Trading Options For Dummies

411 Pages·2017·17.81 MB·English

by  Joe Duarte

Trading
Options
3rd Edition
by Joe Duarte, MD
Trading Options For Dummies®
Published by: John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, www.wiley.com
Copyright © 2017 by John Wiley & Sons, Inc., Hoboken, New Jersey
Published simultaneously in Canada
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Library of Congress Control Number: 2017910916
ISBN 978-1-119-36370-5 (pbk); ISBN 978-1-119-36371-2(ePub); ISBN 978-1-119-36373-6 (ePDF)
Manufactured in the United States of America
10 9 8 7 6 5 4 3 2 1
Contents at a Glance
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Part 1: Getting Started . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
CHAPTER 1: Options Trading and the Individual Investor . . . . . . . . . . . . . . . . . . . . . . . . 9
CHAPTER 2: Introducing Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
CHAPTER 3: Trading Places: Where the Action Happens . . . . . . . . . . . . . . . . . . . . . . . .35
CHAPTER 4: Option Risks and Rewards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53
Part 2: Evaluating Markets, Sectors, and Strategies . . . . . . . . 69
CHAPTER 5: Analyzing Mood Swings in the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
CHAPTER 6: Sector Analysis: Technical and Fundamental . . . . . . . . . . . . . . . . . . . . . . . 91
CHAPTER 7: Practicing Before You Swing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
CHAPTER 8: Designing a Killer Trading Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
Part 3: What Every Trader Needs to Know
about Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
CHAPTER 9: Getting to Know Different Option Styles . . . . . . . . . . . . . . . . . . . . . . . . . . 155
CHAPTER 10: Protecting Your Portfolio with Options . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
CHAPTER 11: Increasing Profit Potential and Decreasing Risk . . . . . . . . . . . . . . . . . . . 199
CHAPTER 12: Combination Strategies: Spreads and Other Wild Things . . . . . . . . . . . 221
CHAPTER 13: ETFs, Options, and Other Useful Tricks . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
Part 4: Advanced Strategies for Options Traders . . . . . . . . . . 263
CHAPTER 14: Making Money without Worrying About the Market’s Direction . . . . . 265
CHAPTER 15: Letting Volatility Show You the Way to Trading Opportunities . . . . . . . 285
CHAPTER 16: Trading Profitably When Markets Move Sideways . . . . . . . . . . . . . . . . . 315
Part 5: The Part of Tens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
CHAPTER 17: Ten Top Option Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
CHAPTER 18: Ten Do’s and Don’ts in Options Trading . . . . . . . . . . . . . . . . . . . . . . . . . . 359
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369

Table of Contents
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
About This Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Foolish Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Icons Used in This Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Beyond the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Where to Go from Here . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
PART 1: GETTING STARTED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
CHAPTER 1: Options Trading and the Individual Investor . . . . . . . . 9
Giving Yourself a Financial and Strategic Checkup . . . . . . . . . . . . . . . . . 10
Understanding Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Knowing option essentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Trying different strategies before deploying them
in real time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Putting options in their place . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Differentiating Between Option Styles . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Using options to limit your risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Applying options to sector investing . . . . . . . . . . . . . . . . . . . . . . . . . 17
Using Options in Challenging Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Reducing your directional bias and making money
in flat markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Controlling your emotions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
CHAPTER 2: Introducing Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21
Understanding Option Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Tuning in to option basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Comparing options to other securities . . . . . . . . . . . . . . . . . . . . . . . .23
Valuing Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Knowing your rights and obligations as an options trader . . . . . . . 25
Terms of endearment and importance . . . . . . . . . . . . . . . . . . . . . . . 26
Making Sense of Options Mechanics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Identifying options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Rotating with the expiration cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Options expiration is decision time . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Detailing your rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Creating Option Contracts out of Thin Air . . . . . . . . . . . . . . . . . . . . . . . . 30
Opening and closing positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Selling an option you don’t own . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Keeping Some Tips in Mind . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Table of Contents v
CHAPTER 3: Trading Places: Where the Action Happens . . . . . . . . .35
The U.S. Options Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Navigating the Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Trade execution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Option market participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Transactions unique to options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Trading rules you should know . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Weighing Option Costs and Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Identifying costs unique to options . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Valuing options benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Grasping Key Option Pricing Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Introducing option Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Connecting past movement to the future . . . . . . . . . . . . . . . . . . . . . 49
CHAPTER 4: Option Risks and Rewards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Understanding Your Trading Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Risking money with stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Calculating option risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .57
Reaping Your Rewards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
Benefiting from stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
Breaking even with options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Profiling Risk and Reward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Profiling stock trades with risk graphs . . . . . . . . . . . . . . . . . . . . . . . . 61
Profiling option trades with risk graphs . . . . . . . . . . . . . . . . . . . . . . . 63
Combining option positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Considering the worst-case scenario . . . . . . . . . . . . . . . . . . . . . . . . . 67
PART 2: EVALUATING MARKETS, SECTORS,
AND STRATEGIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
CHAPTER 5: Analyzing Mood Swings in the Market . . . . . . . . . . . . . . . 71
A Few Words About Select Macro Factors . . . . . . . . . . . . . . . . . . . . . . . . 72
Assessing the Market’s Bias . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Judging the strength of a move . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
(Psycho)-analyzing the market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Watching Call and Put Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Understanding put-to-call ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
Using the put volume indicator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
Using Volatility to Measure Fear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Measuring volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Recognizing impact from changing volatility . . . . . . . . . . . . . . . . . . . 86
Spelling fear the Wall Street way: V-I-X . . . . . . . . . . . . . . . . . . . . . . . . 86
Applying Breadth and Sentiment Tools . . . . . . . . . . . . . . . . . . . . . . . . . . 88
Locating neutral areas for indicators . . . . . . . . . . . . . . . . . . . . . . . . . 88
Identifying indicator extremes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .89
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CHAPTER 6: Sector Analysis: Technical and Fundamental . . . . . . . 91
Getting Technical with Charts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
Chart basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
Adjusting your time horizon for the best view . . . . . . . . . . . . . . . . . 93
Visualizing supply and demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
Identifying Relatively Strong Sectors . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
Relative ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
Rate of change indicator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
Using Sector Volatility Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Displaying volatility with indicators . . . . . . . . . . . . . . . . . . . . . . . . . .102
Analyzing volatility with Bollinger bands . . . . . . . . . . . . . . . . . . . . . 106
Projecting Prices for Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
Support and resistance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .110
Channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
Price retracements and extensions . . . . . . . . . . . . . . . . . . . . . . . . . 114
Projections and probabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .116
CHAPTER 7: Practicing Before You Swing . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Monitoring Option Greek Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
Tracking premium measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
Changing volatility and option prices . . . . . . . . . . . . . . . . . . . . . . . . 121
Paper Trading a Trading Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
Trading on paper: Pluses and minuses . . . . . . . . . . . . . . . . . . . . . . 124
Implementing electronic paper trades . . . . . . . . . . . . . . . . . . . . . . .124
Using Trading Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125
Knowing what you’re getting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
Performing a backtest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
Adding risk management to a backtest . . . . . . . . . . . . . . . . . . . . . . 130
Shifting from Knowledge to Mastery . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
Setting the right pace . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Achieving mastery through longevity . . . . . . . . . . . . . . . . . . . . . . . .135
CHAPTER 8: Designing a Killer Trading Plan . . . . . . . . . . . . . . . . . . . . . . . 137
Developing a Reliable Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
Managing Your Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
Optimizing Order Execution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
Understanding option orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
Entering a new position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Executing a quality trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
Exiting an existing position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Table of Contents vii
PART 3: WHAT EVERY TRADER NEEDS
TO KNOW ABOUT OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
CHAPTER 9: Getting to Know Different Option Styles . . . . . . . . . . . 155
Nailing Down Index Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
Getting to the nitty-gritty of indexes . . . . . . . . . . . . . . . . . . . . . . . . .156
Capitalizing on an index with options . . . . . . . . . . . . . . . . . . . . . . . .158
Watching Out for Style Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
American-style options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .161
European-style options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Exercising Your Options, American Style . . . . . . . . . . . . . . . . . . . . . . . .164
Knowing the nuts and bolts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .165
What you see is what you get . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
To exercise or not, that is the question . . . . . . . . . . . . . . . . . . . . . . 166
Exercising Your Options the Euro Way . . . . . . . . . . . . . . . . . . . . . . . . . . 167
Tracking index settlement (the SET) . . . . . . . . . . . . . . . . . . . . . . . . . 167
Cashing in with exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .167
Satisfying Option Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
American-style stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
Expiring options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
European-style options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
Breaking It Down: American-Style Index Options . . . . . . . . . . . . . . . . .174
Exercising rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Meeting obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175
CHAPTER 10: Protecting Your Portfolio with Options . . . . . . . . . . . . . 177
Putting Protection on Long Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Combining puts with long stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
Weighing protection cost versus time . . . . . . . . . . . . . . . . . . . . . . . 183
Limiting Short Stock Risk with Calls . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Protecting a short stock position . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Further reducing short stock risk . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
Hedging Your Bets with Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
Protecting a portfolio . . . partially . . . . . . . . . . . . . . . . . . . . . . . . . . . 188
Protecting a portfolio . . . completely . . . . . . . . . . . . . . . . . . . . . . . . 191
Avoiding Adjusted Option Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
Justifying option adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
Adjusting from adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
Increasing Profit Potential and
CHAPTER 11:
Decreasing Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199
Leveraging Assets to Reduce Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Determining your total dollars at risk . . . . . . . . . . . . . . . . . . . . . . . .200
Relying on market timing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
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