significant low winning
percentage. The underlying instrument
would, often times, have to make extremely
substantial moves in price in order for these
options to pay off – not to mention the fact
that the power of time decay is always
working against you as well.
If you are going to trade, look for trades that
have an edge to them. Look for positions
that can potentially payoff without an absurd
move in the market. That $100 bucks you
might have spent on an SP call that is 200
handles out-of-the-money, well that can buy a
lot of lottery tickets…
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Sin #3
SELLING OPTIONS WHEN IMPLIED VOLATILITY IS LOW
While option selling has the potential to
provide an income stream, it also has the
potential to drain your account with large
losses, especially if you are selling naked
options with unlimited market exposure.
Many new options traders get this one wrong
too. Options consist of many moving parts,
and while market direction and time are
important, implied volatility is a huge
component of option values and pricing.
Many professional options traders trade
option volatility and nothing else…
Just as with a stock you want to buy low and
sell high, or sell high and buy low, the same
goes for options.
(high IV) and buy low (low IV). Many traders
get caught in the trap of selling options that
are currently low in IV, only to watch the
option’s value explode as IV increases.
Implied volatility has a tendency to revert to
the mean, so only look for opportunities to
sell options when IV is on the high side.
Conversely, if you are going to buy an option,
you will want to look for options that are
currently on the low side for IV.
Sell high and buy low...
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When selling premium, you want to sell high
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A GO-TO STRATEGY FOR THE NEXT MARKET CRASH
The term “market crash” can evoke a great
deal of emotion in traders and investors.
Market crashes are, however, nothing new
and due to many reasons, human nature
being one of them, such crashes will likely
happen from time-to-time.
While many associate a market crash with a
significant loss of market value and wealth, a
crash can also represent huge
opportunities…
Volatility in the S&P 500, as an example, has
been essentially non-existent in recent years
as the market has continued its multiyear
ascent. In fact, stocks are in the seventh year
of the current bull market (the average bull
market typically lasts five years) and may
finally be showing some signs of topping.
This period of extremely low volatility
has caused put options values to remain
subdued…
There are numerous ways to potentially profit
from a crash.
In the world of options trading, volatility is a
key ingredient in option pricing and behavior.
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A simple go-to strategy in such an
environment is a basic Risk Reversal
A risk reversal is a position designed to
imitate a position in the underlying asset.
Risk reversals can be both bullish and bearish
in nature and there are many variations of
such positions.
Now, you could simply look to purchase
relatively cheap puts in the current
environment. There are two primary issues
with this, however.
What you are looking for, then, is a position
constructed in such a way as to minimize time
decay while still providing large profit
potential if a crash does occur.
The risk reversal accomplishes both.
While there are many potential ways such a
position could be initiated, here we will
discuss a simple example…
Let’s assume for a moment that the e-mini SP
500 futures contract is currently trading at
the 2050 level.
First, puts that are significantly
out-of-the-money may have to be purchased.
Second, long puts would be exposed to time
decay, and if such a crash does not
materialize in the given time period, you
could potentially watch your puts expire
worthless.
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The market begins to show serious signs of
weakness, and you believe that a crash is
imminent. A crash that could potentially see
stocks fall by 20, 30, even 40 percent or
more.
If the market crashes, the long put will likely
begin increasing in value as investors
scramble for put protection. Volatility may
potentially rise substantially, also causing the
put to potentially gain in value.
Because implied volatility has been relatively
low for some time, put options on the e-mini
are cheap. You can purchase a put option
with six months until expiration and a strike
price of $1,850 for a premium of about 33
points, or $1,650. To negate the time decay
of your puts, you then look for call premium
to sell. In this case, let’s assume that you sell
a call option with six months until expiration
at a strike price of $2,150. Such a call can
currently be sold for about 38 points, or
$1,900.
As the market falls, the short call sold will
likely be losing significant value.
To get in-the-money, the long put will need a
move lower of about 10 percent. For the call
option to go in-the-money, the market will
need to move up by about five percent.
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In other words, you may potentially be
profiting on both sides of the trade.
What if you are wrong? What if there is no
crash?
That’s the best part… If the market falls at a
gradual pace, or even just goes sideways,
you may still potentially profit. That is
because both options will be subject to a loss
of value through time decay. The loss of time
value in the call will likely offset the loss of
time value in the put.
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And don’t forget,
you collected a net credit of 5 points
or $250
when you initiated the position!
This means that if all options simply expired
worthless, you still made money on the
position.
That’s the good – here is the bad: If the
market begins to rise, the long put will be
losing value while the short call may be
gaining in value. If you sold a naked call to
finance the long put position, that naked call
carries with it unlimited market exposure to
the upside.
As with any other type of trade, you will have
to have an “uncle” point, at which you take
your loss and move on to the next one.
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There are, however, ways that you can
mitigate an upside risk, such as selling call
spreads instead of outright calls…
The simple risk reversal provides a means of
potentially catching a large downside move in
the market while negating time decay risk.
This type of position can potentially profit in
several different scenarios, and can have
huge profit potential if the market does, in
fact, crash.
There are tradeoffs, however. The upside call
exposure should be carefully considered, and
risk must be managed.
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THE KISS STRATEGY
When it comes to options trading, many
traders fall into the trap of using overly
complicated strategies in an attempt to make
money. Some of these strategies may
include:
The Christmas tree spread
5:1 ratio spreads
4:1 back spreads
Box spreads
The list of various option spread
combinations goes on and on. We’re not
saying that such spreads never have their
place, but the reality is that for most options
traders; the simpler the better.
While initiating a multi-leg spread that gives
you X amount of deltas may sound cool at a
cocktail party, transaction costs on these
positions will eat you alive…
We teach a number of different strategies
here at Trading Advantage, but one of the
most important strategies we teach is:
K.I.S.S.
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K.I.S.S.
For those of you not in the “know,” this
stands for Keep It Simple Stupid…
Think about that for a moment… In your
everyday, non-trading life, do you like to
keep things simple and to the point or do
you prefer to make them overly complicated?
Assuming you like to keep it simple, why
would you treat your trading any differently?
The point is this: When trading options, use
the easiest and simplest method of
accomplishing your desired goal…
Here we will provide a few simple tips, tips
that may potentially help keep you out of
trouble and tips that may cost your broker
tons of cash in lost commissions…
Trading options is a means to an
end…nothing more. Options are a vehicle
with which to express a market opinion,
collect premium or attempt to profit from
changes in implied volatility. They may also
be used to hedge a long or short stock
position, and may even be used to hedge
against tail risk.
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Tip #1
Tip #2
Stay away from multi-leg spreads. While
some types of spreads can be quite useful in
mitigating risk or gaining desired market
exposure, others serve little purpose for the
retail trader. In fact, they may serve no one
but your broker. To be clear, we are not
talking about a bull call spread or an iron
condor. We are referring to more “creative”
spreads, the kind that involves more than
four legs.
If looking to trade a potential market move,
look for ways to maximize leverage while
keeping margin or capital requirements to a
minimum. While many novice traders will look
to buy straight calls or puts with fairly high
deltas, these positions have heavy exposure
to theta and vega. A much smarter use of
capital, in our view, may be to utilize
out-of-the-money call or put spreads based
on your market forecast. These positions will
put less capital at risk, while still allowing for
a favorable profit potential. In addition, they
will not be as sensitive to changes in implied
volatility or to the passage of time, giving the
trader more breathing room to let the market
and the trade run its course.
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Tip #3
Always keep in mind that if you are trading
long options, time is your enemy!
Conversely, if you are trading short options,
time is your friend. Either way, understand
the effects of theta on an options position,
and structure your trade and risk
management strategy accordingly.
Tip #4
Always understand your P&L graph – how
you may make money and how you may lose
money. Understand what you are looking for
in a market before putting a trade on.
Knowing where you profit and where you
lose can help make decisions when it comes
time to take profits and when it comes time
to take a loss.
Options are not the complicated
instrument many would have you believe
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Options are one of the most versatile
financial instruments at your disposal. Like
anything else in life, however, they should be
used in moderation.
Only trade options when you have a
thorough understanding of the trade and its
profit and loss potential. Use them to gain
the long or short exposure that you are
comfortable with, and nothing more.
By keeping your options trading clean, crisp
and simple, you can potentially avoid
overtrading and the potentially negative
impacts of overly complicated positions.
Focus on the underlying market, your
forecast for that market and your risk
management strategy.
And keep it simple stupid…
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THERE YOU HAVE IT…
The very steps we have outlined in this brief
yet powerful options trading guide can help
pave the way for your success…
Those that can master these versatile
financial instruments have a distinct edge…
An edge so powerful that you will not likely
find anyone that makes a living from the
markets not taking advantage of…
Forget the mystery, the fancy terms and the
mathematics involved for a moment. Options,
if purchased, are nothing more than
instruments that are used to achieve a
precisely desired amount of exposure for a
limited period of time. Options that are sold
are nothing more than an assumption of risk
for a specific period of time. Keep it simple…
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By just reading this informative options
trading guide, you have taken an important
first step.
Now is the time to take the
second step…
Regardless of what you may be trading now
(stocks, futures, currencies, etc.), mastering
options can potentially open up a whole new
world of trading and investment. They can
potentially hedge against risk, profit from
directional market moves and profit from
nothing more than the passage of time.
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Don’t let the passage of time cost you
another opportunity…
Discover the path to becoming a smarter
options trader and join Trading Advantage
now. Our world-class Online Campus is a
must have resource to take your trading to
the next level, offering more tips and
techniques, invaluable lessons, exclusive
options trading news… and so much more.
Click here now to get
started with Free Access!
Remember, Knowledge = Power. It’s
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GLOSSARY OF OPTIONS TERMS
ATM (At The Money): An ATM option's
exercise price is equal to or near the price of
the underlying asset.
Beta: The correlation between stocks within
the same industry.
Calendar (Time) Spread: An options trade
that involves the simultaneous purchase of an
option with a particular expiration date and
strike price, and the same option with a
different expiration date but the same strike
price.
Call Options: Call options give the owner the
right to buy the underlying asset.
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Delta: Measures the behavior, characteristics,
and value of an option in relation to the
underlying asset. Delta is the rate of change
in the theoretical value of an option for a
$1.00 change in the underlying asset.
Exercise Price: The price at which the
underlying asset may be purchased or sold.
Extrinsic Value: The price of an option minus
its intrinsic value.
Expiration Date: The date the option
expires.
Far-Term Options: Options that expire in
7-12 months.
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Gamma: Measures delta curvature. It is the
rate at which an option gains or loses deltas
over a $1.00 change in the price of an
underlying security.
Historical Volatility: A measurement of how
much a contract's price has fluctuated over a
period of time in the past. It is a very strong
indicator of a stock's future performance.
Implied Volatility: The implied volatility is
what is implied by the current market prices.
It is used with theoretical models.
Intrinsic Value: The difference between an
asset's price and the option's strike price or
zero, whichever is greatest.
ITM (In-The-Money): When a call option's
exercise (strike) price is lower than the
underlying asset price.
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Leap Options: Options that expire more than
one year away
Mid-Term Options: Options that expire in 4-6
months.
Near-Term Options: Options that expire in
the first three expiration months.
Options: A security that represents the right,
but not the obligation, to buy or sell a stock
at a specified price (STRIKE PRICE), until a
specified time (EXPIRATION DATE). If an
option is not exercised before the expiration
date, it will expire, or cease to exist.
OTM (Out-Of-The-Money): Has no intrinsic
value. A call option is out-of-the-money when
its exercise price is higher than the
underlying asset's price.
Parity: When options are trading at their
intrinsic value.
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Premium: The price of an option. It is
determined by many factors, including the
current price of the asset, the strike price of
the option, the time remaining until
expiration, interest rates, dividends, and
volatility.
Put Options: Put options give the owner the
right to sell an underlying asset.
Ratio Vertical Spread: A strategy in which
the a trader either buys 2 higher strike calls
and sells 1 lower strike call (call spread) or
when a trader buys 1 higher strike call and
sells 2 lower strike calls (put spread).
Resistance: Occurs at a price level where
selling is strong enough to prevent a stock
from rising higher.
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Rho: The change in option value that results
from a change in interest rates. The
theoretical value changes in relation to a
one-percentage-point movement in the
underlying interest rate.
Risk/Reward: The amount of risk a trader is
willing to take in relation to the reward in the
particular trade.
Spread Trading: An option spread is a
position that consists of two or more options
that are traded at the same time or as close
in succession as possible.
Strangle Swap: The strangle swap sets up
when the stock has made a significant move,
the front month implied volatility is still
historically expensive, and the stock is
trading between our support and resistance
levels.
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Strike Price: The price at which the
underlying asset may be purchased or sold.
Support: Occurs at a price level where
buying is strong enough to prevent a stock
from falling lower.
Theta: The rate at which an option loses
value as the amount of time to expiration
changes. Theta is also known as the time
decay factor; all options lose value as
expiration approaches
Vertical Time Spread: A combination of the
vertical spread and the calendar (time)
spread.
Volatility: A measure of the amount an asset
or security is expected to fluctuate over a
given period of time.
Volume: How much is being traded in the
market at a given time.
Vega: The amount by which the price of an
option changes when the volatility changes.
Vertical Spread: A trade in which a call (put)
option is bought (sold) at one strike price and
expiration date and another call (put) option
with the same expiration date but different
strike price is sold (bought).
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