Common $ense
Options
“A Common $ense Approach
To Trading Options”
Written By
David Duty CTA
Boquete, Panama
dduty@davidduty.com
www.commonsensecommodities.com
Charts Prepared Using Track-n-Trade Pro
THERE IS A RISK OF FINANCIAL
LOSS IN TRADING FUTURES AND OPTIONS
pg. 1
Disclaimer
THE INFORMATION CONTAINED HEREIN IS BELIEVED TO BE RELIABLE
BUT CANNOT BE GUARANTEED AS TO RELIABILITY, ACCURACY, OR
COMPLETENESS. COMMON SENSE COMMODITIES, AND/OR DAVID G. DUTY,
WILL NOT BE RESPONSIBLE FOR ANYTHING, WHICH MAY RESULT FROM
ONE’S RELIANCE ON THIS MATERIAL, NOR THE OPINIONS EXPRESSED
HEREIN.
DISCLOSURE OF RISK: THE RISK OF LOSS IN TRADING FUTURES AND
OPTIONS CAN BE SUBSTANTIAL; THEREFORE, ONLY GENUINE RISK FUNDS
SHOULD BE USED. FUTURES AND OPTIONS MAY NOT BE SUITABLE
INVESTMENTS FOR ALL INDIVIDUALS, AND INDIVIDUALS SHOULD
CAREFULLY CONSIDER THEIR FINANCIAL CONDITION IN DECIDING
WHETHER TO TRADE. OPTION TRADERS SHOULD BE AWARE THE
EXERCISE OF A LONG OPTION WOULD RESULT IN A FUTURES POSITION.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT
LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW.
NO REPRESENTATION IS BEING MADE THAT ANY PERSON WILL, OR IS
LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN IN
THIS COURSE. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES
BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL
RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING
METHOD.
ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS
IS THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT.
IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL
RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY
ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING.
FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A
PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE
MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL
TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED
TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY
SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED
FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS
AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING
RESULTS.
pg. 2
Common Sense Options - Copyright 2006 - David Duty
Forward Letter
It is my pleasure and honor to be asked to write this forward to David
Duty’s new Common Sense Options Trading Course. David has been working
closely with Gecko Software Inc. in providing new and experienced traders
with a further understanding of the futures and commodities markets for a
number of years now, and I can truly say I’ve never met a more honorable and
honest individual. David Duty is truly a man’s man among men.
David forwarded me a copy of his new options course, and I must say I
was amazed. I was extremely pleased with the quality of information and
examples that David provides. David provides more information in his first two
chapters than Ken Roberts did in his entire TWMPMM II Options course.
David’s course is excellent, it’s simply excellent! I thought I knew a lot
about trading options, but I learned something new in every chapter. I’m sure
you’ll love this new course as much as I do.
Lan Turner
Gecko Software CEO
Providence, UT USA
Forward written by Lan H. Turner, CEO of Gecko Software, Inc. Lan Turner is the
primary designer of the award winning futures charting software application known as Track
‘n Trade Pro, plus he’s the Author of numerous multimedia, educational CD seminars. Mr.
Turner has been a champion of futures trading since 1995 and loves teaching people of the
great opportunities found in trading commodities.
pg. 3
Common Sense Options - Copyright 2006 - David Duty
A Statement of Purpose
This course, my second one, is specifically about trading options. What is
so great about options is that you can trade them if the market is trending up,
down, or even sideways. There is almost always an option trade you can make.
I’ve designed this course with one purpose in mind…. To teach you how
to successfully trade options, to limit risk, make money, and reach your
financial goals whatever they may be.
We are going to start with option basics and why you should consider
them one of your most powerful tools. We will then progress into some of the
more complex strategies. I hope by the time you finish this course and the
accompanying CD ROM videos you will learn to love options like I have.
There are videos on a CD that come with this course so don’t lose the
video! At various places throughout the course, I will have reference to a
particular video lesson. I suggest that you read the course material before
watching the video since I will be referring to things in the printed course.
All the charts in this course and the videos were done with Track-NTrade Pro from Gecko Software using their options plug-in. As a subscribing
student, you will get lessons from time to time via e-mail that I have done in
Track-N-Trade Pro. If you own this software with the options plug-in, you can
open these chart books on your computer and update the lesson with live data
every day.
There is a link on my homepage to get this software at a discount. I
highly recommend that you get it if you don’t already own it. Use the coupon
code ZF380 to get a $10 discount on any Gecko Software you order.
I welcome you to join me in this fascinating journey, and I wish you the
best that life has to offer.
David Duty, CTA
pg. 4
Common Sense Options - Copyright 2006 - David Duty
Table of Contents
Charts Prepared Using Track-n-Trade Pro ..................................................................... 1
Disclaimer .............................................................................................................2
Forward Letter ......................................................................................................3
A Statement of Purpose ........................................................................................4
Table of Contents ..................................................................................................5
Introduction ...........................................................................................................8
Get In Or Get Out! ................................................................................................................ 8
My Experience With Options .............................................................................11
Chapter One ........................................................................................................13
What Is An Option Anyway? (Video #1) ........................................................................... 13
Risk & Trade Management ................................................................................................. 14
Some Common Misconceptions ......................................................................................... 29
Homework Chapter One
........................................................................................... 31
Chapter Two........................................................................................................37
Being Bullish (Video #5) .................................................................................................... 38
Being Bearish (Video #6) ................................................................................................... 44
Using Options as Stops (Video #7) ..................................................................................... 47
Homework Chapter Two
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Common Sense Options - Copyright 2006 - David Duty
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Chapter Eight – Manage
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Common Sense Options - Copyright 2006 - David Duty
C.Y.A.
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pg. 7
Common Sense Options - Copyright 2006 - David Duty
Introduction
Knowledge increases in proportion to its use - that is, the more we teach, the
more we learn. ~ Helena Petrovna Blavatsky 1876
As I stated in my first course, Common Sense Commodities, I started
trading back in the late 90’s and have found that it’s the most exciting business
I’ve ever been in. Yes, I said business. It’s not a game; it’s a business. If you
don’t treat it like a business, you are doomed from the start.
This course should only be read after you have a good understanding of
the underlying product; a futures contract. Let me say here and now that any
option strategy in this course can also be applied to the stock market. So
whatever it is that you like to trade, be it futures or equities, everything you
learn in this course can be applied to either market.
Get In Or Get Out!
“If You Can’t Get 100% Into What You’re Doing, Then You’d Better
Get 100% Out Of What You’re Doing.” (Quote From Zig Zigler)
Back in 1997, I was living in Denver, Colorado and was trying to launch
a new company and it was not going as well as I had hoped. I was working 12
to 14 hours a day, seven days a week and seemed to be going more backward
than forward. I hated it but felt at the time I had no other option but to continue.
I was stressed out, worn out, and burned out! Ever been there?
Then one day I got a brochure in the mail from someone who told me
that trading commodities was the world’s perfect business and than anyone who
possessed even a few brain cells could learn to trade ( I qualified for a few but
later wondered if I was correct). There were even several pages of testimonials
from people who had purchased his course saying that it was so easy that
anyone could do it in less than fifteen minutes a day.
Now keep in mind, I was working 80+ hours a week in a business that I
hated so this sounded just like what the doctor ordered…. It seemed like a
perfect business; fifteen minutes a day, untold riches, no stress, no partners, no
employees, no paperwork to speak of and all I needed to do was spend $200 on
his course. But he didn’t tell me about the “other” $3,000 in courses he sold in
pg. 8
Introduction
the first brochure. As a matter of fact his first brochure said this course was the
only course I would ever need.
Well I ordered all his courses, over $3,000, and in short order lost almost
$10,000 and I was even stupid enough to loan a friend $10,000 so we could
trade together and he lost his just like I did. So that was my first experience
trading commodities. Sound familiar?
Now, don’t get me wrong, it’s the best thing that ever happened to me
because it was the start of something great. Rather than getting upset, I looked
at it that I, or I should say we, lost over $20,000, but on the other hand,
someone else made $20,000. The only question I had was what were they doing
that I wasn’t doing? Or better yet, what was I doing, that they weren’t doing?
Thus, the quest for knowledge started.
I decided to throw in the towel on the business I had started two years
earlier and take a much needed break. I wanted to learn to trade for a living and
was willing to spend the time and money to do so. I used the next year to study
everything I could lay my hands on. I literally read over a hundred books,
listened to various audio tapes and watched dozens of videos; not to mention
hundreds of hours on various web-sites searching for the “Holy Grail” of
trading, which of course doesn’t exist. I also paper traded thousands of charts.
But gradually the light came on and it all started to make sense. I wish I
knew exactly what it was that made this happen so I could tell you. It’s like one
day I sat down and looked at a chart and I was finally able to understand what
was going on. In some ways, the charts started talking to me; at first in a
whisper and then later a little louder. I started to trade again, and just for fun, I
started to teach some friends and neighbors how to trade. At one point I had six
people at my kitchen table one night with paper charts laying all over the place
(before discovering Gecko Software) with lines drawn all over them. I wish I
had pictures as I’m sure it was quite a sight.
Then my wife told me that if I’m going to teach people to trade, then I’m
going to go get a classroom somewhere and take them there and I would no
longer be using our kitchen table for a classroom. So, being such a smart
husband (not wanting to catch the wrath from my wife is being a little more
honest), I went to the local college and talked them into renting me a classroom
pg. 9
Common Sense Options - Copyright 2006 - David Duty
Introduction
a couple of nights a week. That’s where Common Sense Commodities got its
start almost ten years ago.
Currently I have students in over sixty-five countries and now I get the
chance to teach them how to trade options. And with options you can have more
control over your risk than with futures alone. Another plus is that you don’t
have to have as large an account to trade options as you do to trade futures. You
can actually trade with a small account to start with and I think that anything
less than a $10,000 account is a small account.
I don’t know your specific reasons for wanting to trade as my crystal ball
broke many years ago. (Actually, I never had one). But whatever your reasons
are, I’m here to help you. Feel free to ask me any questions you might come up
with. I’m here to help.
Currently I’m living in Gulf Breeze, FL but recently purchased a home in
Boquete, Panama in what I think is one of the most beautiful places in the
world. I call it my little piece of paradise and I hope one day you find yours if
you haven’t already.
David Duty CTA
ps: Many people ask me what CTA stands for. I’m a Commodity Trading
Advisor who is registered with the National Futures Association (NFA) and the
Commodity Futures Trading Commission (CFTC).
pg. 10
Common Sense Options - Copyright 2006 - David Duty
My Experience With Options
My Experience With Options
My first experience trading options was less than stellar. To be a little
more honest it was horrible. But then again, I didn’t have a clue what I was
doing. I will blame it again on “the other guy” because I can’t for a minute
think I could have come up with such stupid ideas on my own.
Let me tell you just how stupid one of the “trading strategies” I was told
to do and I did without hesitation because a so called “expert” told me to. He
told me to look at the long term charts (monthly) and to find something that was
at all time highs or all time lows and then buy options against the trend!
For example, if Wheat was at an all time low, then just buy some deep
out-of-the-money calls, or if Sugar was at an all time high then just buy some
deep out-of-the-money puts. Stupid advice? Of course it was. but if you don’t
know that you don’t know, then how do you know you are doing something
stupid? After all, I was taking the advice of a self-proclaimed Guru! Well later
on, I found out he was not much of a Guru but I at least give him credit for
being one heck of a marketing genius.
There was not even a discussion about things like volatility, historic
pricing, option liquidity, etc. I was at a complete loss about trading options.
Again, if you don’t know that you don’t know……
Something else that was stupid advice (and yes I was even stupid enough
to do it for a while) was to find a commodity that was at an all time low, or at
least five year lows, and buy some deep out-of-the-money calls every month,
month in, and month out, regardless of what the market was doing, until one
day it would take off , shoot up like a rocket, and I’d get rich. Well I didn’t get
rich if you wondering!
I was told that I might have to do this for several years before it took off
but don’t worry about it, just think of it as if I was paying an insurance premium
or some such nonsense.
Maybe you are new to options like I was when I first started trading and
don’t even know what a put or a call is. If that’s the case then you are very
fortunate indeed. Now, you might be sitting there thinking why am I so lucky?
Well, let me tell you why. Because I promise that I will not teach you anything
pg. 11
My Experience With Options
stupid! You have my word on this. Everything that I am going to teach you is
being used by people just like you who are successfully trading options for a
living. I’m pleased to say, I’ve learned from some of the best in the business
and I’m going to take what I’ve learned and teach it to you in a simple and easy
way. Or, at least that is my intention.
I don’t have any “new” option strategies and I don’t know anyone else
who does either. What I will attempt to do is to get you to use some common
sense when you are trading options. I will teach you how to know which option
strategy, is in my opinion, the best one to use for the current market conditions.
Also, by taking my first course Common Sense Commodities, you will
be able to use what you learned in that course to help you understand why a
particular strategy is the best one to use. I will also try to teach you when I think
you should just sit on the sidelines and wait for a better opportunity to come
your way.
Let’s get started!
There is a risk of loss in trading futures and options
pg. 12
Common Sense Options - Copyright 2006 - David Duty
Chapter One
Chapter One
What Is An Option Anyway? (Video #1)
An option is an agreement with someone that gives you the right, but not
the obligation to buy or sell something at a specific price on or before a specific
date in the future. That’s all it is; period.
Let’s imagine you just got a job transfer to a new city and you want to
buy a house but you want to wait until you know that it’s in an area that you
and your family really like and that the new job works out before you buy a
house. Part of your employment contact is that they rent you an apartment for a
year and then at the end of the year the company will help buy you a home. The
catch is that they will not spend more than $500,000 on a home for you, so
that’s your ceiling for home prices.
You start looking at homes that are for sale just to get a feel for the local
market and you find what you think would be the perfect house but don’t want
to buy it for a year
The house is on the market for $500,000 but since property has been
going up in value lately. You think that in a year the house might be worth
$600,000 and if you could be guaranteed to be able to buy the house for
$500,000 anytime in the next twelve months that would be great.
So being a financial wizard, you offer the seller an option to buy the
house for $500,000 ($500,000 is the strike price of this option). The seller is not
familiar with options so you have to explain to him that you are not sure that
you would like to buy the house but you would like to have the option to buy it
anytime in the next twelve months for $500,000 And for giving you this option,
you will give him $25,000 in cash right now to buy this option (this $25,000 is
called the option premium).
You explain to him that at the end of 12 months if you don’t buy it
(called exercising the option) he gets to keep the $25,000 you paid him and you
will just walk away. (If you don’t “exercise” the option in the next 12 months
then you are just letting the option expire.) But if you do agree to buy the house
or “exercise the option” he must sell it to you for $500,00 even if the value
pg. 13
Common Sense Options - Copyright 2006 - David Duty
Chapter One
shoots up to $600,000 or more. He accepts this offer and now you are “long”
one house with a call option.
Now what is your risk for doing this? That’s right, just $25,000, nothing
more. If you decide to buy it you can, but if you decide you don’t want to buy
it, you can just walk away and let the option expire. Either way he gets to keep
your $25,000.
Now keep in mind, the house at the end of 12 months would need to be
worth $525,000 for you to break even ($500,000 to buy it plus the $25,000 that
you paid in premiums to buy the option). But you think it might be worth
$600,000 at the end of the year so it’s a good deal for you if it does go up that
much.
Basic option concepts are pretty easy to grasp. Where the challenge
comes is knowing which options to buy or sell and how to know if the price you
buy or sell it for is fair. You don’t want to pay too much for your options and
you don’t want to sell options for less than they are really worth.
In this course, I am going to cover a whole lot of material and by the time
you finish it I think you will have a very good understanding about why options
are one of the most fascinating and potentially lucrative tools you will ever use.
Risk & Trade Management
Just like in sports, it’s the defense that wins footballs games, and in
trading, it’s going to be the same. You must learn to keep your “opponent” from
scoring more points than you do. This is the only way to win.
Risk and Trade Management are two different things and never forget it.
Risk Management is controlling the monetary risk you are willing to take
before you place a trade, whereas Trade Management is controlling the trade
once you are in it. These two things should be focused on even more than
trading strategies. You might think this is backward but it’s not. The reason is
that even if you know the correct strategy to use to enter a trade but don’t know
how to control your risk or to manage your trade once you are in it, then you are
doomed for failure.
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Common Sense Options - Copyright 2006 - David Duty
Chapter One
You must be able to know the amount of money you are going to risk vs.
the amount of money you are planning on making. And unlike trading straight
futures, you must also know your breakeven point.
Your first job is that of being a risk manager and your second job is being
a trader. Because if you can’t learn to control risk, then you won’t have the
opportunity to be a trader for very long. Fortunately options can be used
strategically to control risk.
The first thing that you should learn to look at is how much money
you could lose! Doing this is your primary job function as a risk manager.
Too many times traders focus on how much money they think they can make
and don’t pay close enough attention to how much money they can lose.
Trading options is certainly something that can lead to huge financial
rewards if done properly. But let me stress right now that trading options is
certainly not a get rich quick scheme. You should look at trading options as a
marathon, not a sprint. Plan right now to spend several weeks learning how to
trade options before you can expect to make a consistent income.
I’m going to show you how to plan your trades from start to finish. It’s
going to be up to you to follow that plan. Keep in mind, that when you plan a
trade you are not yet “married” to the trade. It’s during this time you are able to
look at it logically without getting emotionally tied to it. However once the
trade is placed many people forget whatever the logical reason was for placing
the trade and let emotions control the trade. This is usually when losses occur.
Once you have planned your trade, stick with it! Don’t get emotionally
involved and start jumping into and out of the markets. If you can’t handle
losing money (the risk) then you should not place the trade to start with. Now
from time to time, once you are in the trade, you might make adjustments to it.
That’s okay but it should be part of your plan from the start and not something
that you decide to do because you can’t afford to lose the money. If that was the
case, you should not have placed the trade to start with.
Also, stop looking at everyone else thinking that they know more than
you do about the markets and that you should take their advice about a
particular trade you are in. You must learn to develop you own style of trading;
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Common Sense Options - Copyright 2006 - David Duty
Chapter One
a style that you are comfortable with, that does not keep you so stressed out that
you can’t sleep at night. Nothing is worth losing your health over.
Throughout this course you are going to hear me talk about controlling
risk until you are ready to scream at me that “enough is enough”. Well, I’d
rather you get upset with me about talking about it too much rather than not
enough. Wouldn’t you?
Setting Up Your Business
I’ve always said that trading is a business and if you don’t treat it as a
business you are destined for the poor house. Now obviously, I don’t know if
you have ever had your own business or not but if you want to trade for a
living, or just to supplement your income, you need to “set up your business”.
I doubt that you would open any business without having the proper tools
or equipment, without a complete business plan, without knowing what your
anticipated expenses will be, without a cash flow analysis, etc. Well you get the
picture; or at least I hope you do. Your trading business should be no different. I
don’t know of a single long term successful trader that did not have a business
plan, as well as a solid trading strategy and stuck with. Successful traders are
running a successful business!
This is just common sense, yet so many people want to jump right in the
water and start trading without the proper training. This would be kind of like
trying to learn to swim by just jumping right in the deep end of the swimming
pool. Your chance of survival by doing that would not be real good, would it?
Well, your chance of survival by just jumping right in and starting to trade are
not any better.
I don’t want to scare you away and I’ll help guide you through the forest
helping you avoid many of the pitfalls I experienced. There is a learning curve
and during this time you may get frustrated. If you do, that’s okay, because
sooner or later, if you stick with it long enough, the light will come on. When it
does, it’s a day for great celebration!
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Common Sense Options - Copyright 2006 - David Duty
Chapter One
Going Full-time
I have students who want to know how long it will take for them to start
trading full-time and replace their current income. Well in an effort to always
be completely honest; my answer to that is that I don’t know. There are just too
many variables involved and each person is different.
You must first decide how much income you need to go full-time. Then
you have to decide how much money you can start your trading account . After
you have done that, then you need to carefully think about how much you can
make, percentage wise, every year.
Do the math and see how long it will take you to be able to go full-time.
Maybe you want to make $50,000 a year and you can make 100% a year
(optimistic for most people) then of course you need a trading account with
$50,000. If you open an account with $10,000, and make 100% a year, how
many years would it take for you to go full time and make $50,000 a year? Also
do the math using 25% a year return and 50% a year return. Do several different
scenarios and at the end pick one that best suits your own circumstances. Be
conservative on this! If you can’t live with that answer then trading options is
not for you.
I hate it when I try and read a book or take a course where the author uses
terms that he or she thinks I should already know. This only leads to confusion
and I have to go to the glossary to look up the word I don’t understand, then go
back a read the text again. So, based upon some of my own past frustrations, I
will assume you don’t know even the basic option terms. If you already know
these terms then you might want to skim over them, or even skip, the following
section.
Option Terms
Assignment: A notice to an option writer that the option has been exercised by
the option holder.
At-The-Money: An option whose strike price is the same as the underlying
futures contract. An example would be that sugar is trading at 10.00 and the
strike price of the option is also at 10.00. It does not have to be exactly at the
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same price but very close to it. You know, like they say, close enough for
government work!
Beta: This is a measurement of the options market and how it correlates to the
movement in price of the underlying market.
Call Option: When someone buys a Call, they have the right to buy the futures
contract at the agreed upon strike price. The seller then has the obligation to
deliver the futures contract at the strike price on or before the expiration date of
the option.
Covered Option: An option written against an opposite position in the futures
market. An example would be that you are long Gold in the futures market but
you sold a further out-of-the-money Gold call.
Credit: This is money you receive from the person who you sold an option to
or when you offset an option. In other words, it’s money that is deposited into
your trading account.
Debit: Just the opposite of a Credit. It’s money you pay to buy an option and
it’s deducted from your account.
Delta: No this is not an airline. It’s the amount an option price will change in
relation to the underlying futures price. Options will change in value when the
futures market goes up and down.
Exercising Options: Most options, I’ve heard that it’s as high as 98%, are
liquidated (closed out) before they expire or they expire worthless which is the
case most of the time. An example is that you have a gold call option with a
strike price of 425.00, gold is selling for 475.00 and you still have time on your
option before it expires. But you offset it, in other words you would sell your
option on the open market to someone and take your profits. Of course you
would only take profits if it was worth more than you paid for it. If it’s worth
less than you paid for it then you could probably still sell it but you would sell it
at a loss.
Of course if you are the seller of the option, in other words you sold someone
an option, you can also offset your option at a profit or a loss anytime before the
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option expires by buying your option back. Both these examples would be like
buying back your short futures position or selling your long futures position.
But an option buyer also has the right to “exercise” his option any time prior to
the expiration date. If you were the buyer of a call option, you would give
notice to your broker that you want to turn your call option into a long futures
position. Now if you were the buyer of a put option you would do the same
thing with your broker but you would then be short the market by having a short
futures contract. In each of these scenarios, you would be long or short the
market from the Strike Price of your option. Of course you would only offset
(sell) your option if it was “in-the-money” or in other words if it had Intrinsic
value.
Expiration Date: Every option has a specific date which up until that time, the
option can either be sold to someone else or exercised and turned into a futures
contract.
Free Trade: You are really going to like this one when you get to it in the
course. But a free trade is when you institute a spread (see below) by
purchasing a close-to-the-money call or put and then later complete the spread
by selling a further out-of-the-money (see below) call or put of the same
expiration period at the same or greater premium than you paid for the first call
or put. Once you have completed this type spread, there is no margin required
and the best part is that you can’t lose money once this spread is complete!
Read that again!
Hedge: This is when you buy or sell an option or futures contract to offset your
current position in order to have protection in case the market goes against you.
In-The-Money: When an options strike price is lower than the current futures
market price for a call and when the strike price is higher than the current
futures market price for a put. In each case the option would have intrinsic
value.
Intrinsic Value: This is the amount of money that you would make if the
option were to be exercised immediately. Keep in mind that Out-of-The-Money
options have zero intrinsic value.
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Margin: This is the amount of money that you have to deposit AND maintain
(just like a futures contract) when you SELL an option. No margin is required
on options you buy.
Naked Writing: This is when you sell an option on a futures contract and you
don’t have a futures position in that market.
Neutral Option Position: This is when you put on an option spread and sell an
out-of-the-money put and call of the same expiration month to collect a
premium. This is usually done in a flat or choppy market.
Option: A contract between two people to buy or sell a futures contract at a
predetermined price (strike price) on or before a future date. Every option has
both a buyer and a seller
Option Buyer: When you buy a put or a call, you have the right, but not the
obligation, to buy (with a call option) or to sell (with a put option) the
underlying futures contract at a specific strike price anytime before the option
expires. The seller is paid a premium by the buyer. The most the buyer can lose
is the amount he paid in premiums. So even if the market goes against you
thousands of dollars, as a buyer, you can only lose your premium. However if
the market goes in your favor, you have unlimited upside profits.
Option Seller: When you sell an option, you get paid a premium by the buyer.
This is what you “earn” for taking the risk of selling the option. When you sell a
call option, you have the obligation of selling the buyer a futures contract at the
agreed upon strike price anytime before the option expires. When you sell a put
option, you have the obligation of buying a futures contract at the agreed upon
strike price anytime before the option expires.
In layman’s terms if you sell a Call option you must go to the market and buy a
long futures contract at the option strike price if the buyer wants to exercise the
option. They would never do that unless the futures market was trading above
their strike price. And it’s the opposite for a Put option; where you must go to
the market and sell a short futures contract at the option strike price if the buyer
wants to exercise the option. They would never do this unless the futures
market was trading below their strike price.
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For doing this, the seller gets to keep the premium even if the option is never
exercised. In other words, the seller never has to give back the premium to the
buyer. So as a seller of an option if you were to collect $500 in premium and
the trade when against you, and you wanted to buy it back for $600 then your
net loss would only be $100.
Out-of-The-Money: An option that has no intrinsic value (only has time value)
is called out-of-the-money. In other words a call option that is above the current
price or a put option that is below the current market price.
Premium: This is the amount of money you are paid by the person who buys
the option from you. The total risk that the buyer has is the amount that he pays
the seller in premium. The maximum amount of profits that the seller of the
option can make is the amount of the premium collected.
The amount of premium is set by the floor traders by negotiating between the
option buyers and sells and of course depending on what the underlying
markets are doing. In flat markets options are cheaper and in volatile markets
options are more expensive.
Put Option: When someone buys a put, they have the right to sell the futures
contract at the agreed upon strike price. The seller then has the obligation to
deliver the futures contract at the strike price on or before the expiration date of
the option.
Spread: When someone has two or more options in the same market, but it
does not have to be on the same contract. You would still be in a spread if you
had an option in the January contract and one in the March contract of the same
commodity. The latter is called a Calendar Spread.
Strike Price: This is the agreed upon price of the option The buyer of a call can
purchase the futures contract and the buyer of a put can sell the futures contract
at this price. Every option that is sold must have a strike price as well as an
expiration date.
Theoretical Value: This is the price of an option that is calculated by a
complex mathematical formula developed by two men, known as the Black Scholes formula. This value is based on several factors, volatility, time until
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Chapter One
expiration, interest (a minor part) strike price and the current price of the
underlying commodity.
Time Value: The amount of the premium that exceeds the intrinsic (if any)
value of the option. An out-of-the-money option has only time value. It does not
have any intrinsic value.
Volatility: This measures the change in the options price during a specific
period of time. In very volatile markets option prices can jump up or down very
quickly.
The more volatile the market is, the more the option will cost. As a
general rule, you want to sell options in a volatile market, not buy them, since
they are usually overpriced giving you an opportunity to receive a higher
premium.
Time is Money (Video #2)
We talked about this earlier but the longer an option has (number of
days) until it expires the more it will cost. This is logical because in the
previous example with an option to buy a house, if the seller had given you a
two year option to buy the house he would want more money for it than if he
only sold you a twelve month option. The reason being is the longer the option
has until expiration, the more risk the seller has. More risk = higher cost.
In figure 1.1, an option with 180 days left until it expires is worth much
more than an option with only 30 days left until expiration. This “value” only
has to do with the time value of the option. It has nothing to do with the strike
price of the option which we will discuss on the next few pages.
The last thirty days of an option’s life, the value of the option deteriorates
quickly because people don’t think that it will gain much in value during that
time.
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Chapter One
Options Are A Depreciating Asset (Video #3)
Options have what is referred to as “time decay”. All this means is that as
time goes forward all options lose time value. Remember one of the things that
makes up the value of an option is how much time it has until expiration. This
can be a major part of the price you have to pay. Like they say, “time is
money”, especially in options.
Let’s use an example of buying a Call option in Sugar and we will say
that Sugar is currently trading at about 12.00 cents. We are Bullish the market
and think that sugar will go to 14.00 in the next couple of months. Let’s also
say the front month in the futures market is the March contract.
In the following chart, figure 1.2, you can see the cost (premium) of a
14.00 Call is $134.40 and gives you the right to be long sugar from 14.00. Since
Sugar is trading below the strike price then the entire premium is for extrinsic,
or time value. Since it is “out-of-the-money” (above the strike price) it has no
intrinsic or real money value.
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Chapter One
The person who is selling this option is betting that Sugar will not go to
14.00 in the next 53 days and that this option will expire worthless. Actually it
would have to go a little higher than 14.00 for him to lose money since he
collects a premium for selling it. So the option seller’s breakeven is 14.00 plus
what he collected in premium. We will talk much more about this later on. For
taking this risk, he wants to be paid $134.00. So these 53 days of time value
will cost you $134.00. Options usually expire about 30 days before the futures
contract expires.
Now what if you wanted more time thinking that sugar will indeed go up
to 14.00 cents but it might take longer than 53 days. Well, you will have to buy
an option in a further out contract month. Look at Figure 1.3 which is the May
contract, the next contract month out.
The May contract with a strike price of 14.00 cost almost twice as much
($257.50) as the March contract with a 14.00 strike price. The reason is the May
option has 97 trading days until expiration whereas the March option only has
53 trading days until it expires. Again, time is money and the option seller
wants more money because he is taking a greater risk by giving you more time.
The additional risk he is taking is that he is selling you an option with 97 days
left rather than 53 days left until the option expires.
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Chapter One
In, Out & At-The-Money (Video #4)
You are going to hear the terms, Out-of-the-money, At-The-Money and
In-the-money throughout this course so I guess this is a good time to give you
some examples on a chart. Look at Figure 1.4 where I show you what these
terms mean.
In this example, there are three lines drawn at three different strike prices.
When you buy a call option the seller is agreeing to allow you to be long a
futures contract from whatever strike price you bought.
If you purchased the 103.00 Strike Price for $2,175 then you could be
long a futures contract from 103.00 which is under the current closing price of
104.950. So this option has $975 of Intrinsic Value (real money value) since
you would be long from 103.00. The balance of the premium you pay ($1,200)
is for Extrinsic Value (time value). Since the option has Intrinsic Value then it’s
called “In-the-money”. The reason being if you converted it to an Futures
contract today, then it would be worth $975. A Call option is In-the-money
anytime the Strike Price is below where the price the futures market is trading.
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Chapter One
While I’m thinking about it you should never exercise an in-the-money
Option to a futures contract that has time value remaining because once you
convert it (exercise it) you will lose the remaining time value.
If you purchased the 105.00 Strike Price for $1,525 the option has almost
no Intrinsic value, only Extrinsic Value, so the entire premium is for its “time
value”. If it’s at, or near, the current futures price, it’s called “At-The-Money”.
An At-The-Money option can have either a small amount of Intrinsic
Value (if it’s just below the futures price) or no intrinsic value (if it’s exactly at,
or just above the futures price). At-The-Money simply means the strike price is
close to the futures closing price that day.
The 107.00 Strike Price costs $1,012.50 and is above the futures price so
it is called “Out-of-the-money” and it has no Intrinsic value, only time value. So
the entire premium is for time value. The closer the strike price is to the current
futures price, the more it costs and the further away it is the less it cost.
The 121.00 Strike Price (not shown on chart) only costs $12.50 and is
“Deep Out-of-the-money” and has little chance of ever being “In-the-money”.
Usually you want to stay far away from buying any “Deep Out-of-the-money”
Options. And yes, they are cheap but there is a reason they are cheap and it’s
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Chapter One
because they almost never make any money for the buyer. And they don’t have
enough premium involved to sell them and they are extremely illiquid. Just do
yourself a favor and stay away from them (Think Cheap Options = Chump
Option (most of the time)). In fact, anytime you buy or sell an option always
check the open interest in the futures market. You want to be in as liquid a
market as possible if you need to make a quick exit! This is another area where
a full service broker pays for himself many times over.
Puts work exactly the same way as Calls, just reversed. We will be
looking at a lot of charts with Puts on them in the course but I will show you a
chart with Puts on it at various strike prices. See figure 1.5.
Starting at the top, you see the 92.00 call is In-the-money and has both
intrinsic value and time value. It’s the most expensive of the four because of
how much intrinsic value it has.
The second Put is at 91.00 and it’s at-the-money because it’s close to the
future closing price that day.
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Chapter One
The third Put is at 90.00 and is out-of-the-money because it’s below the
futures price.
The bottom strike price of 86.00 is deep-out-of-the-money and should not
be purchased.
Also, you will hear terms of being short a Call or long a Put. Sound crazy
but what it means is that if you are short a Call, you sold a Call and if you are
short a Put, you sold a Put. And if you are long a Call, you bought a Call and if
you are long a Put you bought a Put. An easy way to remember this is that if
you sell an option, either a Put or a Call, you are short that Put or Call and if
you buy either a Put or a Call you are long that Put or Call.
Let’s say you bought a December 2006 Sugar call in June with a strike
price of 12.00 for $500 and it expires in November (options always expire
before the futures contract ends). Well you would have about six months of
time value left. Now if the futures market was trading at 10.00 when you
bought it, the option is out-of-the-money, or in other words it has zero intrinsic
value. So the entire $500 is for time value. Intrinsic value simply means that if
the option was converted into a futures contract right now, would it be worth
anything? So if you had a 12-cent call option in Sugar and the market was
trading at 10 cents then your option has no intrinsic value.
Even if the price of the futures market goes up to or even past 12.00
before it expires, it’s not necessarily going to be worth more than you paid for
it. Remember the entire premium was for time value. So if the futures price
went to say 12.25 at option expatriation you would have zero time value left
and your option would only be in-the-money (intrinsic value) by .25. Since a
full cent move in sugar is worth $1,120 then your option is only $280 in-themoney with no time value left. You would have a loss of $220 on the option
that you paid $500 for ($500 - $280 = $220), and not only did the futures
market go up as you expected, but the option was also "in-the-money" at
expiration."
You have to learn to buy the right options, at the right time for the right
price. By the time you finish this course, you should have a good handle on
doing this.
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Chapter One
Some Common Misconceptions
Misconception #1: Find a commodity at record lows and buy deep out-of-themoney call options every month because one day the price will have to go up
and when it does you want to be on the “profit train”.
First of all you never buy a deep out-of-the-money option just because
the current market price on the underlying commodity is at a record low. How
many times have you seen a commodity make a record low, and then just keep
going lower, or be at a record high and keep going higher? You have to learn to
purchase the right option, at the right time, and at the right price to consistently
make money trading options.
Misconception #2: If you buy a call option and the market goes up, or if you
buy a put option and the market goes down, you will always make money.
Well that’s nonsense. There are several factors that make up the value of
the option. Like how much time is left, or the time value of the option, how
close it is to the strike price and how volatile the market is.
Misconception #3: To get rich trading options all you have to do is find and
sell over-priced options.
Most options expire worthless, over 80% from what I can find out. It
would seem then that people who sell options are making a killing because they
only have to pay out 20% of the time. That seems logical but sometimes, the
20% they pay out is more than the 80% they collect.
What you have to do whether you buy or sell options, or a combination
of both, is to find the right option at the right time, at the right price and then,
you have to know how to manage the trade on top of that. We will be talking a
lot about managing your trades in this course.
Misconception #4: You should never sell options because they have unlimited
risk.
Nonsense! That would be like saying you should never trade futures
because you have unlimited risk! You can control your risk selling options even
more so than you can control your risk in the futures markets. I’m going to
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Chapter One
show you many different ways to do this. So, put away the misconception that
selling options is too risky.
Misconception #5: Only very wealthy people should sell options.
Again, more nonsense and I wouldn’t be surprised if it was the options
sellers that started this rumor to keep the average person out of their lucrative
market. The fact is that selling an option has no more risk involved than going
long or short a futures contract. Now, you might think I’m crazy for asking this,
but can you tell me why anyone would say that selling an option has more risk
than a buying a futures contract?
Misconception #6: Trading is always a zero sum game.
This is not true. Actually trading is a minus sum game. Now this might
surprise you but there are actually more losers than winners! Have you
forgotten about slippage and commissions? How about the other cost involved
in trading; this course as an example, or your TNT software and data
downloads. This is all part of trading and comes off the top. In other words just
to break even trading, you have to make a profit.
So it’s not that one person wins and one person loses as some people
would have you believe. It’s a tough business (notice I used the word business
again) but it is a business that people can make money in, and some people
make very good money. Hopefully you can learn to be one of the ones who is
consistently making money. I know that I’m going to teach you everything I
can but it’s going to be up to you to implement it correctly.
I am also going to be setting up an Options Alert subscription so be
sure to sign up for it if you haven’t already done so.
End of Chapter One
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Chapter One
Homework Chapter One
1. An option is an ___________ with someone that gives you the _________,
but not the ________________, to buy or sell something at a specific price on
or before a specific date in the future.
2. You buy a ____________ option when you think the market is going to go
up.
3. You buy a ____________ option when you think the market is going to go
down.
4. What is the maximum amount you can lose on a 10.00 sugar call option that
you paid $250.00 for? __________
5. If you pay $500 for an option and want to risk the entire premium on the
trade, how much must the option be worth when you sell it to make a profit of
$1,000? _________________
6. You have a $10,000 trading account and are bearish the Live Cattle market.
A 196.00 put is selling for $172. The maximum number of puts you should buy
would be ___________. (And stay within your 5% risk of your account)
7. You want to trade full-time for a living and you need to make $100,000 a
year to replace your current income. You have a $10,000 trading account and
you feel you can make a return of 100% a year. How many years will it take
you to be able to trade full-time and replace your current income? _____ This
assumes that you take no money out of your trading account during this time.
8. Dec. 2006 Crude is selling for 55.00 and you want to buy a 60.00 call for
$4,500. What size trading account would you need and still be able to keep
within the 5% rule? _______. This is assuming that you risk the entire premium
you paid for the option.
9. When you Buy___Sell ___ options you have limited risk and when you
Buy___Sell ___ options you have unlimited risk. Check the correct answers.
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Chapter One
10. Why would anyone ever want to sell an option?
__________________________________________________________
__________________________________________________________
__________________________________________________________
11. If Sugar is selling for 10.00, a 9.00 Put is...
A. ___ Out-of-the-money
B. ___ At-The-Money
C. ___ In-the-money
12. If the US dollar is trading at 88.90 a 88.00 Call is...
A. ___ Out-of-the-money
B. ___ At-The-Money
C. ___ In-the-money
13. As far as options go, Time is __________?
Answers to homework are in the reference section but don’t cheat.
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Chapter Two
Chapter Two
Let me start out saying that everything we will talk about in this
course can be used to trade equities as well as commodities. But since my
background in trading is in commodities, I will only use commodities in my
examples. You should now have a few of the terms down, so we are going to
look at some other charts. The software that I am using is Track-n-Trade Pro
Version 4.0 by Gecko Software.
Obviously I have the Options Plug-In for the software. This plug-in
allows you to look up strike prices for every commodity and see what the
options sold for that day. If a certain option strike price did not sell that day
(not every strike price of every option has a buyer and a seller every day)
then they use the Black-Scholes formula to calculate the price. BlackScholes is a complicated mathematical formula used to calculate what an
option should be worth based on several factors, like Interest Rates,
Volatility, Strike Price, and Expiration Date. There is absolutely no reason to
know more about it than this; at least at this time.
Black-Scholes pricing can vary considerably to what the option is
actually selling for. As we go along in the course I will explain this by using
some chart examples so don’t worry about it.
You can also place the trade for the option in the software (it does not
go to your broker) and when filled it adds it to your Track-n-Trade
accounting plug in if you have it installed. I obviously use this plug-in so
that I can show you account balances in the examples.
I recommend that you get this software if you don’t already have it. I
would of course get the options plug in as well as the accounting plug in.
You can order this at my home page and get a $10 discount. Just go to my
home page and click on any of the Track-n-Trade logos. Once you get to the
order page there will be a field for coupon code. In that field, enter ZF380
and it will automatically give you the discount.
www.commonsensecommodities.com
Let’s take a look at some charts and I will explain some of the
basic option terminology as we go along. I am going to use candlestick
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charts in this course because it’s what I personally use. I much prefer
these to regular bar charts. You can go to my website and read a short
lesson on the introduction on candles. The link at the website is:
http://www.commonsensecommodities.com/students/candlesticks1.htm
Being Bullish (Video #5)
As we discussed, there are only two kinds of options, Puts &
Calls. In the most simplistic form, you want to buy a Call option when
you feel the price is going up and you want to buy a Put option when
you think the market is going down. We are going to be bullish sugar in
the following example so we would look at buying a Call.
A simple way to remember Puts & Calls is that Put=Plummeting
Prices and Calls=Climbing Prices.
Strike prices in Sugar trade at .50 increments, like 10.00, 10.50,
11.00. (Strike prices are set by the exchanges and you are not able to
pick your own strike price.) The first thing that I would do after
deciding that I was bullish this market is to go back to the long term
charts and find the next major resistance above the current price.
As you can see in Figure 2.1, the next major resistance is 15.38
which came from the Monthly chart.
When drawing out support and resistance lines on my Daily
chart, I use red for resistance and blue for support lines. I also use green
lines for Common Numbers which was covered in my first course. If
the resistance is from a monthly chart, I use a line thickness of three,
two if it’s from a weekly chart and one if it’s on the daily chart. Trackn-Trade makes this very easy for you to do. This way, I can glance at
my daily chart and see exactly where monthly, weekly and daily
support and resistance, as well as common number areas are. This
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makes the chart much more visual and easier to understand. It helps my
charts “talk” to me.
Now, since I’m bullish. my main focus is on the next level of
major resistance. I will use this area as a profit target using a call
option.
Also, I’m going to share with you something that will help you in
all your trades in both futures and options and it’s a little known secret
off the trading floors. It’s that many times support & resistance areas
are option strike prices! Or, to put it another way, option strike prices
often become support or resistance levels.
My friend Scott Barrie who was a floor trader tried to explain the
reason for this. He was very thorough in his explanation and probably
spent a half hour on the phone with me. To be honest, I did not
understand it at all. I understand simple things like the sun comes up in
the East every morning and sets in the West and that support &
resistance areas are often option strike prices. I don’t know why either
of these two things occur and to be quite honest, I don’t care. I’m just
content in knowing that they do happen. I also don’t understand why all
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food that taste good is fattening and don’t ask me how I know this
either!
Now since we are bullish, we want to consider buying a call
option but which one should we buy? The closer the strike price is to
the current price of the futures market the more expensive it is. As an
example if sugar is trading at 10.00 then a call option with a strike price
of 10.00 would be more than one with a strike price of 10.50 and a
strike price of 11.00 would be cheaper than the 10.50 Strike Price. I
will explain more about this as we go along.
I’m a firm believer that you MUST use proper risk controls when
you trade or you won’t be around very long. One of the key mistakes
new traders make is that they risk to much of their account on any one
trade or have too much at risk in any one market (like the Grains,
Metals, Meats, etc.)
With a small account (and I think anything less than $10,000 is a
small account) that you should not risk more than 5% ($500) on any
one trade and the larger your account the less percentage you should
risk. In other words, with a $100,000 account you might only want to
risk 1% on a trade but with a $10,000 that’s almost impossible because
you could only risk $100 (1%)and there are not many trades worth
taking that only have a $100 risk. And when figuring your risk also
include commissions and some slippage.
It’s probably a good time to mention that what you pay for an
option is not what you have to risk on the trade; that’s completely
different. What you pay for the option is your maximum risk. Let’s say
that you have a $5,000 account and you only want to risk $250 (5%)
but there is a great option that cost $500 which is 10% of your account.
Well you can buy the $500 option and then offset it (get out of the
trade) if the value drops to $250 which would be a $250 (5%) loss. So
the option premium was 10% of your account but the risk you take is
only half that or 5%.
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You don’t have to keep the option and let it expire worthless, you
can offset your position anytime you want to. In this respect, it’s like a
futures contract, you don’t have to keep a futures contract until it
expires either.
I’m going to give you two different examples here; one for a
$5,000 and one for a$10,000 account. With a $5,000 account you can
risk up to 5% or $250 and of course with a $10,000 it’s twice that or
$500 but it’s still only 5% of your account. I used the Options Plug-in
in TNT to find the cost of these two options. The strike price of 13.50
is .20 points (option prices are shown in points and in dollars in TrackN-Trade Pro) or $224 and the strike of 12.50 is $470.40. So with a
$5,000 account you could buy one 13.50 call for 20 points ($224) and
with a $10,000 account you could buy one 12.50 call ($470). And yes
with a $5,000 account you could still buy the $470 option and get out
of it if you lost $250.
The first thing to decide is your exit strategy and the risk you
want to take. Like I said, we are going to use the total premium cost as
our risk in this example. So we could set exit targets several different
ways. We could say that we are going to sell the option if we make
200% and it TRIPLES in value or we could say that we are going to let
the market tell us when to sell it.
Now hold on David, what do you mean it has to triple in value to
make 200%? Don’t you mean doubles in value? Remember in my first
course, I always talked about keeping your risk reward ratio at 2:1 or
better? Well you have to do the same thing in options. So if you paid
$250 for an option, that money is gone forever, you don’t get back your
premium whereas in trading futures, you put up a deposit (margin) and
you get that back if you exit the trade with a profit. In options it doesn’t
work that way. The premium you pay for the option is gone forever,
you don’t get it back.
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So if you paid $250 for the option and decide the entire option
premium is what you are going to risk then how much do you need to
make to have a 2:1 risk/reward ratio? That’s right, you need to make a
$500 profit. So to make a $500 profit on an option that you paid $250
for, then the option must increase in value to $750. Why? Because you
paid $250 for it and have to deduct what you paid from your profits.
$750-$250 is $500 or a 2:1 return. If the option went up to $500 and
you liquidated it, then you would only have a profit of $250 and your
risk was $250 which means your risk/reward ratio was only 1:1. And
yes, if you are thinking that your plan could have called for you to
offset the option and get out of the trade if it dropped in value to $125
and sell the option if it went up to $375 which would give you a 2:1
Risk/Reward Ratio. If that was your plan BEFORE you got into the
trade then you could take the profit when the option doubled in value.
There are many ways to skin a cat. (Sorry cat lovers)
Okay, I’ll quit rambling and get back to the example again. Since
the next major resistance on this chart is 15.38, I’m going to look for
resistance somewhere around 15.00 to 15.38. Why 15.00? Because
15.00 is an option strike price. Remember I told you earlier that many
times option strike prices will become support or resistance levels.
REMEMBER THIS!
Now, I’m going to show you what would have happened if you
had bought one of these options. See Figure 2.2.
Notice the market went almost straight up and made double tops
with bearish candles just below15.00 which was an option strike price
and we’ve already talked about strike prices often become support or
resistance levels.
Now, look at the MACD indicator and you can see there is a big
divergence going on between the price, which was going up, and with
MACD going down. Remember from my first course that Divergence
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is when an indicator like MACD is going in one direction and the price
is going in the opposite direction. This is telling me that this rally is
running out of steam and with the potential double tops, it’s probably
time to take profits on this trade.
As you can see, the 12.50 call is now worth $2,497.50. Deduct
what we paid in premium of $470.40 and that gives us a profit of
$2,027.10 which is a net profit of 431% easily exceeding our 2:1
risk/reward ratio. And on the 13.50 call we made a net profit of
$1,300.50 ($1,523.50 less $224) or a 579% again exceeding our
risk/reward ratio of 2:1. We made a higher return, percentage wise, on
the lower priced option. I will get into the details as to why later in the
course but this is not always the case.
Now, there are different strategies that we could have used, like
buying two 13.50 calls with a $10,000 account rather than one 12.50
call. Right now, I just wanted to give you an example of how call
options work and show you an example of profits that can be made
while you have 100% control over your risk.
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Being Bearish (Video #6)
Let’s now take a look at buying a put in a market that we think is
going down.
Figure 2.3 is a chart of March 2006 corn which recently broke
out of a top Head & Shoulders pattern and had the expected bounce off
the neckline. Remember we covered this in my first course so I won’t
go into details about a this again here.
Everything seems to be shaping up to look at buying a put option.
I’ve used Track-n-Trade to find the cost of three different options. By
the way from now on, I’m going to use “TNT” when I refer to Track-nTrade as I’m getting tired of typing it out!
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Look at the chart and you can see that there are three different
strike prices. The 230.00 put cost $625, the 220.00 cost $381.25 and
the 210.00 cost $212.50. If you were using the total premium as your
risk then even with a $10,000 account you could not buy the 230.00 put
(if you risk all of the premium) because it cost $630 and the most you
can risk is $500(5%). You could however buy one of the 220.00 puts or
two of the 210.00 puts and still be within your 5% risk/reward ratio.
With a $5,000 account you would be limited to buying the 210.00 put
for $212.50.
Just for example purposes let’s say that we are going to buy two
of the 220.00 Puts for $381.25 each for a total of $636.50. Now this is
over our 5% rule even with a $10,000 account. But, we could control
our risk and say that if the value of these options dropped in ½ down to
$190.62 each or $381.24 total for both of them then we would exit the
trade and take our losses.
Now that we have decided the risk how do we plan our exit
strategy? Simple, we have two choices. We could exit the trade when
the option doubles in value giving us a 100% return since we only risk
50% of the premium or we could wait and see if it hits the support at
195 and then exit the trade, even if it did not give us a 2:1 return at that
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point. I can tell you from experience that the option would easily give
that kind of return by the time it reached 195.00 since it would be deep
in-the-money at that point.
So, here was our plan; we buy two 220.00 puts for $381.25 each
or a total of $762.50 in total premium and if the options drop in value
by 50% we exit the trade and if they double in value or the price drops
down and hits the support line at 195.00, we take profits.
I can read you like a book about now! You are probably sitting
there thinking you have another idea. Since we bought two options, if
they double in value, then we could sell one of them and keep the other
one and play with “their” money! Right? Absolutely you could do that
and it’s not a bad idea. But for now we are just going to take profits if
we can on both, or exit the trade if they go against us. Let’s see the
outcome in Figure 2.4
Don’t you love it when a plan comes together? By the end of
October, the options that we paid $381.25 for are now worth $662.50
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and we offset the options and exit the trade with our 2:1 risk/reward
ratio intact. Remember we made double on what we paid for the option
but since we were only going to risk ½ of the premium, it gives us a
200% return on the money we were risking. Of course we could also
keep the option if we wanted to.
You are probably dying to find out if the price ever came down to
195 aren’t you? Well open up your own TNT program and find out
because I’m not going to tell you.
Using Options as Stops (Video #7)
Let’s look at a prime example of how an option could have turned a
bad trade into a good trade. Don’t ask me how I know! Yes, I have losing
trades and you will too. Someone who tells you they don’t probably lies
about other things too.
Look at Figure 2.5 which is a chart on Dec. 2005 US Dollar. Notice
how this looks like the perfect set up to buy a futures contract. The market is
heading up, MACD has crossed the zero line and Slow Stochastic has
crossed up and it’s been oversold. We would be trading with the long term
trend on a pull back and by all indications it’s a perfect trade. Right? Well
sometimes even the perfect looking trade goes bad.
We have a 4.75:1 Risk Reward Ratio on futures trade. We are risking
$610 to make almost $3,000. This is an incredible Risk/Reward ratio and
these trades don’t happen that often. We put our protective stop in at 86.49
(just under support) our entry to buy on a stop at 87.10 and to take profits at
90.05 (just under resistance). So let’s assume that we made this trade exactly
as planned. Let’s look at and see what would have happened.
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As you can see in Figure 2.6, we got stopped out for a loss and then
the market took off and hit our profit target exactly where we thought it
would. The problem was that we were not there to take that profit because
we got stopped out! Don’t you just hate it when that happens? I know I do.
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Would there have been a better way to have made this trade and still
be long the market with a futures contract but not have gotten stopped out?
Sure, we could have used a lower protective stop, but that would have not
been a good idea because it would have affected our Risk/Reward Ratio of
4.75:1 and it would have been above the previous support level.
Now think about this for a moment because we discussed this in my
first course, Common Sense Commodities. Figured it out yet? I bet you did
and that you came up with the solution of buying an option instead of using
a protective stop in the futures market. In other words you can buy a Put to
help protect your downside risk. Remember, a Put goes up in value when the
market goes down (usually). So if you were long the futures market and had
a Put for protection, if the futures market went down you lost money on the
futures market but you made money on the Put option. It’s the best of both
worlds.
Keep in mind that you will always lose more money on the futures
than you will gain on the option if you use them for protection. It has to do
with the Delta of the option and we will discuss this more a little later in the
course.
There are several different strike prices you could have used to
purchase your Put.
Two available strike prices we could buy an option below our entry
price at 87.74 are: See figure 2.7
86.00 for $1,080
85.00 for $780
Which strike price is the best one to use as a protective stop? Well,
it’s best to use one that is one or two strike prices below where our
protective stop would have been in the futures market. For this example we
are going to buy a 85.00 Put for $780. If we had kept the futures stop as
protection we would have only been risking $610 on the trade but we stand
the chance of getting stopped out. Remember with a Put for protection you
can’t get stopped out. I still only want to take a $610 risk on this trade, so if
WHOLE TRADE (both Futures & Options) goes against me $610 I would
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offset the option (sell it) and offset the futures side (sell a contract) and be
out of the trade totally.
One thing I want you to look at, for now, is keeping the option until
our profit target is hit (unless we lose $610 on the trade (remember you will
lose more on the futures contract if it goes against you (down) than your Put
will increase in value, so be sure to keep up with your NET gain or loss on
the trade) at which time I would exit the trade. At this time, you can decide
if you want to offset (sell it) the option if there is any value left, or you could
just hang on to it in case the market does in fact hit the resistance that we
think it will and reverse direction and start to come back down again. If that
happens, then the Put Option would start going back up in value. If this does
in fact take place, we would make money on the way up with the futures
contract, take profits, and then maybe even make money on the way back
down with the Put option.
Another option (pun intended) that we have would be to offset the
option if the market takes off if we have enough profits in the trade from the
futures contract. Then we could lock in profits with a protective stop in the
futures market. But for now, I’m just going to assume that we will keep the
Put option during the whole time and get completely out of the trade if our
profit target is hit or we take a loss of $610 on the trade. Let’s place the
trade.
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Let’s look at figure 2.8. We were filled on the order, long one futures
with a Put for protection but look at what happened! The market did in fact
rally some, went back down, went back up, hit resistance and then dropped
like a rock in just two days. If we had used a futures contract as a protective
stop we would have been stopped out with a loss.
I know, I know, you are sitting there thinking that if the market did a
180 on us and headed down from the start, we would have had a losing
trade. And you know what? You’re right we would have lost but we would
not have lost as much as we would have if we had been stopped out on the
futures contract and not have used the option at all. In most cases this is a
win-win situation and should be considered on every trade you make using a
futures contract. READ THAT AGAIN
But David, hold on for a minute… could we not have just purchased a
Call Option instead of going long a futures contract and buying the Put for
protection? Of course we could have done that.
Three strike prices we could have purchased:
$1,160 for the 88.00 Call
$760 for the 89.00 Call
$440 for the 90.00 Call
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In real life you would probably purchase just one of the strike prices.
But you could purchase two or more options at different strike prices. For
this example I want to show you what each of the strike prices would have
cost. Look at Figure 2.9
Now, let’s go forward to the same date we would have been stopped
out on in the futures contract and see what these options would have been
worth. Figure 2.10
The options are now worth:
$2,440 for the 88.00 call
$1,690 for the 89.00 call
$1,240 for the 90.00 call
To figure what we would have made for a profit, we have to subtract
what we paid for the option from what we got for the option when we
liquidated it. Of course there are commissions involved but for now we
won’t factor them in.
Strike Price
88.00
89.00
90.00
Premium Paid
$1,160
$760
$440
Premium Collected
$2,440
$1,690
$1.240
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Profit
$1,280
$930
$800
Chapter Two
So the best return we could have made $1,280 on the 88.00 call. Let’s
look and see what our percentage of return would have been if we had gone
long a futures contract at 87.12 and purchased the 85.00 Put for $780 for
protection. This is about the same dollar risk we would have taken if we had
purchased a 89.00 Call for $760 and not purchased a futures contract. So
let’s compare these two figures. Please look at figure 2.11.
Let’s see how we did. We got a bad fill on the entry (it happens) so
we were long from 87.57 rather than from 87.12 so we made $2,530 on the
futures contract and we liquidated the Put for $110 that we paid $780. So we
lost $670 on the Put and made $2,530 on the futures contract for a net profit
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of $1,860. We would have only made $930 if we had purchased an 89.00
Call. Listen to me now, we made twice as much by going long a futures
contract and buying a Put for protection than we would have made by just
buying a Call option and we took no more risk. Read that again!
The reason we made more on the trade is because the futures market
went up in value faster than the option went up in value.
Okay David, I’m starting to see the value in all this but there has to be
a catch somewhere but I can’t find it. Help me out here. Okay the downside,
and it’s not a big downside, is that you have to have the cash in your account
to afford to buy the option AND enough cash to put up the margin on the
futures contract. That’s it. An easy pill to swallow isn’t it! Oops, I almost
forgot, you have two commissions to pay, one for the futures contract and
one for the option you purchased.
Fuzzy Math (Video #8)
Why did we make more on the futures contract than we would have
by just buying a call? The reason is that until an option gets deep in the
money, it will not increase in value as quickly as a futures contract. It has to
do with the Delta of the option. Delta is calculated by how close the strike
price is to the futures price. No need to get into it now but rest assured that
we will look at it in detail before you finish the course.
It’s very important that you understand that an option will not increase
in value, even if it’s at-the-money or in-the-money (until it’s deep in the
money), at the same rate a futures contract does.
So don’t expect that when you buy an option that is out-of-the-money
that if it gets in-the-money that it will increase in value at the same rate it
would if it was a futures contract. It’s just not going to happen.
You need to keep this in mind in both buying and selling options. As
we go through the course, you will see many examples of this. Let’s look at
Figure 2.12 through 2.15 to see what I mean.
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We were filled on both the futures contract and the Call Option
(Figure 2.12). One week later the futures contract increased $3,140 in value
and the Call Option is worth $3,930 an increase of only $1,430 (Remember
we paid $2,560 for it) which is about ½ of what futures increased. Figure
2.13
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See Figure 2.14 - The last change on the futures contract was an
increase of $7,130 (A) so the total profits on the futures contract is
$10,150.(B)
Now look at the option we bought and you can see that it’s $5,000 Inthe-money “C”. The value of the option is currently $8,110 but since we
paid $2,560 for it, the profit on the option is only $5,550.
The futures contract made almost twice what the option did and if the
price continued to climb then eventually the option would go up at the same
rate, dollar for dollar, that the futures price goes up. But it has to be Deep Inthe-money for that to happen.
Let’s look at a couple more charts because it’s so important that you
understand this I want to make sure you have several examples.
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In figure 2.15 I want to show you that if we bought an At-The-Money
Put at 235.00 for $587.50 and also went short the market with a futures
contract from the same price, 235.00 how the Put and the futures contract go
up in value as the price of the futures market goes down.
You can see in figure 2.16 that we were filled on both the futures side
and the Put side. It’s going to be interesting to watch and see how long, if
ever, it will be until the Put is making dollar for dollar what the short futures
contract is making.
Looking a couple of months into the future (figure 2.16) and the put
has made a profit of $737.50 but the futures has made us $1,387.50, almost
100% more than the Put made but the interesting thing is the strike price and
the price we entered the market were the same, 235.00 on the same day.
It takes getting really deep into the money for an option to go up
in value, dollar for dollar, that a futures contract does.
And Options are much less liquid than futures contracts so you can
have more slippage than you can with a futures contract. Slippage? How can
that be? If an option is worth $500 are you telling me that I can’t buy it for
$500? Yep, not always anyway. Now before you get bent out of shape, I
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want you to put your thinking cap on for a minute.
How can this be a
positive thing that I might not get what my option is worth if I try and sell it?
Think! Did you figure it out yet? Of course you did and it works to your
advantage when you want to buy an option. Just because it’s worth $500
doesn’t mean that you are going to have to pay $500 to get it! Try and make
a bid to buy it for $450 and see if you get a “bite”. You never will know
unless you try.
In the options market, you can make offers to buy or to sell at a
specific amount. It’s like putting an offer on the table and asking your broker
to try and buy or sell it at this price. You can use limit orders to do this.
Sometimes you will be pleasantly surprised at what you can find in the
“bargain basement”.
Okay David, up until now, I was liking these options but it seems like
the way to go is still with futures. Is that right? No, not at all. There are
times to use options, there are times to use futures and there are times to use
them together.
What options do, is give you more ways to control risk and more
opportunities to trade. READ THAT AGAIN!
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In the following chapters we are going to look at dozens of different
option strategies that will have you “chomping at the bit” to get out there
and start trading options. But you know what? Don’t do it until you have
tested each and every strategy that I’m going to show you and that you are
extremely comfortable with what you are doing. Paper trade all these for 3060-90 days and know how, and why, they work and what happens if they
don’t work. And remember nothing works 100% of the time.
When I was learning to trade I took no one at face value after getting
“stung” with my first Guru. I didn’t care who they were, what they had
written, how much money they said they had made or anything else. I had to
prove to myself that what they were telling me did in fact have merit. I
suggest that you do the same thing with this course. Don’t just take my word
for it, prove it to yourself. Then and only then, can you start to feel
comfortable that you can make money using these concepts.
END OF CHAPTER TWO
THERE IS RISK OF LOSS TRADING FUTURES & OPTIONS
I hope you have enjoyed this options mini-course. The full
course is available at the website listed below. It’s almost 250
pages printed in full color in a nice three-ring binder and
comes with 39 videos that explain each example in the course
in even greater detail.
To watch the eight free videos that accompany this mini-course
go to the URL listed below.
http://www.commonsensecommodities.com/CSO_Videos/mini_course_videos.htm
(cut and paste this link if needed)
Best wishes,
David Duty CTA
www.commonsensecommodities.com
www.commonsensecapital.com
Email me at dduty@davidduty.com
pg. 59
Common Sense Options - Copyright 2006 - David Duty