Show Me Your Options!

Books by Steve Burns

How I Made Money Using the Nicolas Darvas System

New Trader, Rich Trader

How to Get More Followers on Twitter

Show Me

Your

Options!

The Guide to Complete Confidence for Every Stock and Options Trader Seeking Consistent, Predictable Returns

Steve Burns

Christopher Ebert

All rights reserved.

No part of this publication may be

reproduced, stored in a retrieval system, or transmitted

in any form or by any means, electronic, mechanical,

photocopying or otherwise, without the prior permission of

the copyright owner.

ISBN: 9781607964193

© Copyright 2012 by Steve Burns and Christopher Ebert

Published by BN Publishing.

ALL RIGHTS RESERVED

info@bnpublishing.com

www.bnpublishing.com

We wrote this book to give stock traders a stock option book that was neither so simple that it insulted their intelligence but at the same time not so complicated that it was beyond comprehension. We also wanted to make it a fun read as opposed to feeling like a boring college lecture. We believe we have accomplished these missions.

op·tion

[op-shuhn]

–noun

1. the power or right of choosing

2. something that may be or is chosen; choice

3. the act of choosing

4. stock option

5. a privilege acquired, as by the payment of a premium or consideration, of demanding, within a specified time, the carrying out of a transaction upon stipulated terms; the right, as granted in a contract or by an initial payment, of acquiring something in the future

- Dictionary.com

CONTENTS

Foreword

Chapter 1 options are not assets, they are bets.

Chapter 2 every option contract has a buyer and a seller; one is long, one is short, but which one has the best odds of winning?

Chapter 3 strong trends are the friend of an option buyer and the enemy of an option seller.

Chapter 4 time is an option seller’s friend, but the option buyer’s enemy. (theta)

Chapter 5 volatility is the option buyer’s friend but the option seller’s enemy. (vega)

Chapter 6 how much of the move do you get for the money? (delta)

Chapter 7 stocks for rent: covered calls

Chapter 8 selling lottery tickets: naked options

Chapter 9 buying lottery tickets: deep out-of-the-money options

Chapter 10 trends determine who wins: strangles and straddles

Chapter 11 the twins: every position has a synthetic relative

Chapter 12 spreads: ratio, calendar, diagonal

Chapter 13 the wind beneath the pro’s wings: butterflies and condors

Chapter 14 dealing with the behavioral problems of immature options

Chapter 15 A trader’s choices: insurance, stop losses, or ruin

Chapter 16 your method, your rules, your edge

Appendix A: relative time value of options based on the time to expiration of the contract

Appendix B: odds and expected payout of selected option strategies

Appendix C: the relationship between option premiums, deltas, standard deviations, and profit probabilities

Appendix D: time progression payout potential

Appendix E:  expanded table of synthetic positions

About the Authors

Foreword

FOREWORD

Steve Burns and I met by chance, however it was inevitable that we would bump into each other given our similar trading styles and how active we are on Twitter in our niche. I was looking for someone to contribute book reviews on my blog and I discovered that Steve had reviewed a mind boggling amount of books with honest and concise summaries. Considering the knowledge that he has accumulated from all those books that he read, I believe him to be the perfect candidate to share his knowledge with aspiring traders to help them avoid many of the pitfalls that new traders can run into. I approached Steve to see if he wanted to post his reviews on my site and soon after we formed a strong relationship. Steve's ability to sift through the sheer amount of  information available in myriad books on trading and take away the important aspects traders need to focus on to be successful is remarkable indeed.

Through Steve I was fortunate enough to be introduced to the "Options Scientist" Christopher Ebert. Steve mentioned that Christopher had a firm understanding of options and was very creative with his option strategies, but that is an understatement as I would say he is in the top 1% of understanding the ins and outs of options as you will soon discover as you progress through "Show Me Your Options." Working with Chris as the resident options guru on zentrader.ca has given me a chance to learn from one of the best. Chris is very generous with his time and is always willing to answer any questions I may have and offer suggestions on how to structure an option trade.

This book has forced me to look at options in a whole new light as it dives from the basics into extremely advanced strategies in an easy to read format. It could have more appropriately been named, "Everything you've ever wanted to know about options, but didn't know to ask." They cover strategies that I didn't even know existed. Having been trading since 1998 I'll be the first to admit that I'm intimidated by complex option strategies, but that comes from a lack of understanding. We fear what we don't know. This book may require a second reading for option novices like myself, but I highlighted many passages to revisit and for the most part Chris and Steve present this information in a story format from the standpoint of a mentor/student that is very relatable. Once armed with the new information such as how to use straddles and strangles effectively, I can expand how I personally trade and invest through the use of options.

There are two kinds of traders in this world. Those who use options and those who don't. I believe Steve and Chris are effectively bridging the gap. Being primarily a momentum trader,  I was a little surprised to see the author's views on covered calls, but it makes complete sense after reading their logic.

The problem with Covered Call writing is that you get a small premium to relinquish the upside profit on a stock, but you retain the whole downside risk. It is like doing the opposite of what you want to do in trading; you are letting your losers run and cutting your winners short.

From this standpoint you should never sell calls in a strong trend as you are capping your winnings, or as they describe more appropriately, a "stop win", which flies in the face of what a lot of option experts will tell you to do with stocks in your portfolio. "Strong trends are the friend of an option buyer and the enemy of an option seller," The book is an education that you will definitely get your money out of, if you apply their principles and various strategies.

When I was approached about writing this forward I was honoured and excited because I believe this is the book that could help me wrap my head around options and help boost my equity curve. I was their target market. Someone who has always wanted to implement options in their trading but hasn't found a book that discusses the many strategies without losing me in the process - until now. Options talk can be very technical but "Show Me Your Options" is broken down into bite-size chapters and useful options analogies that will help anybody muddle through options trading and come out on the other side with a couple of strategies they can use right now. The measure of a great trading book is whether I can take what I read last week and inject that into my trading on the next. Mission accomplished guys.

Jeff Pierce

@zentrader

zentrader.ca

Chapter 1

OPTIONS ARE NOT ASSETS, THEY ARE BETS.

Stock Trader heard the alarm go off. He rolled over in bed and hit his beloved snooze button. It was time to head off to his day job, but his mind rarely stopped thinking of his second job of trading. Trading would be his ticket out of the nine-to-five corporate world. He wanted to move from being an employee of a company to an investor in the company. He wanted his money to work for him and be able to stop working for money. His dream was financial independence. Of course, all his fellow employees thought he was nuts. Most of his friends at work could not comprehend ever not having a job, or that not having a job should even be a goal. Stock Trader, though, was different; he ignored all the negativity and doubt and just kept on doing what others believed was impossible.

He beat the S&P 500 year after year

He went to cash and avoided downtrends

He sold stocks short and made money in downtrends

Many months he made more trading than working

He built his accounts over time even during market crashes

As he lay in bed he realized why he continued working so hard at trading. He wanted the freedom to do what he wanted, when he wanted. His goal was not material things, oddly enough. He wanted time, he wanted freedom, and he did not want to be a slave to earning a wage and paying bills.

“Isn’t that gambling?” They would ask him in a concerned and slightly condescending tone at work.

“No, it is a business like any other. I use the same principles as any other business. I buy and sell inventory, I follow trends and I manage risk. I participate in auctions and use best practices to get an edge over my competitors. The company we work for gambles more than I do,” Stock Trader would respond. Unfortunately, his audience really didn’t understand what he was talking about.

With only a few likeminded friends, Stock Trader continued along his journey in the stock market, trading, reading, and learning. He truly loved the stock market. He would watch CNBC like other men watched ESPN. While other men were entering fantasy baseball and football leagues, he was entering stock trading contests online. For him it was not just about making money; it was a passion of his, a challenge of both strategy and wit. Determination and will power separated many winners from the losers in the stock market. He loved the stock market game.

He had always loved stock trading. He had been fascinated with quotes and what made stocks move up and down from the time he was a small child. As a matter of fact, he had an account and was trading something for as long as he was legally old enough to do so. When he was too young for stocks, he had collected and traded coins, baseball cards, and comic books. He did not know it at the time, but these activities were training him for the markets.

When a certain superhero was popular, that character’s comic books would go up in value. A movie release, cartoon, or television show could cause a bull market in that superhero. This prepared him to see that a hot product could send a company's stock soaring.

Future record setting expectations for a rookie baseball star set his cards on an uptrend as long as he met expectations for home runs, batting average, and RBIs each season, much like earnings expectations drove stock prices in the market. One bad season could lower the value of the player’s cards just like a bad earnings announcement could lower a stock’s price. Rookie cards could make big money if their careers took off, just like small cap companies in the stock market if their products and earnings took off in an uptrend. Hall of Fame players' cards stayed about the same, their growth years being behind them. Everyone knew where the Hall of Famers would end up, much like most big cap stocks that just meander along at about the same price with their growth years being behind them.

When he was young, he visited coin shows and made purchases for his growing collection. Years later, as he sold his coin collection, he learned the difference between what something was purported to be worth by a book on prices versus what a buyer was willing to pay for it. There was evidently a difference in the price of the coins depending on whether he rented a booth and bought coins from people trying to sell them, or if he went to a coin show and bought coins as a customer. This taught him about the bid/ask spread in the market even before he had traded a stock. There are wholesale buyers and retail sellers in most industries; the stock market was no different.

With an energy drink in hand, he sat down and pulled up his accounts, as was his daily ritual. He had two different accounts: one tax deferred for “retirement” and a brokerage account. He stared at the numbers: $201,617 in his retirement account and $103,725 in his brokerage account. It took 15 years of trading and some luck to build his accounts to this size. Many who knew about his success thought he was just lucky and had no idea about the long hours he spent studying the markets to achieve his success. Unlike his peers at work, he had sidestepped the last bear market that mauled many of the buy-and-holders. He was 33 years old and had played to win. He had used trend trading and some swing trading to achieve some outstanding results. He worked very hard to be in the right place at the right time and to seize the opportunities the last bull market gave him. He also used the lessons of past bear markets, which mauled him, to know when to get out and sell short. Moving averages, support and resistance on the charts, prices, and volume were his constant friends and advisors.

He had felt ready to trade for a living on many occasions. The dilemma he faced was that he wanted to produce a consistent income from his capital while exposing it to minimal risk. He was at a place in his trading career that he had to take what he considered to be very large position sizes to keep getting outperforming returns. All he really needed was a 15%-20% annual return and he was financially free. While he had accomplished that many times, and even many years in a row, the problem was that returns like that year after year would be world class. Even the fraudulent money manager, Bernie Madoff, did not produce consistent returns which matched Stock Trader’s goals.

Stock Trader needed a way to trade with less risk and yet produce a relatively safe, regular income. His trend trading, while it had runs of huge returns, also had draw downs of capital. He hated draw downs; the method of trend trading he used had losing years, especially in very range-bound and choppy markets.

So that day at work, Stock Trader kept thinking through his options: “High yield junk bonds? If they were diversified enough and if I bought them on a pullback I might be able to get 8% a year in interest. That is not enough. Real estate investment trusts pay dividends but not enough for me to meet my needs.”

“Could I swing trade for consistent returns? Probably, until a trend caused a draw down,” thought Stock Trader.

“I really want the odds consistently in my favor if that will be my sole source of income.”

That night, as Stock Trader was doing his normal Internet surfing, after checking market quotes and e-mail and sending out a few tweets, he noticed a post in his Facebook group “Winning Traders.”  It was from a new member with the user name Optionz Traderz. Stock Trader did not like it when people did not use their real names on Facebook. He thought that they needed to go to Twitter or MySpace if they were going to have avatars and screen names. Facebook was for real people.

He looked at the post.

Optionz Traderz: Who else on here has had success like I have had trading the triple leveraged ETF options?

No comments were posted.

“This person loves the letter ‘Z’ and has a pink Cadillac for a profile picture. Now he is talking about triple leveraged ETF options? He is a different breed,” thought Stock Trader.

He waited, still no comments.

Stock Trader felt the need to fill the void.

Stock Trader: I mostly trade stocks, not options. I believe options are too risky. Using triple leveraged ETF options sounds like options on steroids; they are too rich for my blood.

He received a posted response on Facebook.

Optionz Traderz: I believe they represent the opportunity of a lifetime; they can be used to manage risk while giving you amounts of leverage that have only been available to professionals in the past.

Stock Trader: You can also lose at the fastest pace ever.

Optionz Traderz: The same trading rules apply to 3x options as to the rest of the market. The difference is that you can get the full upside of a triple leveraged trend while the downside is controlled with only the price you pay for the option being at risk. They are tools to increase leverage and limit downside risk. You can win big and lose small with these. In the past, the only way to achieve similar returns was to either open a large number of contracts or tie up a big chunk of capital by purchasing the shares outright. Utilizing triple leveraged ETFs cuts down significantly on commissions and fees when trading options and enables a huge reduction in the amount of money at risk when trading the underlying shares.

Stock Trader: I have always thought of options as lottery tickets.

Optionz Traderz: They are. The good news is that the odds of winning are on the back of each lottery ticket, and I have been working on determining the odds for each option strategy. If the odds of each strategy are known in advance, it makes it easy to sort out the good strategies from the bad. However, unlike lottery tickets, you can tilt the odds in your favor with a good trading methodology, just like in stocks.

Stock Trader: I want to own an asset, not a lottery ticket. I have not heard of very many option trading success stories. Generally, I think they attract under-funded rookies who buy far out-of-the-money options that the professionals gladly sell to them to collect premiums.

Optionz Traderz: If the pros make that kind of easy money, why don’t you sell deep out-of-the-money 3x options and really clean up?

Pause.

The wheels in Stock Trader's head started turning. “Why didn’t he?” He thought about it. “Would it be worth it? How much premium could he get from two or three strike-out options? Didn’t professionals love the Iron Condor, or whatever that was called? Would this create cash flow that he needed? What would be the risk of a Black Monday or market crash?”

Stock Trader saw a new member had just joined the Winning Traders group. He glanced at the name, Rookie Trader. He couldn’t help feel slightly annoyed that someone who thought of themselves as a rookie would join a group set up specifically for experienced traders. The thought quickly passed when another post appeared.

Optionz Traderz: Did I lose you?

Stock Trader: No, you actually perked my interest.

Optionz Traderz: The 3x options do have some advantages over traditional options and some even have weekly options that trade. They also have very good volume for near months and close-to-the-money options. They are popular and for good reason. The Theta decay on 3x options is very generous, although the increased rate of decay presents an additional risk that needs to be managed.

Stock Trader: I did some trend trading with the triple leveraged ETFs, so I am familiar with them.

Optionz Traderz: The same principles of successful stock trading apply to option trading, risk management, psychology; and you need a trading a method that gives you an advantage through better probabilities. The differences are that for triple leveraged options the option seller gets a much larger Theta premium, so if an Iron Condor works for regular options it can be even more profitable for 3x options. The option buyer gets the leverage of a 3x ETF with a minimum investment compared to the dollar amount controlled. He can buy in-the-money options and get the full movement of a trend and at the same time have his daily returns compound when he is right and a trend continues for the length of his option contract. Also, a trader can go either long or short in the market with the same effort and get the compounding on the way down in a bear market. They are powerful derivatives of derivatives. They are like derivatives 2.0 or derivatives squared. I believe they give good traders the opportunity to make a lot of money with limited risk.

Stock Trader: How long have you traded options?

Optionz Traderz: Nine years.

Stock Trader: How have you done?

Optionz Traderz: I lost my entire account the first year, broke even the second year, and have not had a losing year since.

Stock Trader: Have you made much money, Optionz Traderz?

Optionz Traderz: I bought my condo and my Cadillac with cash.

Stock Trader: That is your real car on your profile picture?

Optionz Traderz: Yes, what did you think, it was a dream car?

Stock Trader: You never know on social media who you are chatting with.

Optionz Traderz: I thought it would be fun to talk trading online with like-minded traders.

Stock Trader: It is. Glad you are in the group. We mainly talk stocks and market direction in this group.

Optionz Traderz: I have traded winning strategies where it didn’t matter which direction the market went in.

Stock Trader: O.K., now you have lost me. How is that possible?

Optionz Traderz: You know the old Iron Condor – sell options out-of-the-money and buy options further out-of-the-money. As long as the trend doesn’t reach the long options and they expire worthless, you win, regardless of the trend’s direction; you are just predicting the lack of the trend’s magnitude. The key is to manage the risk of the position the one or two times out of ten that the underlying actually reaches the strike of the long options. In options you can buy a hedge or buy back the option instead of using stop losses. Options on 3x ETFs can also be used to create all of the other options combinations available on non-leveraged funds. One of my favorites, the Reverse Iron Butterfly, can make a nice profit when the underlying moves up or down by as little as one dollar, sometimes less. Think about it: would you rather have a Reverse Iron Butterfly using 3x options or 1x?  Sometimes the cost to open both Butterflies is similar, but the triple leveraged Butterfly has three times the odds of success.

Stock Trader: Hmm… I have never traded like that.

Optionz Traderz: I have; it is sweet when you win eight times in a row.

Stock Trader: There are option systems with 80% win rates?

Optionz Traderz: Yes, but the key is managing the two losses correctly so you do not give back your profits from the eight wins. The option market is very efficient. Over time, given a large enough number of trades, all options strategies tend to break even. The odds are that historically a system with 8 wins and 2 losses will take back all the winning dollars with those two losses. The key is to manage those losses through hedging or unwinding the position. Each option system has an inverse system, just like there are long and short stock strategies, bull and bear ETFs, and more recently, 3x and inverse 3x ETFs. Option systems have mirror opposites. If you lost the 8 times in a row on the out-of-the-money options that you were long, the odds are you would make it back on the 9th and 10th trades. This is simplifying but you get the idea.

Stock Trader: No Holy Grail, just risk management.

Optionz Traderz: Risk management, discipline, and a thoroughly tested trading system are the Holy Grails.

Stock Trader: Well, I agree with that; it is the same with stock trading.

Then a post came in from a new member of the group.

Rookie Trader: Good grief! You two get a room.

Stock Trader: Very funny. Well, it was great chatting with you. I am going to sleep on what you have said. Very interesting.

Optionz Traderz: I look forward to chatting again sometime.

A little while later there was a post from the new member. Stock Trader had already shut down his computer so he was not aware of the discussion.

Rookie Trader:  Seriously, you two are made for each other. You make options sound so complicated. You use terms like long and short and Condors and leverage. I just got some stock options from my employer and they told me it was easy to make money on them and there was no risk.

Optionz Traderz:  The options that Stock Trader and I were discussing are different from the ones you are talking about. It is confusing to a lot of people. The options you own are perks offered by employers called Employer Stock Options. They give you the right to buy your company’s stock at a specified price sometime in the future. You can make money on Employer Stock Options when the stock price goes up. The options we were discussing are Standardized Options that are traded on major market exchanges, similar to the way stocks are traded on Wall Street and other stock exchanges around the world. Unlike Employer Stock Options that are only available to a select group of employees, Standardized Options are available to almost anyone who opens a trading account.

Rookie Trader: I saw what you wrote about making money no matter what happens in the stock market. That sounds like some kind of scam.

Optionz Traderz: I can assure you it is not a scam. It is a proven method of trading that consistently produces more profits than losses.

Rookie Trader: If that’s true, why isn’t everybody doing it?

Optionz Traderz: A lot of people are doing it. But it involves risks, just like any other investment. Some investors are not comfortable with the risks. Other investors do not take the time to learn the risks and end up losing a lot of money.

Rookie Trader: You said you made enough money to buy an expensive car and a condominium.

Optionz Traderz:  It is possible. However, it is not easy money. If you want to profit from trading options, you will need to understand how they behave.

Rookie Trader: If I can trade options and make enough money to buy a car and a condo, then I want to know how options work. How do I get started?

Optionz Traderz:  There are many books about options. You can find a huge amount of information on the Internet. Also, you might want to watch videos, take classes, or attend seminars dedicated to explaining all of the different option strategies.

Rookie Trader:  Is it really that simple?

Optionz Traderz:  I wouldn’t call it simple. If you want to trade options and make consistent profits, you will need to dedicate some time to learning about them. You will also need to practice trading. It is no different than learning how to do any job. To be good at anything, you need to learn and you need to practice.

Rookie Trader:  Practice?

Optionz Traderz:  Yes, after you have studied options and all of the strategies, you will need to design a trading system that fits your personal taste. Then you will need to practice trading your system until you are good at it. There are several ways you can practice. A very simple way is to open a hypothetical trade and use historical prices to see how it would have performed in the past. Next, you might want to try opening a fictional trade to see how it performs in real time. There are many websites that offer virtual trading for free. When you are satisfied with the results, you can continue practicing by opening a small trade with real money. When you have practiced enough, you will have the confidence to trade options in real time with real money.

Rookie Trader: I am glad I joined this group. You have given me some real hope that I can be as wealthy as you. I can’t wait to get started.

Optionz Traderz: Good to hear it. It has been nice talking to you, but I really need to get some sleep now.

The next evening, Stock Trader was sitting at his computer with his usual energy drink. He checked his accounts: $201,675 in his retirement account and $103,599 in his brokerage account. After seeing that markets were mostly flat worldwide, he tuned into CNBC for a while. He watched for a few minutes, but the report about a global surplus of bananas did not keep his attention for very long.

Soon he was cleaning up his e-mail and looking at his Facebook page. Once there, he saw that there were additional comments in the Winning Traders group he had visited the previous day. He read through the comments between Optionz Traderz and Rookie Trader. “Why is this guy, with all of his experience, taking the time to discuss options with someone so inexperienced?” he thought. Then his eyes were drawn to the pink Cadillac icon in the “members online” section of the page.

That pink Cadillac stuck in his mind. As successful as he was at trading stocks, he had not yet found a trading system that could justify selling his old pickup truck and buying his dream car. Stock Trader had thought about his conversation with Optionz Traderz all day while he was at work. Was it really possible to make money with options no matter what the market was doing? Could this be his ticket to having the lifestyle he wanted so much? So many questions filled his mind that there was nothing else he could think about. Now was his chance to get some answers. He began typing.

Stock Trader: What do you think about that Rookie Trader?  How long do you estimate it will take him to lose everything? I give him 2 months, tops.

There was a pause for a few minutes.

“Maybe my comment was offensive,” Stock Trader thought. But his fears were allayed when after a few minutes there was a new post.

Optionz Traderz: I always like to help people who want to learn about options. After losing everything in my first year of trading, I feel like I am helping others avoid the same mistakes that I made.

Stock Trader:  All day while I was at work I couldn’t stop thinking about what you said about making money no matter what the market does. I would really like to learn how you do it. As successful as I have been at building my retirement funds and my brokerage account, a method of investing that generates consistent income is what I am seeking the most at this point in my life. If options are the answer, I hope you will share your trading secrets.

Optionz Traderz: I enjoy sharing. It’s refreshing to find people with that same interest in options. Sometimes I talk about options with my friends and I get nothing but a blank stare, as if I were the most boring person on Earth.

Stock Trader: I don’t find options boring at all. To me, they seem like the most exciting trading tools I have ever encountered.

Just as Stock Trader was beginning to enjoy the conversation, it was interrupted by a new post from the beginner.

Rookie Trader: I thought it was going to be easy to learn options, but when I looked up some information about them, all I found was a bunch of complicated equations. How can you two possibly get excited over some stupid equations?

Optionz Traderz: I understand your frustration with the formulas. I studied calculus in college, and even with my mathematical background the differential equations that are used to determine options pricing are difficult for me to understand. From my experience, it is not necessary to understand the formulas to make a profit. There is plenty of information available on options that can easily be understood without a mathematics degree. I suggest you keep looking until you find a book that explains options in a manner that makes sense to you.

Stock Trader:  I have to admit I was a little intimidated when I started trading options and saw the Black-Scholes model and all of its equations. When I encountered terms like Implied Volatility and “the Greeks,” I thought I might have been in over my head. But I stuck with it and am glad I did.

Optionz Traderz: Black-Scholes is merely an explanation of how the market determines the premiums for options. I believe it is important to understand why the formulas exist. Implied volatility and the Greeks are helpful as well, but understanding them does not necessarily increase a trader’s profitability. Profiting from options is not about formulas; it is about developing a trading system that works in the real world.

Stock Trader: I agree with you there. If profiting from options was only available to those who understood the formulas, we would live in a world where the option scientists controlled all of the wealth.

Optionz Traderz: I don’t know whether or not I should be insulted by that comment, as I see myself as a sort of option scientist.

Stock Trader: I did not mean to insult you. I really would like to see more of your ideas on how to profit regardless of what the stock market is doing.

Then another interruption came from the novice trader.

Rookie Trader:  Hey, you two, I saw you talking about the Holy Grail earlier. I just bought a subscription to a website that says it has found the Holy Grail. All I need to do is sell Covered Calls and I am guaranteed thousands of dollars of income every month. What do you think? Not bad for a 22-year-old who doesn’t understand formulas, huh?

Optionz Traderz: Yes, it is possible to generate income with Covered Calls. But you need to understand the risks before you start trading. I really hope you test it for a while before you start trading with real money. Writing Covered Calls could look like the Holy Grail in a flat or up trending market and you may even get by in a market that is slightly trending down, reselling Calls on the way down. The problem is that in a sharp market downtrend or a crash you will take the full losses while only receiving a small premium and will not be able to regain the losses in an uptrend because the Call holder will get the full upside. I would like to discuss this more tomorrow.

Stock Trader: It is hard to believe that I, too, was that naïve at one point. I guess everybody has the same reaction when they are exposed to options for the first time. In some ways they look so simple to trade; in other ways they seem too complicated to understand. And there are so many sharks in the water just waiting to prey on the next trader’s inexperience.

Optionz Traderz: You nailed it! That was my experience, exactly. I am looking forward to telling you how I was able to profit from options; unfortunately I have a service appointment at the Cadillac dealer early in the morning. If I don’t get to bed soon, I might oversleep. I’ll be here again later tomorrow morning though. I can tell you more then.

Stock Trader:  O.K., tomorrow morning it is.

Chapter 2

EVERY OPTION CONTRACT HAS A BUYER AND A SELLER; ONE IS LONG, ONE IS SHORT, BUT WHICH ONE HAS THE BEST ODDS OF WINNING?

Stock Trader opened his eyes. “No alarm?” he thought. Oh, it was a blissful day off – no job and no responsibilities. He could get up when he chose and do what he wanted. He wished every day could be like Saturday; maybe one day they would be. He almost slipped into a mild depression on some Saturdays when there was no market to follow. He enjoyed key parts of every trading day when the stock market was open. When he awoke on trading days, he was curious how the Asian markets closed; next he would look at what levels European markets were trading; and then he had to see the action in the pre-market in the United States and of course the futures. After he had his energy drink and looked at the updates, he would move on to his day job. However he made sure that he checked in to see how the market opened and where it was before lunchtime. Then he liked seeing where the market was two hours before the close. Finally, at the end of the day, he studied the closing prices on a long-term chart and examined the day’s volume.

His watch lists were generally composed of the major indexes: the S&P 500, the Dow Jones Industrial Average, and the Nasdaq. He would watch these along with about five stocks on which he was bullish. By watching these fluctuations over the years he got a feel for the markets. He used his observations to build systems that he used in his trading. These systems were designed based on what the market had done in the past. They were mainly built on past price action that he believed was caused by other trader’s emotions. He thought a lot of the market behavior was caused by emotions, and his long-term charts helped him predict those emotions. These systems worked for him.

He had moved away from his discretionary shoot-from-the-hip trading. He no longer believed he could beat the market by being a market genius. He now believed that by placing high probability trades he would win in the long run.

His mind drifted back to what Optionz Traderz had posted in the online group.

“An 80% win rate? Could options put the odds that much in my favor? What were the risks?”

With those kinds of odds, he could pay bills through his trading on a regular basis. He had traded systems that had given him those kinds of winning percentages, but in stocks those results were more a function of the market environment than a long-term sustainable winning percentage. Tech stocks were great for day traders in the late 1990s, and then trend traders cleaned up in the fall of 2008 by shorting financial stocks. However, when the tech bubble burst in early 2000 and when the market reversed and got choppy in early 2009, those same traders realized they were not the geniuses they believed themselves to be. He no longer had any delusions about easy over-performance; he knew you earned your keep in the markets.

He wondered if options, with all their moving parts, were something he could use for a steady income. He really liked the idea of selling the sucker bets, the far out-of-the-money options that amateurs loved to buy. If they were going to expire worthless eight times and he only had to cut losses early twice, that would be his ticket. He had to look up some option tables to see how much he could get for them and calculate his margin requirements. He was intrigued.

He went over to his computer and signed on although it was not his usual routine for a Saturday. He usually read and relaxed early in the morning and surfed the web at night. But he signed on anyway and went to his e-mail. He had an e-mail in his inbox from his Facebook account; it was a friend request from Optionz Traderz. He already felt that Optionz Traderz was violating a Facebook rule with the use of a misspelled name. In his mind, this guy was now violating a second Facebook rule of his; he would chat in groups, but his Facebook account was for family and real friends only. He did not know who the heck Optionz Traderz really was. But there sat the familiar Cadillac on the message in his inbox.

“This guy is too much,” said Stock Trader out loud.

He clicked to accept the friend request, but he didn’t really know why he was doing so. They could just as easily chat online without having to be Facebook “friends.” He was doing things he usually did not do; it seemed Optionz Traderz had a knack for easily crossing Stock Trader’s boundaries on the first try.

In the late morning, Stock Trader pulled up his Facebook account and clicked on his Winning Traders group. Only a few of his buddies were online. He looked at some of the posts from the previous evening. Posted were the usual prognostications of where the market was going: which stocks were hot and where support and resistance was in the major averages. There were also a few annoying penny stock pumpers that were constantly pushing some garbage penny stock on the over-the-counter market. He read one of several posts.

Penny Trader: ZXLL just hit .06 cents, like we predicted.

Stock Trader: Who cares?

Penny Trader was offline, probably enjoying his Saturday, so no response was forthcoming. Stock Trader felt a little boredom creeping in when he saw this post.

Rookie Trader: I have read over the information from my Covered Call Holy Grail. I have done it; I found a system that cannot lose. I will not be able to make the thousands I thought I would, though, because I do not have enough money to invest right now. But I can make hundreds easily!

Stock Trader: Are you serious?

Rookie Trader: I have the simulated records to prove it. In back-testing, it worked perfectly. You simply get a great stock and sell three-month-out Call options, over and over again. Even if the market trends down, you just sell another option. You generate income every month and keep the stock. I have the proof in all the thorough back-testing.

Optionz Traderz: I believe what you are seeing is what is called “curb fitting,” where in hindsight people create a system that works. In the real world, in real time, things do not always work out perfectly.

Rookie Trader: How can I lose if I still own the stock and sell Calls against it for income? Looking at the Call prices, I should collect enough premiums to cover the cost of the stock itself in 18 months on some of these.

Optionz Traderz: Oh, let me count the ways. It will work out fine if you have picked a great stock and you are in a bull market. Unfortunately, in the real world, there are bear markets, down trends, Black Swan events, scandals, and bankruptcies. If Covered Calls were the golden ticket into the Willie Wonka factory, we would all quit trading and go in and eat the chocolate. If you found great companies in a bull market you could make more money buying Calls in those hot stocks, not selling them.

Rookie Trader: Huh?

Stock Trader: Preach it, brother!

Optionz Traderz: There is no Holy Grail in trading. There are probabilities, risk management, historically winning systems, discipline, and trends. But no system wins all the time. Looking for a Holy Grail is a sign of not understanding the market. Many investors thought selling out-of-the-money Naked Puts in the late eighties was the Holy Grail, and they won almost 100% of the time until Black Monday in 1987 bankrupted many of them in a matter of a few days.

Rookie Trader: But I have the back-tests right here.

Optionz Traderz: I am sure they hand-selected some wonderful stocks like an Apple or a Google, not an Enron or a Global Crossing during an accounting scandal. I am sure they did not pick an Exxon or a BP during an oil spill. I bet they never would have selected Internet stocks in March of 2000 or financial stocks in 2008. Any of these choices would leave a huge hole in your strategy, unless you had strong stop loss rules. A Black Monday or market meltdown would really devastate your strategy.

Rookie Trader: But it explains how in the long run it is a winning system.

Optionz Traderz: If you select the right stocks it may be. What does it say is your average drawdown?

Rookie Trader: What is that?

Optionz Traderz: How much you can expect to lose when the market moves contrary to what is needed to be profitable.

Rookie Trader: It says it always wins, every month.

Optionz Traderz: Now I know you have been conned; all systems have losing months and years. There is only one option trade that can never lose. Would you like to know what it is?

Rookie Trader: If you know of a trade that can’t lose, of course I want to know.

Optionz Traderz: Pick any stock, then sell a Covered Call and buy a Put at the same strike price.

There was a pause for a few minutes.

Rookie Trader: You are a genius! This trade can never lose. No matter how much the stock drops, I can use the Put to sell it without any loss. Is this how you made all of your money to buy your Cadillac?

Optionz Traderz: No, I did not. If you look closely, the trade I described wins 100% of the time, but the maximum profit is always zero. You would probably even lose a little on the bid-ask spread, plus you would have commissions to deal with. There is no risk in this trade and therefore there is no reward. The reward of an options trade is exactly proportional to the risk. There is no Holy Grail with options.

Stock Trader: If those guys had the Holy Grail, they would be managing big money, not selling $100 black-box systems. Good grief! Writing Covered Calls is not rocket science; you don’t need to buy a program to do it.

Optionz Traderz: The problem with Covered Call writing is that you get a small premium to relinquish the upside profit on a stock, but you retain the whole downside risk. It is like doing the opposite of what you want to do in trading; you are letting your losers run and cutting your winners short. A friend of mine once described a Covered Call as the exact opposite of a stop loss. He likes to refer to a Covered Call as a “stop win.”

Stock Trader: That sounds like the worst thing you can do. It makes me wonder why they are so widely promoted.

Optionz Traderz: It is often touted as the safest way to use options, but in reality it can be a losing system in bear markets. In raging bull markets you give up the uptrend and in bear markets you receive all the losses. The efficiency of the options market and commission costs make it a poor bet most the time. With that said, there are times, especially when volatility is elevated, when it makes sense to sell Covered Calls. Other times it might be safer to sell a Straddle or Strangle.

Stock Trader: A what? That sounds violent. I guess I always just accepted the belief that the Covered Call was one of the safest options strategies.

Optionz Traderz: Selling a Covered Call is just a system and one of many strategies. They all have inverse bets, and all work best in specific market environments. If you are the Call buyer you get the full upside, but are limited to losing only the amount of the intrinsic value and time value. There are times you should buy Calls and other times when you should sell them. From my years of options research, it is evident that all systems, left to run unmanaged, revert back to their mean and investors break even. The only way to outperform is through managing the inherent risk.

Stock Traderz: I never thought of it that way before. Options systems are like stock systems, and the way you win is to manage the risk?

Optionz Traderz: Yes. Risk is what options are all about – a seller selling their own risk for a price. The seller of a Call option is renting a stock to the buyer of the option for a set period of time, while retaining all of the risk. The buyer is paying the seller a set amount of money for control of the profits of the underlying stock, but without the risks inherent to owning the stock.

Stock Trader: Selling options sounds risky, but I have had a lot of people tell me that selling options is the only way to make a profit.

Optionz Traderz: Thanks to the Black-Scholes model and market efficiency, the premiums usually reflect the correct price of all the known risks involved at the time the contract is opened. Selling is no different than buying. All you have to do is beat the efficient market and commissions and you will make a profit. Are you familiar with Matthew 13 in the Bible?

Stock Trader: I am familiar with the Book of Matthew, but I don’t have the passages memorized. What does it have to do with options?

Optionz Traderz: That passage is a perfect analogy to options. It reads: “A sower went forth to sow; And when he sowed, some seeds fell by the wayside, and the fowls came and devoured them up: Some fell upon stony places, where they had not much earth: and forthwith they sprung up, because they had no deepness of earth: And when the sun was up, they were scorched; and because they had no root, they withered away. And some fell among thorns; and the thorns sprung up, and choked them: But others fell into good ground, and brought forth fruit, some a hundredfold, some sixtyfold, some thirtyfold.” Options are like seeds. You want to get the most out of each one, so you need to choose the best place and time to use each one.

Stock Trader: I see. So you are saying that by just opening options as if I were randomly planting seeds, market forces would immediately devour the value of some of them; others would be in the wrong place at the wrong time to make a profit, and some would be in the right place but would have the value choked out of them by whipsaw. The ones that remained would multiply in value.

Optionz Traderz: Blindly trading options is the same as blindly sowing seeds. For every winning buyer there is a losing seller, and for every winning seller there is a losing buyer. Unlike the stock market, the options market does not increase or decrease the total amount of wealth; it just shifts it around. The key to making money with options is managing the risk. You will have much better luck if you plant your seeds in good ground.

Stock Trader: How do you do that in options?

Optionz Traderz: The same way you do in regular trading: methodology and discipline. The rules don’t change, just the complexity. Going from stocks to options is like going from checkers to chess. Pieces start moving in nine directions, not just four. It seems much more complicated, but the basics are the same. You are trying to out-maneuver your opponent and get their pieces.

Stock Traderz: That is another good analogy, but I have always been told that option sellers make more money than option buyers. That always sounded believable to me because the option buyer needs to have the underlying stock not only go in-the-money, but go deep enough to cover the premium. Don’t sellers have better odds than buyers?

Optionz Traderz: Neither one has better odds; all options are created equal. There are times that option sellers make money and times when option buyers do. Market conditions determine which side has the better odds. On average, selling options is no better than buying. I have seen studies that indicate that markets move sideways about 75% of the time and trend 25% of the time. Even with 75-25 odds, an option seller is no better off than an option buyer. The seller’s winning profits, which in my experience occur two-thirds of the time, will on average be wiped out by the losses that occur one-third of the time. Likewise, buyers will rarely make money, but when they do they will make a lot.

I think the perception that sellers make more money stems from two aspects of trading. First, sellers make profits twice as often as buyers; and second, many sellers are market makers. Market makers who sell options do make consistent profits, but not because selling is more profitable; their profits are the result of their ability to sell options at the higher ask price and buy them at the lower bid price. Think of them as wholesalers, making money on the price markup to the retailer.

Stock Trader: Now I understand what you are saying. In a bear market, Call writers and Put buyers are making money, and in a bull market it is just the opposite. In a more common sideways market, all of the buyers are losing their profits, and the sellers are making up for their previous losses.

Optionz Traderz: Exactly! You can buy any listed option for a price. It is up to you to determine which side of the bet has the better odds. If the market just experienced a huge move and had also become volatile, it might be a great time to sell far out-of-the-money Call and Put options to benefit from the increase in premiums due to volatility. If there were a huge systemic risk in the financial sector, it might be a good time to buy three-month-out Puts that are at-the-money on the whole sector. If you were to find a stock that you thought was the greatest thing since sliced bread, rather than buy the shares, you could buy in-the-money Calls, get much better leverage, and be able to use a smaller amount of capital while also limiting your downside risk. You can use options just like you use stocks; the key is to understand how they function and the risks involved.

Stock Trader: You are actually beginning to convince me that options could be less risky than stocks are. That is quite an accomplishment.

Optionz Traderz: When used correctly they can help reduce risk substantially while leaving the profit potential in place. There are many different ways to use them for profits because there are many ways that they work. You just have to find a style that fits your personality, and above all, define your maximum risk and profit goal before placing the trade.

Stock Trader: I am very interested in learning more.

Rookie Trader: I could e-mail you guys the Holy Grail so you don’t have to think so hard.

Stock Trader: Ugh! I am going to run some errands and look at some option tables.

Optionz Traderz: I am going to get a margarita and sit by the pool.

Stock Trader was feeling much better than usual for a Saturday morning. Even though there was little financial news for him to follow, he was growing more confident that trading options was going to be his key to financial freedom. He was impressed by the explanations that Optionz Traderz had given, although he had to admit that he was a little surprised to learn that every options strategy has the same long-term odds of profitability. However, knowing that one vital piece of information made him feel much better about options than he had ever felt in the past. If every options strategy was created equal, he did not need to be so concerned about learning every strategy. Instead, he needed to learn how to best apply the strategies that he did understand.

Stock Trader’s success in the stock market was based on one simple rule: Win more money than you lose. Profiting as a stock trader required only that he take advantage of trends, going long in up trends, selling and selling short in downtrends. Charts of price and volume gave him all of the information he needed to spot a trend. Optionz Traderz had opened his eyes to a new way of trading, one where profits could be had in sideways markets as well as trends. “If I was able to make substantial profits in the stock market simply by putting the odds in my favor, surely I can do that even better with options,” he thought.

Stock Trader’s mind started wandering. He thought about a time many years earlier when his broker had recommended a mutual fund that had a historical return of 8% per year. At the time, it seemed like a great way to get started in the stock market – buying a diversified fund with a history of profitability, managed by professionals. But he could not forget the 5% sales charge taken off the top, nor the three years of losses that followed. Looking at options tables, he could not help but notice that a lot of year-out Put options had premiums that were less than 5% of the underlying stock price. “If only I had known this years ago I would have just bought stocks and protective Puts instead of mutual funds,” he thought. After all, the premiums on the Puts were about the same as the load on a mutual fund. “Not only would I have had the same upside potential as a mutual fund, but I would not have suffered those three years of losses.”

As he researched one of the five stocks he was following, he noticed that it had just pushed through resistance on high volume. The ten day moving average had also just crossed above the twenty-day average. He knew the emotions that investors would feel with such movements; outsiders would be enticed to buy, those who were short would feel the need to cover their shorts, and the buy-and-holders would feel less pressure to sell. In the past, Stock Trader might have chosen to buy the stock on Monday morning, if it held above resistance on good volume. Instead, he found himself looking at the option tables to find the premiums for in-the-money Calls.

It seemed Optionz Traderz had affected his entire outlook on trading. “Here is a guy I have only known for a few days, that I have never met except through Facebook, and yet he has changed the way I trade,” he thought to himself. Stock Trader had never met anyone with an understanding of options like Optionz Traderz. He liked having someone new to talk to about trading. It wasn’t that he did not enjoy discussing the markets with his longtime friends, but this was someone with some fresh ideas about a new way to trade. Although they were traders of two entirely different instruments, he was surprised at the similarity of their trading philosophies. But he could not help but to think one thing: “A margarita, really? You have to be kidding me. What a girl’s drink!”

Chapter 3

STRONG TRENDS ARE THE FRIEND OF AN OPTION BUYER AND THE ENEMY OF AN OPTION SELLER.

Stock Trader awoke on Sunday morning, his mind racing through option strategies before he even got out of bed. He was pondering what his new friend had said about all bets from both buyers and sellers reverting to the mean over time. He thought the same was probably true in stock trading. He had heard many a story of a hot-shot hedge fund manager, thinking he knew the markets inside and out, then proving his skills by having a great year managing a fund, returning maybe 40% gains in an otherwise down year for the broader market. This guy got millions in bonuses and was treated like a rock star; money poured into his fund. But then, many times the strangest thing would happen; he would be flat the next year and maybe down 10% the next year, and  to add insult to injury, down 30% the 4th year, eventually giving back all his previous gains. What had happened? The zero-sum game and the efficient market brought the trader back to the mean average. The ‘rock star’ trader simply traded the correct way during one particular market environment, but failed to adapt when the environment changed. He may have been buying all the dips during a bull market, but doing the same in a future bear market only resulted in a succession of losses – losses that would sometimes exceed the gains he achieved in the preceding bull market. Even the most touted investment con in history, “buy-and-hold investing,” brings many investors back to even after periods of ten years, especially when the effects of inflation are taken into account. The result of buying into these ‘rock star’ managed funds can be devastating to a portfolio, even in an average market, and crippling during a severe bear market.

Stock Trader had made most of his money trading trends. He thought this style gave traders an advantage over the majority of market participants. Some of history’s best traders did not try to predict the future prices of stocks. They simply reacted to the current price; they looked for the trend. They had different ways of measuring trends. Some loved to buy breakouts to new highs; others wanted to trade trend reversals; many used moving averages, and some bought a stock or index when the highest price, over a set number of days, had been reached. Even though they were trading using different entries and exits, and although some of them were trading commodities and currencies in addition to stocks, they all were in search of the same thing: identifying and trading trends. Stock Trader wondered: “How can I use options to trade trends more safely and with more leverage? What does an option trend trader look like? What option strategies would be best suited to trend trading?” Stock Trader had never heard of an option trend trader before, but he was confident that such people must surely exist.

Stock Trader also combined risk management into his trend trading. He would let his winners run and cut his losers short. He wanted to lose small and win big. He had found that most successful trend traders often had many small losses preceding their really big wins. Most trend traders were simply ‘betting’ that markets and stocks would eventually trend strongly in one direction or the other over the long term. If their bet was wrong they would take their money off the table quickly, usually only risking 1% to 3% of total capital. This allowed them to be wrong many times without destroying their account. When they were right, the best trend traders allowed their winning trades to run with the trend, utilizing systematic stops which would cause them to sell out on a pull back, often to a moving average or recent low price. He and other trend traders required only one thing: that their big winning trades pay for all their small losses and give them an overall profit. Stock Trader was thinking through all of these principles and trying to connect them to option trading. How could he use options to control risk while trend trading? How could he use options to capture trends without having to predict anything? It was time to get the answer straight from the source.

Stock Trader looked to see who was online in his Facebook group.

He clicked on his Winning Traders group and opened the group’s box. He saw that he was joined by:

Rookie Trader

Penny Trader

Penny Pumper

Ghost of Darvas

“Good Grief!” he thought.

He felt a desire to chat with Optionz Traderz.

Penny Pumper: ZXLL is at .06 and is projected to go to $1.00; you need to get in now!

Rookie Trader: Can you sell Covered Calls on ZXLL?

Stock Trader: Penny Pumper: I will pay you a dollar to get out of this group and go pump the over-the-counter penny stock garbage out of a boiler room. Rookie Trader: Can you do math? How do you sell options off a $.06 stock? OTC stocks do not have options; they do not even have much volume on the shares themselves most of the time. Good grief, guys, really?

No response from Rookie Trader or Penny Pumper.

Optionz Traderz: Is this group for winning traders or just anyone?

Stock Trader: Anyone can join.

Optionz Traderz: Obviously!

Stock Trader: Glad to see you online. I have the option question of the day.

Optionz Traderz: I hope I have the option answer of the day.

Stock Trader: What is the best way to use trend trading methods with options? Say you have indications that there is a high probability that the market or a stock is about to trend in one direction sharply; how do you play it?

Optionz Traderz: That is a good one! If you were bullish on a stock over a long period of time, I would suggest you play a slightly in-the-money Long Call, two or three months out. But you would only want to do this on stocks that have options traded in a sufficient volume to ensure that the bid and ask spread doesn’t eat up your profits going in and going out. Being a relatively long-term play, you would most likely do best by avoiding the current month options because the Theta decay is accelerated in the final month of an option contract. However, if you felt more comfortable using the current month options, you could lower your exposure to Theta decay by buying Calls a little deeper in-the-money. Depending on how confident you were about the likelihood and magnitude of an uptrend, you might also consider buying the Calls, a strike or two out-of-the-money which would not only limit your exposure to decay but would lower your maximum risk as well. Other times, when the market might be giving off signals of an impending bearish trend, you could just do the reverse, buy Puts instead of Calls.

Stock Trader: How about if I am just betting on a trend, not predicting? I just want to win if there is a trend in either direction.

Optionz Traderz:  Well, that is a little more difficult. Long Strangles and Straddles are trend grabbers. But their efficiency in grabbing a trend comes at a high cost. The market is very efficient at pricing all options and even more efficient at pricing combinations of options, such as Strangles and Straddles. Chances are the premiums required to open these types of trades would reflect the probability of the underlying stock price moving by nearly one standard deviation, a relatively rare scenario. With Straddles and Strangles, strong trends are the friend of an option buyer and the enemy of an option seller.

Stock Trader: I have seen other option traders discuss standard deviations and they’ve always lost my attention at that point. I vaguely remember learning about the ‘bell curve’ in high school, and how the curve is determined by using standard deviations, but I have never fully understood how it applies to option trading. Is it really necessary to study standard deviations in order to put together an option trade?

Optionz Traderz: Yes and no. Standard deviations can be very helpful, but their use is by no means a requirement for success. Despite the complex-sounding name, standard deviations are not a complex subject. I believe I have found a simple means of understanding them. If you would like, I believe I can help explain.

Stock Trader: Forgive me for sounding skeptical, but if you think you can make me understand standard deviations, give it your best shot.

Optionz Traderz: O.K., here goes. Simply put, a standard deviation is the average amount of change in a stock’s price over a specific amount of time. Let’s say you are studying a stock that is trading at $25 on the first day of the year, and over the next 365 days it moves up and down in a range between $15 and $35, and ends the year with a price of $26. Looking at the closing prices from each day of the year, you might find that the average daily price was $27, but each day’s closing price deviated from that average, some days by only a few pennies, and other days by as much as twelve dollars. You might also notice that the average amount that the stock deviated from that $27 price was $2.

While it is helpful to know the average amount that the daily stock price deviates from the 1-year average, it is not so useful in predicting future prices. A stock that has a move of several dollars in one day and then remains nearly flat for the remainder of the year is actually more difficult to predict than a stock that moves up or down consistently by a few cents every day. In order to account for the added difficulty presented by large movements in price, it is possible to make predictions by exaggerating the effect of large price swings in some fairly simple calculations. This can be accomplished by squaring the daily price deviation from the 1-year average, averaging the result, and then taking the square root of the result. By doing so, you might find that the squared amounts average out to $9 and the square root of that is $3. That last result is the most important because $3 represents the standard deviation of the stock price. Based on past performance the stock can be expected to be within a range of $3 lower to $3 higher than the current price after one year of trading.

Stock Trader: O.K. That makes sense. But I am not sure I understand why I would need to know that in order to trend trade using options. Just because the stock price had a standard deviation of $3 last year doesn’t mean it will be the same this year.

Optionz Traderz: You are exactly right, and you have just pointed out an important difference between what we like to call Historic Volatility and Implied Volatility. Historic Volatility is simply the observed standard deviation of the underlying stock price during a specific time frame. But the options market is too efficient to rely solely on Historic Volatility to determine prices. Instead, options rely on Implied Volatility, which again sounds complex, even though it is really nothing more than the standard deviation that the market is predicting will occur during the length of the upcoming option contract.

The market is very efficient; it has to be. Traders don’t just give their money away. Millions of traders around the world, many of them professionals, are studying the same stocks as you, all in an effort to make as much money as possible. They are utilizing sophisticated software to analyze performance; they are keeping up with the latest news and events that could affect the stock price; and they are using computerized trading platforms to execute their entry and exit points at the optimal times. And as you just pointed out, just because a stock had a standard deviation of $3 last year does not mean the market expects it to remain at that level. Taking into account all of the available information on Earth, market forces might instead predict a standard deviation of $5.

Stock Trader: So, let’s assume the market did predict my stock would have a standard deviation of $5 next year. First, how would I get access to this type of information, and second, how would I use it to benefit from a trend?

Optionz Traderz: A few days ago we were chatting about every option contract having a buyer and a seller. For every Call seller of your stock, each believing the stock would go up by less than $5 next year, there would be a Call buyer whose research pointed to a rise of more than $5. In order to make a profit, each seller would be hoping to collect at least enough time premium to cover his risk, and each buyer would be hoping to pay no more than necessary to get his reward. When the buyer and seller were able to agree upon a price of an at-the-money Call, it has been my experience that most of the time that price would likely be somewhere around 40% of one standard deviation, or $2. The premium on at-the-money options is usually very close to 40% of the market’s prediction of the stock price’s standard deviation over the length of the contract. Or to put it another way, if you look up the price of an at-the-money option that expires in one year and multiply it by 2.5, you will get a rough estimate of the implied standard deviation or Implied Volatility of the underlying stock. If the at-the-money options are trading for $2, the market is telling you that one standard deviation is approximately 2.5 times that or $5; the price of your stock at the end of one year will likely be $26, plus or minus $5. This is important to know because if you were to open a Long Straddle, you would probably pay $4 in total premiums, and the stock price would then need to move up or down by nearly one standard deviation in order for you to make a profit. Most of the time, stocks do not exceed a range of one standard deviation, so this would most likely be a losing trade.

Stock Trader: Wow. I’m sorry I doubted you. That is a great explanation. So it seems like it is possible to use a Straddle to bet on a strong trend without predicting the direction. But I would need to be confident that a trend was going to occur because the trend would need to move the stock price by 80% of one standard deviation before I would make a profit. Does that mean I could also choose to bet on the direction of the trend by just buying a Call or a Put, and I would see gains if I the stock moved in that direction by 40% of one standard deviation?

Optionz Traderz: You are correct. One-sided at-the-money long options usually require a trend of at least 40% of one standard deviation, while two-sided trades, although being profitable twice as often require a move of 80% to be profitable. Either strategy could work if the market conditions were favorable. You might also consider a Long Strangle, which simply involves buying a Call and a Put out-of-the-money. The effectiveness of a Strangle depends on the volatility of the stock and the time to expiration, but as a general rule of thumb, increasing the strike price of the Long Call by $1, while lowering the strike price of the Long Put by $1, will lower your initial cost by $1. Each altered trade saves you nearly fifty cents, so you are saving nearly $1 in total premiums while giving up the first $1 in profits. You would be putting much less capital at risk if the trend never ensued. Also, in the absence of a trend, both options of the Strangle would expire worthless, saving you the commissions and fees you would otherwise need to pay to close a Straddle. In the case where a trend did develop, your profit would be nearly identical to a Straddle because although your profit would be $1 less per share than the Straddle, you paid $1 less to open it.

Stock Trader: That is very interesting. A Long Strangle costs much less to open than a Straddle, but both strategies work similarly in capturing a trend. I would not have even thought to take into consideration the cost of the added commissions. I am really enjoying learning about options from you. This is such a nice way to spend a Sunday morning.

Optionz Traderz: Thank you. It is so refreshing to be able to talk about my trading with someone who truly seems interested. Sometimes I talk to my pet tortoise about options, because he is the only one who doesn’t get bored and walk away, at least not very fast.

Stock Trader: That’s funny! I don’t think I have ever met another trader who discusses his trades with a tortoise. Do you have any other ideas about how I could use options as a trend trader?

Optionz Traderz: Let’s say you want to bet on a trend in the triple leveraged exchange traded fund TNA. It is currently trading at $91 at the end of July and you can buy an October $91 Call for $11 and a $91 Put for $11. One contract of each costs a total of $2,200, and you capture 100% of the trend, on 100 shares, in either direction. This particular Straddle would give you control of the full move, in either direction, on the equivalent of $9,100 in underlying stocks, for four months. But instead of $9,100, you have reduced your down side to $2,200 while retaining an unlimited upside. Four-month-out options are relatively inexpensive to hold because the uncertainty in the market during that timeframe helps them retain a fair degree of time premium; the Theta decay is very slow. As you get closer to October you may experience a price discovery if a strong trend makes one side of your trade worth more than the original cost of both options. This is like letting your winners run automatically with a known downside, something I have heard other trend traders swear by. You lose if the underlying ETF does not trend at least $22 in four months. The good news is that the efficient market, in fixing the premium of the options, has baked-in the probability that the underlying shares will trend one way or the other by at least $11. So you would realistically only expect to lose half of your capital if you were wrong about a strong trend and the market’s prediction of the magnitude of a trend was more accurate. When you analyze the trade in this manner, it is as if you are putting only half of your $2,200 at risk while capturing a full trend above $22 on $9,100 worth of underlying shares, over a four month period. In sharply trending markets TNA has historically moved as much as $5 in a single day, and you can imagine how far it can go in four months.

Stock Trader: Wow! That is a very interesting concept, capturing a full trend in either direction at a preset price. I like that. I can see many ways that Straddles could be used to trend trade. And the best part is I would not need to predict the direction of the trend.

Optionz Traderz: Straddles are really good trend grabbers, but they have a downside, just like every other option strategy. Because they require the purchase of two at-the-money options, they require a move of nearly one standard deviation in order to be profitable.  The market is very efficient in determining option premiums, but it is not perfect. Over the long term, the market is about 68% accurate in predicting a move of one standard deviation. While that is a respectable percentage, if it were the grade on a college exam, it would at best deserve a ‘D.’ Because a Long Straddle requires the purchase of two at-the-money options, each option premium being approximately equal to 40% of a standard deviation, the combined position requires a move of at least 80% of one standard deviation in order to generate a profit. The market gets a ‘D’ trying to predict a price change of one standard deviation, and it’s even worse at predicting smaller changes. The chances of the market correctly predicting a move of 80% of a standard deviation are closer to 56%.

Stock Trader: So are you saying that when I open a Long Strangle, I will lose if the stock price does not trend at least 80% of a standard deviation, which is the amount required to offset both premiums, and I should expect a loss 56% of the time?

Optionz Traderz: Exactly. But as a trend trader, you are probably already accustomed to losing most of the time, right?

Stock Trader: That is a good point. Losing trades do not bother me as a trend trader because I control my losses and I always know that my future gains will eventually outweigh them.

Optionz Traderz: It works the same way with options. If you opened the Straddle using the October options and a trend had not materialized by September, you could close it early and cut your losses. You can also reduce your losses by reducing the initial capital you put at risk. As I was saying earlier, a Strangle is almost as effective as a Straddle. You use less money to open a Strangle with the understanding that it usually gives you a slightly wider price range (where you could lose 100% of your capital) than you would get with a Straddle.

Say you decide to go out $11 in price on both sides and you buy the TNA October $102 Call for $7 and the $80 Put for $7 when the underlying shares are trading at $91. You now have an outlay of $1,400, instead of the $2,200 required to open a Straddle. TNA then has to go up or down $25 for you to get to break even, within the next four months. The shares have to move $11 first to get to your strike price, then another $7 to overcome the time value on your winning side, and then another $7 to overcome the cost of your losing side of the trade. The Strangle is a slightly less expensive bet, but with lower odds of winning; a $25 move has a slightly lower probability than a $22 move. But just as with the Straddle, you could cut your losses by closing the Strangle early if a trend did not develop.

Stock Trader: O.K., I am going to have to digest that one mentally; $1,400 could allow me to capture 100% of any move on TNA greater than $11, over a four month period. Straddles and Strangles seem like they are good bets for trend traders. They lose more often than they win, but the wins are unlimited.

Optionz Traderz: They are good long option bets, but only when the market or a specific stock trend more than the market expects during the period of time the option is valid. They are bad long bets when markets are stable or range bound, but good short bets during those markets. The expected volatility is priced in; hence the trend is accounted for in the option premiums. No Holy Grail, just an alternative way to buy into trends at a price that normally reflects the true amount of risk involved.

Stock Trader: So would Straddles and Strangles be best used if I expected a strong trend, especially when I believed that the expected trend was not adequately priced into the premiums?

Optionz Traderz: Yes, that is correct. In the past, I have had success on the long side, playing Straddles on volatile stocks just before earnings. I limited my holding time to just the few days around the earnings announcements to limit Theta decay. But after earnings are released, the baked-in volatility collapses, so I often had to close my positions almost immediately because they usually lost value very quickly when I was wrong.

Stock Trader: I think I understand what you were trying to accomplish: opening a Straddle when you believed that the anticipated earnings were insufficiently priced into the premium, then cutting your losses if you were incorrect. That seems like a good plan. You say you did this in the past. Did something make you stop trading this way or are you still placing the same type of trades?

Optionz Traderz: It was one of many strategies I have used. These days, I personally prefer the short side of Strangles and Straddles; they have winning odds of 56%, on average. When I lose, I can cut my losses to prevent big draw-downs. When the strategy wins for the buyer, it sometimes wins big, but I can often close out before losing too much on my short position. I am the winner most of the time. To win, the buyer needs to not only overcome market efficiency, but also Theta decay and the Black-Scholes option pricing model; that is no easy task. The odds are definitely in favor of the seller winning in a Straddle or Strangle. I have found that I am more comfortable as an ‘anti-trend’ option trader. I discovered it to be much less stressful for me to make consistent profits and occasionally cut a loss than it was when I attempted to weather a series of small losses in a quest for that one big win. But that’s just me; all traders are different.

Stock Trader: So I guess if I want to trend trade using options, I should pick my Long Straddles and Strangles carefully. If I comprehend this correctly, I am probably going to see losses at least 56% of the time. From what you told me last week, I would have to assume that on average my winning trades would yield about the same gains as my combined losses. If I constantly traded Straddles or Strangles, I would eventually break even. But if I can give myself an advantage, even if it is a small advantage, I will eventually see a profit.

Optionz Traderz: By George, I think you’ve got it! All you need to do is increase your probability of success, limit your losses, or both. That’s it! It does not matter whether you are trading stocks, options, futures, commodities, or any other instrument; the rules are the same. Increase your wins, decrease your losses, or both! It’s that simple.

Stock Trader: The 56% losing odds of a Long Straddle seem a bit daunting. I may have to reconsider whether that strategy would work for me. As a trend trader, I usually have to deal with some losses, but I was hoping to find an option strategy that would give me better odds than that.

Optionz Traderz: Straddles and Strangles reflect the combined prediction of every trader on the planet regarding the magnitude of a trend; it is very difficult to outwit the entire market and overcome the odds. I think that is the reason I started trading Short Straddles. The confidence of having 56% odds in my favor and the relatively small number of trades required to cut my losses suits my personality. As a trend trader, you might want to consider Long Calls or Puts instead. If you can predict the direction of a trend, a Long Call or Put is a much better choice than a Straddle or Strangle. The premium of an at-the-money option is about 40% of a standard deviation, and the market is only about 38% successful in predicting a trend that precisely. Not only does the option market do a poor job of predicting the magnitude of trends with that degree of accuracy, but it does even more poorly predicting the direction of a trend. If you can predict the direction of a trend, you can double your odds on a Long Call or Put, in effect reducing the market’s odds from 38% to 19%. That means a Long Call or Put, at-the-money, will make you a profit 81% of the time if you are correct about the direction of the trend.

Stock Trader: It sounds like Short Strangles and Straddles have given you a consistent way to make money betting against a trend. But if I want to trend trade with options, maybe Long Straddles and Strangles are not the best way to do it. In my stock trading, I use charts of moving averages and volume to help me determine the direction of a trend, so I think I might take your advice and stick with one sided option trades. 81% odds are what I was looking for.

Optionz Traderz: One sided option trades are highly suitable for trend trading. The option market is very efficient at predicting the future price movement of stocks, but much less efficient at predicting the direction of a trend. I like to think of it this way: the market looks at volatility more as a fear that prices will fall, rather than a fear that prices will merely change. What this means is that most of the time Put option premiums reflect the combined fears of every trader in the world. Put sellers fear an increased risk and raise their ask price. Put buyers see an increasing opportunity and raise their bids. On the other hand, most investors do not feel the same fear when they think about prices going up. So, Call option premiums, while they should reflect the ‘fear’ of rising prices, instead represent the required parity with Put options. If Call options truly represented the ‘fear’ of rising prices, they would become more expensive in bull markets. But in an up-trending market, where fears decrease, in turn driving down the premiums on Put options, Call premiums must also decrease. If the price of Calls did not decrease in parity with the Puts, it would be possible to make free money by buying stocks, along with low priced Puts, while selling higher priced Calls at the same strike price. Free money is not something that an efficient market tolerates. The result is that in an up-trending market in which traders tend to be less fearful, the premiums on all options, including Calls, may actually decrease, giving a trend trader a perfect Call-buying opportunity.

Penny Pumper: You got that backwards. Call option prices go up when the stock price goes up.

Optionz Traderz: I apologize if I did not explain that clearly enough. What I meant was that the premium of an at-the-money Call during a down-trend is often higher than the premium of an at-the-money Call in an up-trend. If a stock quickly declines from $50 to $40, the $40 Calls might be priced at $5, but when the same stock rebounds to $50, the $50 Calls might only cost $4.

Penny Pumper: Or you could just avoid options altogether and buy ZXLL before the 1600% increase that is certain to occur next week.

Stock Trader: Penny Pumper: If you are making 1600% returns, what are you doing pushing stocks on Facebook? You should be out enjoying your yacht. Good grief!  Optionz Traderz: I never thought of the price of Long Calls becoming more affordable in an up-trend. That would be a gift to a trend trader.

Optionz Traderz: I agree. It is somewhat like a gift. Calls are often under-priced in a true rally. Straddles and Strangles are cheaper to buy in an up-trend as well, but they get rather expensive in a downturn. In a down-trend it is sometimes better to use a Long Put instead. I have traded options that way in the past. When that last major oil spill occurred, I did not open a Long Straddle. I bought Puts only, on the oil company’s stock that was responsible for the mishap.

Stock Trader: What I think I like most about trend trading with options is that I can control my risk. If I want to risk 2% of my total capital on a trade, instead of setting a 2% stop loss on the stock I can just buy options with 2% of my capital. I can then let the stock price fluctuate more without the risk of a stop loss being tripped. My down side is limited to the same amount I would have risked buying the stock, but I still capture the full upside of a movement. I really like that it also enables me to stretch my equity into more positions, if I decide to.

Optionz Traderz: Option trading is really not much different than stock trading. Both can be done using many different strategies and both are all about risk and reward. If you wanted to buy 1,000 shares of TNA at $91, you would need to put up $91,000 and use a stop loss of about $2 in order to risk 2% of your capital. I don’t know about you, but a $2 stop loss on shares that sometimes fluctuate $5 in a single day is much too close for my comfort. To try to simulate the same position, you could use Long Calls. But I should point out that it is not as simple as just taking your $2,000, the amount you would have risked on the shares, and using it to buy options. By doing so, you would be forced to either buy 10 contracts far out-of-the-money, or settle for a much smaller number of contracts at-the-money. Let’s say the October $91 Calls on TNA were still selling for $11; the only way to catch the same trend as if you owned 1,000 shares would be to open 10 contracts at-the-money, and that would cost you a whopping $11,000. But that is far less than the $91,000 you originally needed. As always, not wanting to risk more than 2% of your money, you would need to employ some sort of stop loss. The good thing here is that four-month-out option prices, at-the-money, initially only move about half as fast as the underlying shares. It is likely that it would take a $4 decline in TNA to result in a $2 decline in your Calls, so you could set your stop loss farther away than you would if you owned the actual shares. In effect, this gives you double the amount of protection against immediately being stopped out by whipsaw.

Stock Trader: I see what you’re getting at. Options aren’t so much about reducing risk as they are about changing the way the risk will affect a trade. In the case of using Long Calls in place of long shares, I would be taking away a lot of the ‘risk of ruin’ in case of a sudden, violent, downturn because my maximum loss is reduced from $91,000 to $11,000. Another benefit would be lessening of my risk of being stopped out by whipsaw. But those reductions of risk would be balanced by the increased risk I would be taking by opening myself up to time decay.

Option Trader: Again, you are correct, and I have more good news. There are many different ways to trend trade with options while also choosing exactly the type of risk exposure with which you are comfortable. Maybe you wouldn’t be able to stomach risking $11,000 on an all-or-nothing trade, even though you were confident in your ability to spot a trend. Despite your trust that you were protected by your stop loss, a fear of the shares gapping-down, falling in price overnight and opening the next trading day at a price far below your stop loss, might make you lose sleep. As an alternative, you might instead consider opening a Vertical Spread: buying ten October $91 Calls for $11,000 and selling ten $95 Calls for $9,000. Your maximum risk would be locked-in at the same amount you previously decided was appropriate, $2,000. However, your trade-off for locking in the maximum loss would be a reduction in your upside potential to a maximum of $2,000. Another trade-off with Spreads is that they respond very slowly to trends in the underlying; and while this would allow you to cut your losses very efficiently if the trend went against you, it would also mean that you would need to hold on to your winners right up until expiration to see the full benefit of a trend.

Stock Trader: I never imagined there would be so many ways to trend trade using options. It is interesting to see that option traders are able to choose the type of risk that makes them comfortable. When I trade stocks, I use a method of risk management that reduces my stress. I have found that when I do not feel stress trading stocks, I am able to stick to my proven system and avoid allowing my emotions to tempt me into trading at the wrong times. If I can find a system of trading options that makes me comfortable, I imagine I should be able to stick to it as well. You’ve really given me some new ideas to think about. Well, I don’t want take up your entire Sunday, but I am interested in learning more.

Optionz Traderz: You aren’t wasting my Sunday. I really enjoy talking with you about options. I’d like to talk a while longer, if that’s O.K. with you. But I probably should get going in a while. It is such a nice day, and my pet tortoise likes to take walks in the yard when it’s sunny like this.

Stock Trader: I won’t take up any more of your time. I need some time to myself to mentally digest what you have said. Having developed a stock trend trading system that served me well, I guess all that I need to do now is learn how to apply those same principles to develop a system using options. I am almost ashamed to admit that the option market once seemed so much different than stocks that it provoked a fear of the unknown, even though I have been trading stocks for so many years that I feel I should no longer be afraid of anything. It was almost as if stocks were from Mars and options were from Venus. But after talking with you, it is now apparent that both markets have the same goal: avoiding risk and generating income.

Optionz Traderz: I agree. Stock options are the best way I know of generating income while controlling the risks of trading. Many stock traders are just too afraid of time decay to even consider looking at options.

Stock Trader: I am no longer scared of options. I am fascinated with all the possibilities to make money.

Optionz Traderz: Good to hear it! I’ll leave you with one more option trend trade to think about before I go: a Synthetic Long or Short. To go long, instead of tying up $91,000 on those shares of TNA you might have wanted to purchase, you could have bought ten $91 Calls for $11,000, and sold ten $91 Puts for $11,000. The trade would have cost you nothing to open, but it would have behaved nearly exactly the same as owning 1,000 shares outright, assuming you met your broker’s margin requirements. It would be like betting on a trend with free money. If you had been bearish, you could have done the opposite, created a Synthetic Short, by buying at-the-money Puts and selling Calls at the same strike. Enjoy your Sunday!

Stock Trader: That sounds almost too good to be true, betting on a trend without putting any money upfront. Enjoy your Sunday too, and have fun walking your tortoise.

Penny Pumper: If you really want to catch a great trend, buy ZXLL now!

Penny Trader: I agree. One dollar, here we come!

Stock Trader: And I am selling both of you guys short.

Optionz Traderz: Those guys are so annoying. Your post summed up my thoughts perfectly. Way to go, Stock Trader!

Chapter 4

TIME IS AN OPTION SELLER’S FRIEND, BUT THE OPTION BUYER’S ENEMY. (THETA)

“Monday morning…great,” thought Stock Trader as he was roused from his blissful sleep by that annoying alarm clock. It was time to get to work so he could pay his bills. Every day he pondered how he could create a steady stream of income to pay his bills without having to sell his own personal time for money. Even with all his success in the stock market and a hefty account size, he lacked the confidence to trade for a living. He rationalized to himself that the reason for his fear was justified because traders had losing years, and his type of trend trading was more suited for long term capital appreciation than for meeting daily living expenses. Long ago he had written in his trading journal the secret formula for winning as a trend trader.

The Market Trends = I make money as a Trend Trader.

No Trend in the Market = I lose money as a Trend Trader.

He smiled as the memory of that revelation came to mind. When he was a new trader, his ego had to be right. He felt like a failure if he took a breakout in a hot stock and it floundered and retraced back below the breakout. He eventually was able to accept that a loss simply meant that his system did not win on that particular trade, and it did not mean that he was a loser. He had learned to separate his system and method from his ego, and that meant he didn’t need to be right every time.

Babe Ruth didn’t hit a home run during every at-bat, and he didn’t fall into a depression every time he struck out. Hall of Fame baseball players didn’t win every game; they simply had excellent statistics.

His morning routine was on auto pilot: shaving, showering, and dressing. He was not thinking about the routine because his mind was pondering options and all their moving parts.

“I wonder if option trading is just like trend trading. If you use the right system in the right market environment, you make money. The market behavior is the ultimate determinant of whether you make money, not your inherent trading genius,” thought Stock Trader.

On his commute to work, he was frustrated that he was selling his own personal time for money, or maybe it was the realization that he was just not getting enough money for the time he was dedicating to work.

Then he had a revelation. Option sellers were just selling time. Option sellers were selling the rights to own stocks at a specific price for a set period of time. Option buyers were simply buying time. Of course, this time value was based on many factors, such as the stock’s Historical and Implied Volatility, time to expiration, and the amount of intrinsic value already present in the option. Option sellers, it seemed, were just selling the rights to control a set amount of shares. They were selling the right to leverage stocks for a specified time period.

The seller gets to keep the ‘time premium’ no matter what happens. That is the seller’s defined maximum gain. The buyer receives the full profits of the stock he controls, if there are any, but his maximum loss will always be the time premium he paid to control the stock position. Intrinsic value is a separate consideration because it functions differently than time value.

In his mind he could see sands running through an hour glass. Options are not assets because they deteriorate as time goes by and go to zero if there is no intrinsic value at expiration. That was one of the things that had always scared Stock Trader away from options. They truly were defined bets over a period of time for which buyers had to pay a set amount. They were not assets; they were tools. Stocks did not expire or lose value due only to the passing of time, but options did.

Stock Trader was sitting on the interstate in bumper to bumper traffic on his way into the city. “If I was trading from home, I would not have a morning commute in rush hour,” he thought. More of his precious time was being wasted, and this was now his morning routine almost every day that he worked. “If I was a stock option I would expire, worthless, before I got to work,” he thought.

“Was the real heart of all option trading nothing more than the buying and selling of time?” he pondered. “With stocks, you can only go long and short on price; is it possible in option trading to go long and short time?” If he was able to survive this horrendous commute and finally make it home, his first priority would be to find out what Optionz’ thoughts were about the element of time on trading options.

After a long day at work, followed by two grueling hours on the interstate, Stock Trader finally arrived home. He retrieved a nice cold beer from the back of his refrigerator. Like most bachelors, he had the typical grocery stock: beer, pizza, chips, dip, and a few frozen items. But his mind was not focused on food; it was focused on options. He did not even want to let the financial network’s talking heads catch him up on the day’s fundamental news and prices. All he wanted to do was learn more about options.

“What did those guys really know about trading anyway?” While some of them started out as traders and became journalists, the majority of them were merely journalists reporting the financial news. He thought most of them were hypocrites, not even following their own advice. While reporting on investing and trading, they were actually invested in their good old buy-and-hold 401Ks. He occasionally watched financial news networks, mostly for entertainment, like sports fans watch sports channels. He did not need journalists to tell him how to trade; charts told him all he needed to know.

Stock Trader finished his beer and realized he wasn’t really hungry, so he skipped dinner and went right to his computer.

After he made it to his Facebook account, he clicked on his Winning Traders group. He saw that he was joined by:

Ghost of Darvas

Optionz Traderz

Penny Trader

Penny Pumper

Rookie Trader

Trend Man

Ghost of Darvas: So if I believed a stock was going to break out to a new high, I could buy the stock’s Call option and get a huge amount of leverage with much less capital?

Optionz Traderz: Yes, and also a much bigger percentage return on the capital you are using. You do not have to purchase the options until the stock actually breaks out. But if you do buy options at the price of the break out and you are correct, then you get the full intrinsic value of the move above the breakout, after having bought the options for their time value only.

Ghost of Darvas: So all Call options that are higher than the current price of the stock are only worth time value? How is time value derived?

Optionz Traderz: The time value is based on variables, like Historical Volatility and Implied Volatility, current price of the underlying asset, strike price, risk free rate of return and the probability of the option being in-the-money. There is a complex formula, which is probably only understood by math whizzes, but you can get a good understanding of a stock’s Theta value be looking at an option chain. The at-the-money options have the highest time value because when they are at-the-money, they have a 50/50 chance of going in-the-money. As you go farther and farther out-of-the-money the probability becomes less and less. It is possible that a two strike out-of-the-money option might only have a 25% chance of going in-the-money, so it could be priced at half as much as the at-the-money option.

Ghost of Darvas: What about in-the-money options time value?

Optionz Traderz: If you look at the in-the-money options in the chain you will notice that the time value gets less and less as you go deeper and deeper in-the-money. Go deep enough in-the-money and you will have pure intrinsic value and no time value.

Ghost of Darvas: I do not understand that. Why would anyone buy or sell an option with almost no time value?

Optionz Traderz: Hedging, leverage, and locking in gains; there are many reasons. The reason that there is little time value in deep in-the-money options is that there is very little chance that they will expire worthless. At expiration the value of these options is not determined by whether or not they are in-the-money but how deep they are in-the-money. Trading deep in-the-money options is almost the same as trading the stock itself, which has zero time value. The value of these options is almost entirely dependent on the movement of the stock’s price regardless of the amount of time that passes, whereas the passage of time has an equal chance of causing at-the-money options to either expire with intrinsic value or worthless. The buyers of these options can get the full move of the underlying with a relatively small amount of capital compared to trading the shares at their full value. Those buyers have the risk of the price moving in the opposite direction, but their risk is much more limited than being long or short the underlying shares; and because the options have very little time value, they experience very little time decay. For example, Call sellers have already been paid to give up any upside trend, but instead of selling time value, as they would with at-the-money options, they are selling intrinsic value. As long as the underlying shares do not increase in price, the sellers make a profit. Some traders and investors may want to delay trading their stock because of tax consequences, so they sell a deep-in-the-money option against their position to lock in the gain for a period of time.

Ghost of Darvas: It is interesting that the Darvas stock options I have looked at are very cheap when buying them out-of -the-money at the next possible price breakout. Why is that? I would think that the options for the hottest stocks would be expensive.

Optionz Traderz: The pricing for those options is based on the probability that they will be in-the-money at expiration. As a Darvas style trader, you know that some of the best opportunities for buying stocks are when they are trading in a range for several days, and then break out above that range with high trading volume. When those stocks are stuck in a price range, the probability of a break out is perceived to be low, so the Call options with a strike price at the top of that range are usually fairly cheap.

Ghost of Darvas: Are you saying that the option pricing reflects the probability of the option being a winner?

Optionz Traderz: Yes and no. The Black-Scholes option model determines pricing, but there are also supply and demand pressures in the option being traded. On some underlying stocks there are very few options traded, and this has a huge impact on prices. Be sure to be careful with low volume options; the bid/ask spreads could really eat into your profits, resulting in large percentages losses when buying and selling. Gravitate toward the most liquid options on your watch list. With so many to choose from, there is no reason to add the risk of loss due to the bid/ask spread to the list of things that you need to overcome in order to be profitable.

Ghost of Darvas: Good point. I never really looked at the price spread. Some of the hot stocks on my watch list are small-cap up and comers, with low trading volume and even lower volume on the options, and many do not have options at all. One of the stocks I have been following has at-the-money Call options with a bid price of $4.00 and an ask price of $5.10. That means if I bought 10 contracts at market price I would pay $5,100, but if the trade immediately went against me, I would be forced to sell for $4,000, or less. I could lose more than $1,100 in one day, due almost entirely to the bid/ask spread. I guess I will have to be very selective. But you have given me some great ideas for a Darvas-style trading system using stock options.

Optionz Traderz: Glad I could help.

Stock Trader: It’s good to see some honest traders in this group for a change. As a trend trader, I often use the Darvas technique as a guide.

Ghost of Darvas: Darvas was a genius. His trading system is so simple, but it works so well. All it involves is watching a stock when the price range is inside a ‘box’ and then buying it when it breaks out above the box, using a stop loss for protection. Now I am looking for a way to trade the same way, but with options.

Stock Trader: Same here. It looks like Optionz Traderz had some good advice for you.

Ghost of Darvas: Definitely. I’m glad I joined this group. I’m on my way out right now, but I’d be interested in sharing ideas on Darvas trades sometime.

Stock Trader: That sounds good. I’m here in the Winning Traders group almost every day.

Optionz Traderz: You two, get a room!

Stock Trader: Very funny. I guess you like to use options to trade many different ways.

Optionz Traderz: Good to see you online. Yes, they are great tools to have in my toolbox. The problems with some option traders is they only want to trade the far out-of-the-money lottery tickets, looking for the big win and not even considering all the different ways to trade. When all they want to do is knock the ball out of the park, every ball looks like it is in the strike zone.

Stock Trader: I have seen this also. Many of them also only talk about their big wins, not about all the losses they had that were twice as much as their wins. It’s just like some gamblers, who tell only about their winning trips to Las Vegas, while quietly losing on a lot of their bets. I think a lot of people trade for the adrenaline rush and the sport of it.

Optionz Traderz: I only trade for the money.

Stock Trader: Me too. Do you have any ideas about ways to make Theta trades with options?

Optionz Traderz: Well, you know long options are long Theta and short options are short Theta. Each day an option deteriorates at the rate of its Theta. An option’s time value is usually, but not always, worth less at the close than it was worth at the open because the time available for it to be profitable is less by one day. If the underlying price remains stable, an option contract with a Theta of -0.12 will lose $0.12 of its value every day, even on weekends and market holidays. This rate of decay accelerates in the last month before expiration, as the odds of the underlying price changing become much lower as expiration day approaches. Many option traders avoid going long options in the last month to avoid the majority of the time decay. Also, many option traders like to sell options in the last month before expiration so they can profit from time decay. I sometimes sell weekly options where Theta is very generous.

Stock Trader: I have noticed the acceleration in time decay. It almost seems like every time I buy options, Theta eats up the value, even when I am correct about the direction of a trend. I understand how Delta works with options, but Theta has always been a more difficult subject for me. A while back, I bought 1,000 shares of stock on a breakout and it did really well in the first week. But the gains were all on low volume, so I was fairly confident that the trend was going to reverse. I wasn’t ready to sell at that point because the stock was only a couple of weeks away from the ex-dividend date and holding onto the shares would have qualified me for a substantial profit. Thinking that I could lock in the profit by buying at-the-money Puts, I looked up the Greeks. The Puts showed a Delta of 0.50, so I bought 20 contracts. I thought I was Delta-neutral; if the stock price went down $1, I would lose $1,000 of my gains on my 1,000 shares, while my Puts would go up in price by fifty cents because their Delta was 0.50; and because my 20 contracts covered 2,000 shares, I thought I would recover that $1,000. As it turned out, I was partially correct. The stock price fell $1 over the next week, but my Puts only went up in value by $500. I ended up selling everything at a $500 loss and that caused me to also miss out on the dividend. It seemed like I made the right decision, creating a Delta-neutral position, but Theta decay ate up all of my profits.

Optionz Traderz: Time decay, or Theta, is really the most important concept in all of option trading. Option prices are determined by risk, and risk in the markets is simply a factor of the uncertainty of how time will affect prices. Delta, Gamma, Vega, and all of the other Greeks are nothing more than different ways of expressing the effect of the time related risk of being long or short on any particular option. An understanding of Theta is the key to success with options. You can spend time researching all of the Greeks, but in the end, I think you will find, as I have, that they are all derivatives of Theta. I discovered option trading to be much simpler when I made Theta my main focus. I think Theta may be the reason your trade failed, and I may be able to pinpoint what went wrong, if you like.

Stock Trader: That would be great.

Optionz Traderz: You were correct in your assumption that your position was Delta neutral, at least initially. But your position was not Theta neutral; the time value of the options you purchased was decaying every day you owned them. To be Theta neutral, you would need to sell time value in order to offset the time value you were buying. Instead of buying 20 Put contracts, you could have made your position Theta neutral by buying 10 Puts and selling 10 Calls. But I should point out that the option market is very efficient, and it considers everything that affects the price of the underlying stock, including dividends. On the ex-dividend date, a stock is expected to fall in price by the amount of the dividend, or at least a portion of that amount. That makes Puts more expensive than they would be otherwise, while Calls get cheaper. It is likely that buying 10 Puts at an inflated price due to the anticipated dividend and selling 10 Calls at a discounted price would result in a net cost approximately equal to the dividend.

Stock Trader: I think I get what you are saying. In order to use options to lock in the gains on my stock I would need to use a strategy that was Theta neutral, so that I would not experience time decay.

Optionz Traderz: Exactly, and there are other strategies that are Theta neutral or very close to it. You could have simply bought deep in-the-money Puts with very little time value; but again, the price of those Puts would have been inflated to reflect the decline in price that was expected on the ex-dividend date.

Stock Trader: So I guess options are not usually good tools for locking in gains. I probably would have done just as well selling the stock when I saw weakness, rather than try to protect my gains using options.

Optionz Traderz: Exactly! But there are times when using a Theta neutral position to lock in your gains might come in handy. Let’s say you just had a great year in the market and have a huge amount of unrealized gains that are all taxable. It is possible to use options to lock in those gains, but delay realizing the gains until the following tax year. You can Synthetically Short your gainers by selling a Call and buying a Put at the same strike price, but use options that expire after the current tax year. You would still sell each stock with all of its gains intact, but you would be delaying the sale, and that could save you a bundle on taxes. The position is Theta neutral, so you would not experience the effects of time decay.

Stock Trader: Wow, I never thought about using options to save money on taxes. But I’m more interested in learning how to profit from Theta. Do you have any ideas?

Optionz Traderz: Of course, you probably would want to sell options when the Theta decay takes place the fastest, the last month. Some traders even like trading the weekly options, which have even greater Theta decay. You could sell out-of-the-money options that you believe are above resistance and have a very low probability of getting there. You could sell those sucker bets, which is a high probability system, or you could sell both Calls and Puts at-the-money on a stock. This puts the odds in your favor – a Short Straddle, like we talked about yesterday. There is also a play called a Calendar Spread, where you buy a long term option and then sell a short term option at the same strike. You profit from the faster time decay of the shorter term option compared to the longer term option. The only losing scenario on a Calendar Spread occurs when the underlying shares move a huge amount in the short term and then level off or reverse the trend in the long term.

Stock Trader: Hmm, that all makes sense, putting the odds in my favor and benefiting from time ticking away. But I still don’t fully grasp the concept of Theta. Why is it that stock options with a monthly expiration only cost about twice as much as weekly options; shouldn’t they cost four times as much?

Optionz Traderz: Theta is not as difficult to understand as you might think, and it really is important to understand Theta to be successful with options. I can try to explain, if you would like.

Stock Trader: Here we go again. I know I shouldn’t doubt you anymore, so give it your best shot.

Optionz Traderz: Time value simply represents the uncertainty of what effect time will have on a future event. I was thinking about time value just this past weekend. I had taken my pet tortoise for a walk and was sitting by the pool enjoying my margarita when I realized he had wandered off. I quickly got some of the other condo owners to help me search and we started fanning out in all directions. Luckily, we found him after just a few minutes, but we had to cover a large area to do so.

Stock Trader: I’m glad to hear it. I know how much you like your option trading buddy. But what does a tortoise have to do with options?

Optionz Traderz: Think of it this way. My tortoise usually walks very slowly, constantly changes direction, and sometimes stops altogether, just as stock prices do. But when he wandered away, the area we had to search became larger and larger as time went by. The search area represents the uncertainty of his location due to the passage of time. As it turned out, we had to search a rather large area, but in reality he was not very far away when we found him. Ultimately, it is his distance from my chair that normally concerns me; his distance from my chair by the pool. It is the same with options. You are not concerned with the amount of area of uncertainty of the underlying price during the contract, only the distance the price might move from its starting point.

Stock Trader: I follow you so far, but I don’t yet understand how it relates to Theta. You have not disappointed me with your past explanations, so go on.

Optionz Traderz: O.K., so we all remember learning in math class how the area of a circle is πR². I even had one math teacher who would always follow that equation with the remark, “No, they aren’t; pie are round.” I don’t think any of us ever laughed at his attempt to be a comedian, but it was his way of trying to get us to remember the equation. It is important because the area of a circle is related to the square of the radius; or to put it another way, the radius of a circle is related to the square root of the area. If the area of a circle becomes four times larger, the radius doubles because 2 is the square root of 4. So when we were searching for my tortoise, as time went by we had to expand our search over a larger and larger area, even though his distance from my chair was not increasing very fast. Think of the effect of time on stock prices like the search area for a tortoise. As time goes by, the area of the circle that would represent the search area grows, but you are only concerned with the distance of the stock price from its starting point, which is the square root of that area. The distance of a stock price from its starting point is its ‘speed’ or volatility, multiplied by the square root of time.

Stock Trader: Now I think I am starting to understand. Stock prices don’t just go up or down consistently; they meander around, like your tortoise does when you take him for walks. So while they cover a larger and larger area as time goes by, the prices do not change nearly as fast as the area they cover. If I understand correctly, predicting a stock price four weeks away would involve four times the search area of predicting the price one week away. But the square root of 4 is 2, so the uncertainty of the price four weeks out would be about double the uncertainty of the price a week away.

Optionz Traderz: Exactly. I like talking with you because you are a very fast learner.

Stock Trader:  Thanks, you are a good teacher. If I understand your analogy, it explains why a lot of the monthly options are about double the price of weekly options because the uncertainty is not four times as much, but two times greater.

Optionz Traderz: Yes, but only for at-the-money and out-of-the-money options. Intrinsic value on in-the-money options is the same no matter what their expiration date. So although the time value would still be double on the monthly in-the-money options, the actual premium would not be twice as much as the weekly ones because a portion of the premium would be based on the same intrinsic value. Deep in-the-money options, having very little time value, might have similar premiums despite having different expiration dates.

Stock Trader: That’s a good point. It is only the time value of an option that is dependent on the expiration date. Would the same process apply to other expiration dates? Does an option expiring in one year have double the time value of an option expiring in three months?

Optionz Traderz: Yes and no. Using the square root of time as a difference, you were correct in your assumption that because 12 months is four times as long as 3 months, you would expect the further out options to have the square root of four, which is two, times the time value. However, that is not always the case in the real world; option premiums are determined by a very efficient market. For example, the market might be predicting low volatility in the next three months but increasing volatility over the coming year. In such a scenario, the longer term options might have more than two times the time value. But as a general rule, you are correct; a contract with an expiration date 12 months away will have a time value approximately double that of a three-month contract. I have a chart that shows the effect of the expiration date on Theta. I’d be happy to share it if you like.

Stock Trader: Sure. I’d be interested in seeing it. I already do a lot of my trading based upon charts. I know some traders who don’t use charts at all, but I prefer them. To me, charts are a trader’s best friend.

Optionz Traderz:  I agree. I can’t imagine what I would do without charts. I’m sending it now.

As time passes, the search area doubles, but the predicted distance from the starting point is the radius of the search area, which is proportional to the square root of elapsed time.

Stock Trader: That is a great chart. I always thought of stock prices moving in only two directions, up or down. But I can see how picturing a stock price like a tortoise, moving left and right, as well as up and down, makes sense. The area where the stock price will be in 10 minutes is twice the size of the area after five minutes, but the distance from the center does not double because the radius increases at a rate equivalent to the square root of time. I think I am finally starting to understand Theta now; it is like the square root of time.

Optionz Traderz: You nailed it. Theta is a logarithmic function, equivalent to the square root of time. I have two more charts that show the effect of time decay on an option. They are basically the same chart in reverse, but you may find them helpful. I’m sending them both to you.

The time value of options is based upon the uncertainty of the price of the underlying stock due to the passage of time.

As expiration day approaches, options lose time value at an accelerating rate. A monthly option may lose half of its time value during the final week of trading.

Optionz Traderz: I should also mention that these charts only apply to options that are at-the-money. Time value is always the greatest on at-the-money options. Theta only applies to the amount of the change in the price of an option due to time, but the time value of an option can change for other reasons. A decrease in volatility can cause a loss of time value; that is measured by Vega. A change in the underlying stock price will cause an at-the-money option to lose time value, and that is measured by Delta. Even events such as a change in risk-free interest rates can cause a decrease in the time value of an option, which is commonly measured as Rho.

Any one of those scenarios would not only result in a change in time value, but also the rate of time decay. When factors other than time lower the time value of an option, Theta will also decrease. Just as an example, if you buy an at-the-money Call and it suddenly goes in-the-money, it will lose time value, but its actual price may increase if the increase in intrinsic value is enough to offset the drop in time value. However, because the time value of the Call is lower when it is in-the-money, Theta will decrease, so you would then experience a lower rate of time decay. If you look at deep in-the-money options, many of them have no time value at all; they often trade at par with the underlying stock because Theta is nearly zero. When an option has no time value, it cannot lose value due to time decay, although it can lose value for other reasons such as Delta.

Stock Trader:  Theta is affected by factors other than time. I’m going to have to mentally digest that. I think I’m getting too tired to ask you to explain that now, but maybe another day. I think I am really starting to understand Theta though. Now that I know more about how it works, I should be able to minimize the risk of time decay when I apply it to my trend trading. I think it will help me put together a system that, as you pointed out, should give me an 80% win rate when I am right about spotting a trend.

Optionz Traderz: And don’t forget to manage risk when you are wrong.

Stock Trader: Yes, an 80% win rate is not the Holy Gail, just a winning trading system.

Optionz Traderz:  I prefer short Theta trading, which is basically the opposite of trend trading. Instead of a few huge wins paying for a bunch of little losses, I have a bunch of small wins and then cut my few losses short before they become big. I benefit from Theta eating up the value of the options, but I have to beware of intrinsic value causing me to lose.

Stock Traderz: That is different; I do not know if it fits my personality. All day while I was at work, I was thinking that selling time was going to be the path to my success with options. But now, I think I might be better off sticking to developing a system of trend trading.

Optionz Traderz: Just like in stock trading, you must find a system you are comfortable trading and develop faith in your system. If understanding Theta helps you do that, I’m glad I could help.

Stock Trader:  I’m definitely comfortable trend trading. Thanks to you, I now know a lot more about how Theta works, and that should make me more comfortable trend trading with options. Short Theta trading seems like trading perishable goods; they have an expiration date on them. I think I would feel much less stress buying Theta.

Optionz Traderz: It is funny that some think only the seller is at an advantage due to every option contract having a time of expiration. They don’t want to buy options because they know they have to be right, not just about the move, but when it takes place. Obviously, you are able to see that there is also value in being a buyer. Options are a zero sum game; the option seller has to be right about the stock not moving to a certain price in a designated time frame; the buyer has to be right that it will move to that price.

Stock Trader: In an efficient market both sides are always equal at the time the trade is executed.

Optionz Traderz: Exactly. Selling Theta is a lot like selling lottery tickets. You can make a lot of money because the odds are in your favor, but you have to also pay the winners. Some traders, like me, prefer selling the tickets and then buying them back if they look like a winner just before the last lottery number is called. You seem more like the type of trader that would prefer buying lottery tickets and selling them if the first few ‘numbers’ in the lottery drawing made them look like a loser.

Stock Trader: Good point. Well it’s been nice talking to you, but it’s getting late and after this afternoon’s commute, I’m wiped out.

Optionz Traderz: I should get going soon too. It’s been nice talking options with you.

Ghost of Darvas: I hope you can answer one more question before you go. Should I trade my Darvas system principles but just adjust them to options?

Optionz Traderz: I think options may work for you. For instance, you may want to only buy two-month-out options at-the-money at the time of a breakout, to keep the same buy point you would have used to purchase the stock. That would alleviate the stress of trying to predict breakouts and minimize losses due to time decay, but still capture the full move in intrinsic value.

Ghost of Darvas: Great advice, as always. Thanks. You have a good night!

Stock Trader: Nice chat, Optionz, and thanks for the charts. Stock Trader out…

Chapter 5

VOLATILITY IS THE OPTION BUYER’S FRIEND BUT THE OPTION SELLER’S ENEMY. (VEGA)

It was Thursday night and Stock Trader’s eyes were getting heavier and heavier. It was 11:10 p.m. and once again he was up past his usual bedtime. He was looking at the charts of the stocks on his watch list. Now he found himself looking at red candlestick after red candlestick.

“Yuck!” he thought. “These charts look terrible!”

He had been watching these same charts intently for over a month, during what appeared to be a slow grind downward. His system had taken him to cash, as the stocks on his watch list all lost their 10-day moving averages nearly three weeks earlier. While he was waiting for a reversal back above the 10-day, they lost the 20-day moving average. Nevertheless, he had kept watching intently over the past week. “The 50-day would be a chance to enter long again,” he thought. That was often a great place for support in an overall long term up-trending market. Also, if the market leaders lost support at the 50-day moving average and had trouble retaking it a few times, that would be a major sign of a change in trend and the probable beginning of a bear market. His watch list would then morph into a list of stocks to sell short; not his favorite way to trade, but a way to make money in tough times.

Oddly enough, he missed his entries because both the 50- and 100-day moving averages were lost within days. The Dow Jones Industrial Average was losing 100 points a day, sometimes more. Tonight was particularly interesting because the S&P 500 index had closed right on its 200-day moving average, the Nasdaq composite was a few points above its 200-day moving average, and the Dow Average was a safe 50 points above the 200-day moving average. One of Stock Trader’s systems had him go long the S&P 500 Index when it bounced off and headed back up in price at the 200-day, or short the index if it lost that last critical support level. His holdings were now in cash, waiting for a direction; it was too soon to take a position because this was neither a reversal nor a loss of support. The price was lying right on the fence, creating a waiting game.

It was now 11:30 p.m. and time for sleep.

Beep, Beep, Beep, Beep, Beep, Beep

It seemed as if he had just fallen asleep, but the alarm clock was now summoning a tired Stock Trader to put on his tie and get to work. The open road and his day job awaited him.

He rolled out of bed, truly exhausted from his late-night chart observations. He sleepily walked to the living room and clicked on the television; as always, it was already tuned to his favorite financial news station. He retrieved his last energy drink from the back of his nearly empty refrigerator and almost dropped it when he saw that the European markets were down over 5%.

“What the…!” came out of his mouth.

Then he remembered he was flat; all his capital was safely in cash equivalents, no stocks. He felt like a bullet had just whizzed past his head.

Immediately he was wide awake. “What is going on?” he thought.

Commentators talked about how the leaders in one European nation had failed to pass austerity measures to get more bailout money from the International Monetary Fund. They would default, their bond holders would be wiped out, and companies which sold insurance on those bonds would lose billions of dollars. This was unexpected news, an outcome that seemed to have a low probability just yesterday, and the markets were reacting violently to the news.

“Wow! A socialist paradise collapsing under the weight of government regulation and entitlements…truly shocking,” said Stock Trader out loud, barely attempting to restrain the sarcasm in his tone of voice.

He saw a quote for the U.S. Dow futures. They were also down 5%. “No surprise there.”

On his commute to work he kept pondering the meaning of all of the recent financial turmoil. He considered himself to be a technical trader. He had missed his short entry, so now what? Was it too late to short and too early to go long? That gap down caused him to miss what he thought was the ‘meat’ of the move. Should he open a short position at the open? That would be keeping to his system. Should he use a trailing stop to exit? These were not easy decisions to make; these were strange circumstances, for sure. He quickly came to his senses and decided to watch the market but not place any trades.

Years earlier, he had discovered that one of the keys to his success was avoiding emotion. He had found that he could avoid emotion if he planned his trades when the market was closed, then placed trades based on his winning system when the market was open. Trying to plan a trade while watching financial news on television on a day when markets all over the world were down 5%, would be like placing a bet on the Super Bowl with the score tied and only two minutes remaining in the fourth quarter. Emotions were controlling the market today, and he made a decision to stick to his trading rules. He would watch the market as if it was a football game, but he would not place any bets during the trading day. Tonight, when the markets were closed, he could study the recent events and plan his trading for tomorrow, hopefully with some help from Optionz Traderz.

He was watching the quote at the open. The Dow Average opened down 4.5%, and then fell some more, down 5.5% at one point. Thirty minutes after the open it rallied, so it was only 4% down from the previous day. It was exhausting to watch, but he did not feel the adrenaline rush that he knew other traders were certainly experiencing. His accounts were all safely tucked away in cash – or were they? This was one of those days the market was so disturbing that Stock Trader felt the need to check all his accounts and ensure without any doubt that they were all completely in cash. This was not a normal functioning market; anything could happen. Other governments could take some kind of bailout action and that could lead to a rally, or it could be exposed that a major financial business was defaulting on its debt and going bankrupt, setting off a systemic problem in the financial system. This was not a market Stock Trader cared to trade. Truly, anything could happen. But it was as entertaining to watch from the sidelines as any sport championship game.

Throughout the day he was drawn to get quotes. He was fascinated with the price action. Finally at the end of the day the market closed down over 6%; this was a 675-point haircut off the Dow Jones Industrial Average. He was relieved to find that indeed all of his long positions had been closed. He was 100% in cash. Days like today made Stock Trader cherish his trading system. He had not made any money today, but so many people lost so much money that breaking even on a day like this meant he had still fared better than most traders.

“Wow!”

On the drive home he was very interested to know how Optionz had done. Did he have one of his Short Straddles on? If so, he certainly must have been hurt.

When he got home, he did not even take his shoes off; he went straight to the computer. Optionz Traderz was online.

“Great”, he thought.

He did not go to the Winning Traders group; he wanted to send him a private message so as not to open a trading wound.

Stock Trader: How are you doing today?

Optionz Traderz: Very well. What a CRAZY DAY, huh?

Stock Trader: I know, right? I was right at a crossroads looking for an entry signal and safely in cash. Today was so stressful I had to double check all my accounts to ensure I had no long positions on. I felt almost as though I had an obsessive-compulsive disorder.

Optionz Traderz: When trillions of dollars in value evaporate, it is good to double check on the safety of your hundreds and thousands. It’s not O.C.D., it’s a sound trading practice. Trading is stressful enough without worrying if you forgot about a long position. If it gives you peace of mind to double check your investments on a crazy day like today, do it! Today’s trading was unlike anything I have seen in many years. It would be crazy not to obsess over your positions on a day like this. And it would be even more insane to risk leaving them open over the upcoming weekend.

Stock Trader was anxious to know what positions Optionz Traderz had on this day. The curiosity was driving him crazy.

Stock Traderz: Many people got really hurt today.

Optionz Traderz: Tell me about it, I really feel sorry for the guy that sold me those Puts two days ago; that has to hurt. However the guy I bought the Calls from did well as long as they were not Covered Calls. Ouch!

Stock Trader suddenly felt a little envious. He was confident that being 100% in cash had saved him from horrible losses. He had broken even today, while millions of other traders had lost big time. He had missed out on a great opportunity to go short because most of the move had occurred overnight. Even if he had attempted to go short in the pre-market, he would have missed nearly 90% of the move. But Optionz Traderz actually made money today?  How was that possible?

Stock Trader: What? You bet both ways?

Optionz Traderz: Yes, some markets lend themselves to trading Theta, and others are best for trading Vega. When the markets meandered around slowly last winter, I made a killing selling Theta; but with the recent spike in volatility, it makes much more sense to capitalize on Vega.

Stock Trader: I remember you mentioned Vega last time we talked, but it seems confusing. Volatility is always changing, so how do you know when it is best to focus on Theta and when to shift to Vega?

Optionz Traderz: Vega is an important concept in option trading. Usually it is not as important as time-decay or Theta in my opinion, but there are occasionally days like today when volatility spikes that Vega can not be ignored. There are no set rules for capturing profits from Vega, but I’d be happy to share my thoughts about it.

Stock Trader: I’d appreciate it. All day, I thought I was doing better than most traders by not losing money while most others were. It would have been nice to be able to profit from the rise in volatility, but I did not know how to do it. I think I have a good understanding of Theta now, but Vega seems a little more complex.

Optionz Traderz: Vega is not complex at all; in fact, it is simpler than Theta. Vega is nothing more than the effect of volatility on option premiums. When volatility increases, stock prices make wild swings up or down or both. That makes predicting the price of a stock on some future date more difficult than it would be if prices were stable.

Stock Trader: I understand the basics of volatility. High volatility means there is a lot of uncertainty in the markets; low volatility means prices are flat or rising. But I’m having trouble relating volatility to Vega. I think if I understood Vega, I would have been able to profit today, just as you did.

Optionz Traderz: Well, I have good news. Theta is the most difficult concept of option trading. If you were able to understand Theta, you will have no difficulty grasping all of the other ‘Greeks,’ including Vega.

Stock Trader: That’s reassuring. Theta was not easy to comprehend, but when you showed me the charts that used your tortoise as an analogy, I understood completely.

Optionz Traderz: I have found analogies to be very useful when it comes to understanding options, so here’s another one for you. The homeowner’s association for my condo forbids cats and dogs – that’s why I have a pet tortoise. Some other residents have pet birds, lizards, even snakes. But there is an older lady that lives on the other side of the complex and she has a pet rabbit. I think her rabbit may help you understand Vega.

Stock Trader: I guess I shouldn’t be surprised. If you were able to use a tortoise to explain Theta, then I won’t question your use of a rabbit to explain Vega.

Optionz Traderz: That’s good to know. Sometimes I think my analogies are so crazy that my tortoise is the only one who will listen to them, but I really enjoy sharing them with you. It’s nice to have a real person interested in my ideas about options for a change.

Stock Trader: It’s great to have met someone like you that can explain options in such detail. But I feel like I owe you something for all of your insight. If this conversation was in person instead of on Facebook I’d offer you a beer for your thoughts.

Optionz Traderz: Well, thanks for the offer, but I’d really prefer a margarita instead.

Stock Trader: As expensive as a margarita might be, it would be well worth the cost, given the advice you have given me about options so far. I am really intrigued by your analogy of Vega and your neighbor’s rabbit.

Optionz Traderz: O.K., here goes: My neighbor takes her morbidly obese rabbit out for walks, just like I do with my tortoise; he likes to eat the grass and weeds by the pool too. But as big as he is, he moves much faster than my tortoise. I can’t count the number of times we have had to form search parties to look for her rabbit when it wandered away, while my tortoise has only gotten away once.

Stock Trader: So are you saying that the rabbit represents Vega?

Optionz Traderz: Well, it represents higher volatility than a tortoise. Implied Volatility in stocks is quite simply the predicted ‘speed’ that they will change in price. I think I have another chart that may help you understand.

Stock Trader: That would be great. Your charts have been very helpful.

The search area for the rabbit is about 25 times the size of the search area for the tortoise, representing the increased uncertainty of the location of a stock price with higher volatility.

Optionz Traderz: As you can see from the chart, the search area is exponentially larger for the rabbit. However, when trading stocks, it is not the search area that is of concern, but the distance of the price from its starting point. The rabbit may cover a much larger area than the tortoise, but its distance from the starting point is equal to the radius of the circle. On average, the rabbit will be about five times further away than the tortoise. It works the same way with stocks. A stock with an Implied Volatility of 50% will generally move five times the distance of one with an I.V. of 10%, over a set period of time. The result is that the time premiums on the high volatility ‘rabbit’ stock would be about five times as high as those on the low volatility ‘turtle’ stock.

Stock Trader: I think I see where you are going with this now. If I buy at-the-money Call options on one of the stocks on my watch list, and volatility suddenly doubles, the time premium should double too, even if the underlying price remains unchanged.

Optionz Traderz: You’ve got it, exactly! That’s all there is to understanding Vega; no complicated formulas. Vega is simply the change in the time premium of an option due to a change in volatility. And you are correct that an at-the-money option could double in price if volatility doubled. I have two more charts to send you. I think they might help you see exactly how volatility affects premiums.

Direxion Financial Select Sector SPDR (ETF)      NYSE:XLF               Last Trade 12.73

Options Expiring September 17, 2011

The premium to open a straddle at the $13.00 strike (at-the-money)  on XLF is about $1.12, so one would expect the premium to be approximately three times that amount, or $3.36, if volatility tripled.

Direxion Daily Financial Bull 3x Shares (ETF)     NYSE:FAS            Last Trade 13.85

Options Expiring September 17, 2011

The premium to open a straddle on the $14.00 strike (at-the-money) options on FAS is about $3.12, roughly three times the premium to open a straddle on XLF, because the ETF is triple-leveraged, causing its share price to move at three times the speed of XLF. Implied volatility on FAS is approximately three times that of XLF.

Stock Trader:  That is a really good example. I knew volatility affected option premiums, but I never imagined it would be so simple. I used to struggle to understand the equations in the Black-Scholes pricing model, but this makes it so much easier. If volatility triples, the premiums triple; if volatility drops 10%, option premiums fall by 10%. Thanks for clearing this up.

Optionz Traderz: You’re welcome. I think I’ll take you up on that offer to buy me a margarita now. But seriously, you need to remember that the effect of volatility, or Vega, only applies to the time value of an option. Vega does not affect intrinsic value. An option that is deep in-the-money or out-of-the-money always has much lower time value than an at-the-money contract, and therefore it is affected much less by Vega.

Stock Trader: That makes sense. Increasing volatility would make it more difficult to predict the future price of a stock, but if the option is deep in-the-money, there’s a pretty good probability that it will stay there, so it is much easier to predict its outcome than an at-the-money option with 50-50 odds of expiring in-the-money. So I guess the effect of Vega would always be greatest on at-the-money options, the ones that are the most difficult to predict. Am I right?

Optionz Traderz: Exactly! It’s sort of like betting on horses at the racetrack. If you bet on a horse with that is showing 9 to 1 odds of winning, it’s likely you will win. The same goes for 1 to 9 odds; it’s fair to say you will probably lose. But 1 to 1 odds will drive you crazy. Of course, taking a 9 to 1 bet will make you money, but not much of it; it costs a lot to place a bet with such great odds. The big money is made and lost on the 1 to 1 odds.

Options are no different. So it should come as no surprise that at-the-money options, the ones with 1 to 1, or 50-50 odds, are the most heavily traded; that is where the biggest potential profits are. Most anything that affects the price of an option, such as time to expiration or volatility, will have a more pronounced effect on at-the-money options. When it’s starts to rain during a horse race, it’s not the guy who chose the 9-to-1 bet that is sweating bullets; it’s the one with the 1-to-1 bet who is unsure whether his pick is a ‘mudder.’

Stock Trader: That is another great analogy. I guess the good news is that in the options market there is no racetrack to take a cut of the winnings. With options, the winners always walk away with the same amount of cash that the losers have lost. I wonder if all those guys down at the racetrack understand how much better their odds would be if they started betting on stock options instead of race horses.

Optionz Traderz: That’s a good question. I doubt many of them would make the switch. Betting on horses is more emotional than options, in my opinion. I think most of them do it for the adrenaline rush.

Stock Trader: You’re probably right. Most of them would be bored to death trading options, even if they did end up with more money in their pocket.

Optionz Traderz: You hit the nail on the head. Racetracks are great places for emotion and entertainment, but they are no place to earn a living, except for a few lucky folks. When you trade options, there is no racetrack to take a cut of the winnings, and that is definitely good news. Now, here’s some more good news. The majority of the time, Implied Volatility increases when prices fall to lower levels. That means if your trend trading system led you to buy a Call, and the underlying price suddenly dropped, the time premium on the Call might actually increase due to Vega. Sometimes the increase is enough to offset much of the loss of time value due to Delta. Fear increases Put premiums more than greed increases Call premiums.

Stock Trader: That’s a good point. If I am going to trend trade using options, Vega could help me cut my losses when I am incorrect predicting the direction of a trend. I guess it would also work with Puts. If I bought Puts to protect one of my long stock positions, Vega could help amplify the increase in their value in the case of a volatile downturn.

Optionz Traderz: Yes, and there are many other ways to trade Vega. When volatility spikes way up like it did this week, I usually like to sell Naked Calls. The premiums are very generous now and prices are continuing to fall. Of course, I’m not really selling Vega because Vega is merely a measure of volatility’s effect on option premiums. I am really selling Theta, but taking advantage of the increase in premiums and the subsequent increase in the rate of time decay due to Vega. However, in my opinion, the current market is much too volatile to take risks with Theta. Yes, the premiums are much higher than they were just a few days ago, but the risks are just too big, even for my taste.

I prefer betting on volatility instead. I have been playing Long Strangles in the SPY, and also Long Calls on the ETF pair FAS/FAZ. When the prices move violently, like they have done recently, I can profit nicely from the Strangle on SPY. I can also profit from the Calls on one side of the FAS/FAZ pair going deep in-the-money soon after I open it, while the Calls on the other side maintain much of their time value. This method works best in either volatile or sharply trending markets, and I prefer to use front month options. When you buy out-of-the-money Strangles your primary risk is Theta decay, while you capture moves with intrinsic value and increasing Delta. However, you need a sharp move, quickly, and Puts get more expensive in a volatile market that is trending downward. So you do have the Vega risk; if volatility collapses it could cause the value of your Long Strangle to collapse along with it. Usually, when trading Straddles or Strangles, increased volatility is the option buyer’s friend and the option seller’s enemy.

Stock Trader: I don’t want to sound critical of your trading system, but why would you have used a Strangle when you could have just bought Puts?

Optionz Traderz: My trading is mainly technical. I really did not know if we would get a breakout to the downside or a sharp reversal upwards if the European Union put together some kind of a rescue. Nowadays, governments seem to constantly interfere with trends. So I have been opening Straddles and Strangles, three-weeks-out, over the past few weeks, and planned to close them out on sharp moves. Today was one of those moves. I did very well; my Put side increased dramatically more than my Call side lost. It increased not only in intrinsic value, as my right to put a price on someone became much more valuable because of the increase in probability that it would retain that value at expiration (Delta), but also because the insurance it provided became much more expensive due to the increased volatility of the market (Vega).

Stock Trader: So this was a non-directional trade and you made money. You did not predict any direction just that the market would soon trend sharply?

Optionz Traderz: Yes and no. I was not betting so much that it would trend, just that it would be volatile. I closed my positions today for a hefty profit and opened a new Strangle at-the-money again. I also did this a few days ago when the market gapped up huge at the open, amid rumors of an ensuing bailout. That morning I closed out my Long Strangle in the SPY for a nice profit, then opened another and made an additional profit when the market lost the early morning gains and collapsed in price before noon. It got a little ridiculous, like I was a day trader using volatility-pumping to make money. I usually expect one large move a week to make me profitable, not two in one morning!

Stock Trader: I’m not sure I understand. Why didn’t you just let your profits run? That is what I would have done.

Optionz Traderz: With volatility increasing each day and intra-day moves of over 200 points in the Dow, I just do not feel comfortable with a directional trade. When my Put side went many strikes in-the-money, it was no longer a Straddle; it was a Long Put with intrinsic value, while at the same time a Long low probability Call. I wanted to take my money off the table while it was there. I wanted to get Delta neutral again and only be long Theta in this market.

Stock Trader: In my style of trading I would have let my profits run on the Put side and closed my Calls.

Optionz Traderz: That is a viable plan for a trend trader. I personally can’t stomach a trend trade in this kind of market. The average daily range is just so wide. I feel more comfortable risking Theta in this environment, and I have learned that my comfort with my trades is the main key to my success.

Stock Trader: Yes, sweaty palms do not make for good trading decisions.

Optionz Traderz: Neither due wildly swinging, volatile prices. Many times volatility=stress=panic. What better way to capitalize on volatility than to open a Long Strangle or Straddle and sit back and watch the show, with only Theta and Vega as risks? I am risking a small amount of my equity and will profit in either direction as long as there is a strong move.

Stock Trader: I get it, though I would probably have let it run its course and watched which direction the trend finally went for really big profits.

Optionz Traderz: That is also a valid system and could make you some serious money. I trade, though, for living expenses, not long term capital appreciation, so I tend to take profits quicker than a trend trader who is looking for homeruns. I am happy with a high batting average and getting runs batted in to home plate.

Stock Trader: Wow, you are just full of analogies today. But that makes sense. I also want to trade for a living one day soon. So let me see if I fully get the Long Straddle and Strangle concept completely. The market is getting volatile; the daily ranges for the main indexes are getting wider and wider. We are in a general march downward in prices, but not without some big up days in between. A long straddle would be like going to two traders and making an offer.

To the first bearish trader you say,

“The Dow is at 11,000. I will pay you $2,000 but you have to pay me the full move the Dow moves above 11,000 on $110,000 worth of the Dow Diamonds Exchange Traded Fund, ‘DIA’, over the next four weeks; however you can keep the $2,000, just pay me my profits.” This would be like 10 Long DIA Call contracts, or 1000 shares.

To the second trader, who is bullish, you say,

“The Dow is at 11,000. I will pay you $2,000 but you have to pay me the full move the Dow makes below 11,000 on $110,000 worth of the Dow Diamonds Exchange Traded Fund, ‘DIA’ over the next four weeks; however you can keep the $2,000, just pay me my profits.” This would be like 10 Long DIA Put contracts, or 1000 shares.

The beauty of this trade is that on a day like today, when the Dow moves over 6%, the person who sold you the Puts is sweating bullets because he owes you $6,600 in intrinsic value in one day, plus time value, so it could cost him over $7,500 to buy back his Short Puts from you. At the same time, the guy that sold you the Calls is pretty happy he may have made $1,500 and would probably be happy to by back the Calls he sold you yesterday for $2,000, at a fire-sale price of $500. All in all, you would lose $1,500 on the Calls but earn $5,500 on the Puts. That amounts to a $4,000 profit or the equivalent of a 100% return on capital in one day. However, closing the trade is not mandatory because you would have the choice to let it run its course and own 100% of the downside trend for the remainder of the month, which could further increase your profits. You have the choice of taking your profit while it is ‘on the table’ or letting the bet play out for the rest of the month to maximize its potential. In the meantime, you are allowing two other traders, the sellers of the DIA options, to take a lot of risk in a volatile market. But you can feel confident when you open a Long Straddle that you are the most likely to come out ahead because in a volatile market the losing seller usually loses more than the winning seller wins.

Optionz Traderz: I believe you have it, although I have to say that was a unique way of explaining it. It really is a great way to profit from volatility, not to mention how it gives me defined risks on my long options, so I control my losses and my risk of ruin in a wild market. Also, from a psychological perspective, I have very little stress during troubled times, so I sleep like a baby at night while other traders are up all night watching all the world’s markets and the future’s markets, attempting to read the next market direction. What a big waste of time that is!  In my opinion, trading options eliminates a lot of that waste. I sometimes use options on the iPath S&P 500 VIX Short Term Exchange Traded Note, VXX to profit from volatility. When volatility is low, far out-of-the-money Calls on VXX sometimes cost only pennies, but they can be huge profit makers when the market goes berserk like today. Some of my Calls on VXX had a 300% return today, despite the fact that they are still out-of-the-money. I closed them this afternoon and took my profits while they were there and decided not to open new Calls because Vega has caused the premiums to get too high for my comfort.

Stock Trader:  I must admit that I am very impressed with your option trading prowess in this market. You must have different systems in different markets?

Optionz Traderz: I have a garage full of different vehicles for different terrains.

Stock Trader: Huh?

Optionz Traderz: I don’t take a Ferrari out 4-wheeling, so I don’t sell close-to-the-money Naked Puts in a market that is collapsing in price.

In a flat market, I sell short Straddles at-the-money.

In a range bound market, I sell Short Strangles, with Calls above resistance and Puts below support.

In a raging bull market, I buy Calls on hot stocks and sell Naked Puts.

In a bear market, I buy Puts.

In a wildly volatile, 400 points up today 500 points down tomorrow, roller coaster market I buy long Straddles and Strangles.

Stock Trader: So the moral of the vehicle analogy is don’t trade the wrong option strategy in the wrong market? I guess that must be one of the most important rules for an option trader: use the strategy that is best suited to the current market conditions. But when do you bring out the pink Cadillac?

Optionz Traderz: On Saturday night.

Stock Trader was feeling a new sense of confidence that he would one day be able to trade options as a means of financial independence. Optionz Traderz seemed to make trading stock options appear to be simpler than he ever imagined. Previously, Stock Trader had found that time decay and Theta were difficult to understand, but Optionz made it so easy when he changed it into a simple equation related to the square root of time. Then he had shown how volatility and Vega are even easier to understand, affecting option premiums without any complex equations at all. All those days he had spent researching the Black-Scholes pricing model suddenly seemed like a waste of time. “I wonder if Optionz is correct about all the other Greeks being this easy; what about Delta and Gamma, could they be simple too?” he thought.

It was getting late and there was another grueling day of work ahead, so Stock Trader decided to wait until the next evening to find the answers. But he would definitely have to inquire about Delta the next time they talked. Maybe now that he knew how Theta and Vega worked, a grasp of Delta was all that remained to satisfy his desire to trade options for a living. As tempting as it was to ask for answers now, Stock Trader’s stomach was empty, his eyelids were getting heavier, and he slowly drifted off to sleep in his chair in front of the computer.

Chapter 6

DELTA: HOW MUCH OF THE MOVE DO YOU GET FOR THE MONEY?

Stock Trader slowly opened his eyes and discovered that he was still sitting in his computer chair.

“Good grief, where am I? What day is it?”

It was still dark; his computer was in sleep mode, just like he had been. He clicked the mouse to bring the monitor back up and he looked to see that it was 3:21 in the morning and it was Saturday.

He loved Saturday because he was paroled from his cubicle on that day, but at the same time he was a little sad that the markets would not be open, as they had become his major source of entertainment.

Almost immediately, thoughts of Vega and Theta began to float through his mind. He started pondering how these option variables would affect his trading. Such dynamics did not exist in stocks. With a stock, what you see is what you get, but with options he owned dated contracts.

With options he had to be right about a stock's movement within a timeframe, and changes in volatility could also help him or hurt him in his trading.

He looked down casually at the time and saw that it was now 4 a.m.

“My name is Stock Trader and I am an ‘optionaholic,’” he said out loud.

He made himself get up and go to bed, where he continued to think about options. He figured he could risk less per trade but still get most of the movement when he was right. It was possible that he could lose capital at a faster pace than with stocks but greatly limit his losses with a clearly defined downside. He figured an option contract has a built-in stop loss due to much less capital needed to buy a contract; would option trading prove to be more protective than a stop loss on a stock’s price? Stop losses on stocks do not protect traders from aftermarket and pre-market gaps in price. With the way the market was currently moving he did not feel confident in the protection of a traditional stop loss. Stop losses were ineffective on gaps on the open in the wrong direction. When the broader market moved over 4% and individual stocks were being hammered with up to 10% losses in one trading day, and with the majority of those moves happening with gaps down at the open, Stock Trader was beginning to feel more comfortable with smaller option positions than larger stock positions. This was truly a crazy market.

“While long options may not protect me completely, they do limit the losses to the price of the contract which is far less capital at risk,” he thought.

Stock Trader started to envision how when he bought contracts, the seller took on much more risk than he did. He liked that. The seller would benefit from time decay; he would benefit from a favorable move in the right direction. As a buyer he would benefit from an increase in market volatility while the seller would benefit from a collapse in volatility.

He started to believe that the option buyer might actually have an advantage through actual capital at risk. But he was unsure of whether he was correct, and his thoughts went back to Optionz Traderz saying it was a zero sum game and the risk to the seller was reflected in the premium. He had read conflicting studies, some showing 30% of options expiring worthless, others indicating that the rate was closer to 80%. Whatever the actual rate, he felt reassured by Optionz Traderz' philosophy that the winner’s winnings, whatever their percentage might be, would be offset by the loser’s losses in the long run. Still, although he couldn’t put his finger on it, there was something about selling options that made him feel uneasy. He felt much more comfortable contemplating option trading as a buyer. If there was a way to keep option trading in his comfort zone, it would greatly increase his chances for sticking with a winning system and ultimately lead to his success. Thanks to Optionz, he was now much more comfortable with the concepts of Theta and Vega, but what about the other Greeks?

His thoughts wondered to Delta. This was interesting. If options had no value when they expired, they were worthless. He needed to fully understand how Delta functioned to help in his trading. He could not just flip his stock trading systems over to option trading and expect the same returns. He figured it would be like applying the rules for checkers into a chess game and wondering why he had lost. He had to fully understand what he was doing BEFORE he started trading options. He wanted to learn about options without having to pay higher than needed ‘tuitions’ in the option markets themselves, with losses he might not yet even contemplate. He felt he had already paid his full tuition, suffering substantial losses as a stock trader before eventually finding a successful trading system. He wanted to avoid those initial losses this time. If he was going to convert his stock trading system to option trading, he would do it the right way.

He knew that soldiers did not go into combat without full military training and he would be no different. He would understand options before he traded them. Luckily he had his own personal option sergeant running a very friendly boot camp.

He needed to continue his education in options.

He picked up his smart phone and looked at the time; it was now 8 a.m.

“Would Optionz be online this early?” he wondered.

There was only one way to find out for sure.

He went back to his computer and sat in his desk chair. He looked on his favorite social media site for good news.

Online Friends: Optionz Traderz

Bingo!

Stock Trader chose a direct chat, instead of the group setting, to avoid all the annoyance involved with ignorant know-it-all traders and those relentless penny stock pumpers.

Stock Trader: You are up early this morning.

Optionz Traderz: I guess my sleeping pattern is geared with the markets.

Stock Trader: I have been thinking about transitioning my stock trading to option trading and wondered what your thoughts were about the best way to do this without actually getting worse performance by not considering the Greeks correctly.

Optionz Traderz: That is a great question. There are many factors you will want to consider. First, you will have to make your options match your timeframe. You shouldn’t trade weekly options if you plan on your trade working over two months; at the same time it is not usually a good idea to day-trade two-month-out options. Just to illustrate how important matching your options to your timeframe can be, consider this: A buy-and-hold stock trader who attempts to protect his trade using monthly Puts would pay about three times as much in combined premiums over the course of one year as he would buying one set of Puts expiring in a year.

Stock Trader:  That makes perfect sense. If one of the stocks on my watch list usually had breakouts that only lasted a few weeks, I would be wasting money paying the increased premium on two-month-out Calls. What do you think are the main variables to consider in converting my trend trading system over to using options?

Optionz Traderz: In my opinion, Theta is the most important concept to understand when converting to options. Unless you have a streak of incredibly good luck, you will not make a profit unless you understand how time affects options. Next is Vega, because even if you understand time decay, you don’t want to be surprised by volatility’s effect on options. Without considering Vega, you run the risk of paying overly inflated premiums during periods of high volatility. Or you might find yourself closing otherwise profitable trades if volatility caused your options to move in a way that you did not expect. Time and volatility are really the only two major things that affect the price of options. If you can comprehend those two concepts, then you are well on your way to being successful. But if you are going to adapt your stock trading system to options, Delta might prove to be the most important concept of all for you.

Stock Trader: I definitely wouldn’t consider myself an expert when it comes to the Greeks, but I think I have a basic understanding of Delta. From what I have read, Delta causes the price of an option to move up or down at a fraction of the price movement of the underlying stock. If a stock price goes up by $2.00 and I own a Call option with a Delta of 0.50, wouldn’t Delta cause my Call to go up in value by $1.00?

Optionz Traderz: Yes and no. Unlike Theta and Vega, Delta does not have any direct effect on option premiums; it is simply a measure of the observed effects of time and volatility as the underlying price moves up or down.

Stock Trader: I’m not sure I understand. If time and volatility are the only factors that determine option prices and Delta has no effect, why would understanding Delta be more important than Theta or Vega?

Optionz Traderz: Theta and Vega are the two most important factors of several that go into option pricing, and although Delta is not one of those factors, I think I can explain why it still might be the most important.

Stock Trader: Oh, great, here we go with another tortoise story.

Optionz Traderz: LOL! Sorry to disappoint you, but no tortoise and rabbit analogies this time. I hope they helped you gain a better understanding of Theta and Vega though.

Stock Trader: They were very helpful. So what do you have in mind this time, lions and tigers and bears?

Optionz Traderz: Not exactly. Even with as much success as I have had with options, I wouldn’t consider myself to be the Wizard of Options. That’s funny though. So here goes. You already know how time and volatility affect options. Risk-free interest rates also have an effect. When interest rates rise, rather than risk money on stocks, traders can put much of their money in a risk-free account, then use a much smaller amount to buy Calls. That drives up demand for Call options, which causes premiums to rise slightly, which is measured by Rho. In my experience, the effect of Rho is so small, especially when trading options only a month or two before expiration, that it can generally be ignored.

Stock Trader: That’s good to know. If I can ignore Rho, it is one less thing to think about.

Optionz Traderz: I agree. The less you have to think about, the more you can focus on the parts of options which are the most important. There are a dozen or so additional Greeks that in my opinion can also be ignored. There are Greeks that measure everything from the ‘charm’ of an option to its ‘color’; but it has been my experience that Delta is the key to option trading success.

Stock Trader: That’s interesting. I believe that is similar to stock trading. When I clutter a chart with a dozen technical indicators, it does nothing but take my attention away from the moving averages and volume indicators which I have found to be the most useful in my trend trading system. However when I focus on a few key indicators, it is much easier for me to spot a trend.

Optionz Traderz: I’m glad you agree. With that said, there are a couple of factors that are not Greeks which you shouldn’t ignore; one of those is ex-dividend dates. Dividends are like unwanted pests to an option trader. When a company announces an upcoming dividend, the price of Calls decreases while the price of Puts increase to compensate for the expected drop in price on the ex-dividend date. It normally does not have a huge effect on premiums, but you should at least be aware of it. Also, if you own Calls on a stock that is about to go ex-dividend, you might consider exercising them early even if they are out-of-the-money if you expect the dividend to outweigh the loss of the remaining time premium. Conversely, if you have Short Calls on a stock nearing ex-dividend, you should pay close attention to your account because there is an increased risk of early assignment, not only on Calls that are in-the-money, but also those that are slightly out-of-the-money.

Stock Trader: Wow! I never thought of that, but it makes sense. If I owned a Call that was 10 cents out-of the-money and was so close to expiration that the bid price was 25 cents, it might be profitable to exercise it early if the dividend was enough to offset the combined loss of 35 cents. But if the stock price usually falls on the ex-dividend date, wouldn’t I just be setting myself up for a loss?

Optionz Traderz: Not necessarily. Stock prices are dependent not only on the assets and obligations of the company, but on the expectation of future earnings. A dividend creates an additional obligation for the company, but it normally does not affect future earnings. The result is that all other market forces being equal, the price of a stock will normally fall by only a fraction of the amount of the dividend, most often in the pre-market hours on the day it goes ex-dividend. So using your example, if the stock consistently paid a dividend of $1.00, and the price historically dropped 50 cents the morning of ex-dividend, that would still be more than enough to offset your 35-cent loss.

Stock Trader: I never would have thought to exercise an out-of the-money option and certainly would never have expected to get assigned an out-of-the-money Short Call. That’s something I will definitely consider from now on. So now I think I have a pretty good understanding of Theta and Vega. I will ignore Rho, and I will pay close attention to my options around ex-dividend dates. But I’m not sure I understand how this is all going to tie in to Delta.

Optionz Traderz: O.K. I’m getting there. But first, there is one final factor you should watch: liquidity. Liquidity is often more important than Theta, Vega, Rho, and dividends combined. As I often like to remind option traders, it has been my experience that every option strategy left unmanaged will eventually revert to the mean, and given a sufficient number of trades will break even. I attribute most of my success with options to be the result of managing my trades. Management is different for every trader, but it might require taking your money off the table when it is there, or it could involve closing your losing trades quickly while letting the winners run. It could also employ tactics such as rolling options to a different strike or a different expiration when the trade gets too risky. Whatever the means undertaken to manage the trades, it will almost certainly become necessary, at least occasionally, to open or close positions. Doing so with options that don’t have sufficient liquidity, those with large spreads between the bid price and the ask price, could quickly lead to ruin.

Stock Trader: I think I see what you’re saying. If I buy Calls at the ask price with a bid/ask spread of 50 cents, even if I am correct in predicting a trend and the premium rises by 50 cents, I would probably only break even if I sold them at the bid price.

Optionz Traderz: Exactly, and if you only break even on your winners, how are you going to offset your losing trades?

Stock Trader: That’s a good question. I guess the answer is to stick with options that have good liquidity.

Optionz Traderz: Oh, yes, liquidity is a big deal with options. Like we have talked about before, you have to be more selective about which options you trade when you convert from stocks to options. Options do not have the depth of liquidity that most stocks have. Even if you trade the most liquid options, they have wider spreads, especially at strike prices farther away from the current price or expirations farther out in time than the current month.

Stock Trader: So while I benefit from leverage with options, I am at a disadvantage with liquidity if I get too far off the current beaten path.

Optionz Traderz: Exactly, the stocks and ETFs on your option trading watch list will probably be much shorter than your stock trading watch list.

Stock Trader: I guess I will need to trade in the ‘big river’ options and stay out of the ‘small option creeks.’

Optionz Traderz: Yes, generally it costs too much to jump in and swim in the small creeks and then more to get out.

Stock Trader: I guess I could lose my shirt swimming in the small option streams.

Optionz Traderz: LOL. O.K., now for the final part of the equation: Delta. If you always hold your option positions until expiration, there is no need to consider Delta. Delta disappears on expiration day, so either your position will expire with intrinsic value or it won’t. But I’m sure you see the value in managing your option positions to enhance your long term profits. Even if you are able to avoid the pitfalls of reduced liquidity, you will eventually find it necessary to close or roll your positions before expiration, either to increase profits, reduce losses, or both. You could use complex formulas involving time decay and volatility to calculate the expected results of those required trades, but Delta combines everything into one simple formula. When you have an open option position, Delta is your most important indicator. Like a speedometer in a car, it tells you your option price’s velocity relative to the underlying stock. But just as a car’s speedometer does not control the car’s speed, Delta does not control the price of your options.

Stock Trader: Delta shows me the amount of money I will win or lose based on the combined effects of each and every factor that determines the price of an option. So it’s like a summary of all of the Greeks?

Optionz Traderz: Exactly. Just like driving a car, you would go insane trying to calculate all the different variables that affect your speed – the amount of pressure you are applying to the accelerator pedal, the uphill or downhill grade of the pavement, wind resistance, tire pressure, etc. It is so much easier to just look at the speedometer.

Stock Trader: That’s a good point. So if Delta is like a speedometer for options, how would I apply it to a system of trend trading?

Optionz Traderz: Well, there are two ways you can use it. Profitability from trading options, as with any other type of trading, requires either increasing your profits, decreasing your losses, or both. If you have a proven system that allows you to predict trends, you are well on your way to increasing profits. You could simply use your system to help you choose the best entry point for an option trade and then ignore Delta and all the other Greeks by letting each trade ride out the entire contract until it expired. In most cases, that would be a valid way to ensure profits. As long as you were accurate about the direction of a trend more than 50% of the time, chances are you would be profitable in the long run. However, I’m assuming you are probably like most trend traders who do not rely solely on increased profits for their success; they also limit their losses. If you are going to limit your losses with options, Delta should help you determine not only the most appropriate option for your strategy, but also the best position for either a stop loss or a trailing stop.

Stock Trader: That makes perfect sense. When I trade stocks, I often set a stop loss just below resistance. Sometimes I use a moving average to determine a resistance price, other times I use a recent low. So how would you suggest putting Theta, Vega, and Delta together to create a winning system?

Optionz Traderz: If you are using options to trade a classical stock trading system, Theta and Vega will be less of a factor most of the time. Your ability to use less capital to trade and win more on a percentage basis when you are right will be much more important than time decay or volatility premium increasing and decreasing – well, at least most of time. There of course will be times that the market does not move at all and time decay costs you some capital, as well as times when volatility collapses and causes the options you own to fall in price, but this should be the minority of the time if you have a robust system. Theta and Vega are important Greeks, but Delta is the one that will help you make money.

Stock Trader:  That’s good to hear. So putting Theta and Vega to the side, what are your thoughts on trading using Delta?

Optionz Traderz: Delta is often the most difficult part of options for new traders to grasp. Unlike stocks, where the prices move up and down exactly the amount that market forces are pushing them, option prices usually move at a slower rate. When the price of a stock goes up by $1, the at-the-money Calls usually increase about 50 cents because Delta is usually near .50 with at-the-money options.

Stock Trader: I’ve always noticed that at-the-money Calls increase in price at about half the rate of the underlying, but I have never completely understood the reason why.

Optionz Traderz: I think I can explain, if you like, and I promise, no analogies involving pets.

Stock Trader: That would be great.

Optionz Traderz: O.K., say you buy an at-the-money Call for $1.00 and the stock price immediately goes up $1.00. When you initially bought the Call, the odds that it would end up expiring in-the-money were 50-50, and that is the highest possible amount of uncertainty possible in an option trade. Later, when the stock price has risen by $1.00, the odds are much greater that the Call will expire with intrinsic value, in-the-money. The odds are greater, so there is much less uncertainty about the outcome at expiration, and less uncertainty means that the time value of the option is much less. So while the intrinsic value of your Call would increase by $1.00, the time value would likely decrease by 50 cents.

Stock Trader: I’ve noticed that on some of my favorite stocks, Delta on at-the-money Calls is lower than 0.5 and on others it is higher. If there is a 50% chance of these options expiring in-the-money, shouldn’t the Delta always be 0.5?

Optionz Traderz: That’s a great observation, and it’s definitely worth discussing. The strike price of a Call with a Delta of 0.5 is based upon odds being 50-50 that such an option will be in-the-money at expiration.

Stock Trader: I understand that, but I’m looking at options on a stock that is trading at $75. Why would the Delta on the $75 Calls only be 0.44?

Optionz Traderz: Does that stock pay a dividend?

Stock Trader: Let me look… Yes, there is a 68-cent dividend and the ex-dividend date is next week.

Optionz Traderz: There you have it. The odds are that the stock price will drop slightly after the ex-dividend date to reflect the amount of money that the company will be obligated to pay out as dividends to its shareholders. So the odds of the $75 Calls expiring in-the-money are not 50-50 because all other market forces aside, the stock would be trading slightly lower than $75 after the ex-dividend date. The chances of the $75 Calls being in-the-money at expiration are slightly lower than 50%, due to the dividend.

Stock Trader: O.K., I can understand that. Dividends lower the likelihood of a Call closing out with intrinsic value, but why would the at-the-money Calls on one of my ETFs have a Delta of 0.67?

Optionz Traderz: I think I can explain that too. Much of the time, 0.5 is a good approximation of Delta on at-the-money options, but it is just that: an approximation. Volatile stocks and ETFs, especially those that are double- or triple-leveraged, have a tendency to increase in value much faster than they lose value.

Stock Trader: So the at-the-money Delta could be higher than 0.5 because there is a greater chance of the price increasing?

Optionz Traderz: Yes and no. The odds are the same, but the outcomes are different. Consider a volatile stock that increases in price 20% for three consecutive months. Due to compounding, the price would be nearly 73% higher at the end of the last month. Now, assume the same stock declines 20% each month. At the end of the third month, it would have lost about 51% of its value.

Stock Trader: I see. The extreme volatility would make the expected gains much greater than the expected losses.

Optionz Traderz: Exactly. The underlying shares can only lose 100% of their value, but it is possible they can increase in value by more than 100%. Most of the time, stocks do not see such wild swings, so at-the-money Delta is often very close to 0.5. But on very volatile stocks and ETFs, Delta is a reflection of the limited downside potential and the unlimited upside. The chances of the underlying price going up or down are still 50-50, but the potential profit or loss from each of those possibilities is not equal.

Stock Trader: Now I understand. Delta is not just a measure of the odds that an option will end up in-the-money, but how deep in-the-money it will be at expiration.

Optionz Traderz: True. So if you are buying Calls, you need to not only consider the strike price, but also the Delta. If you buy Calls with a very low Delta, you won’t make much money unless the underlying shares see large gains.

Stock Trader: So I guess what you are saying is that if I use options to trend trade, I should probably buy Calls with higher Deltas so that I pick up more of the move of the underlying.

Optionz Traderz: Exactly. If your system has a good track record of predicting trends, then you will likely do better with in-the-money and possibly at-the-money options because they have much higher Deltas. There are times when I use far out-of-the-money options in my trading, but for a trend trading system, I think the in-the-money ones will work best for you. When you are right about a trade you want to profit, you do not want to be right and still lose.

Stock Trader: How is that possible? When I trade stocks and I am right about predicting a trend I almost never lose.

Optionz Traderz: Say your charts are indicating a bullish trend, so you decide to buy far out-of-the-money Call options because the ask price appears very cheap. You might be tempted to think you are getting a great deal on the Calls and anticipate a great return on your capital at risk. You are sure that your stock will go from $100 to at least $110 in one month, so you buy one-month-out $110 Call options. The Delta on your Call options might be .10. What is not realized by many of these other ‘river boat gambling’ traders is that a .10 Delta means there is only a 10% chance the stock will make it to $110 in a month. That is a 10% move in the stock for goodness sake. These options are nothing short of lottery tickets; your stock might go up to $105 over two weeks and these options would probably move less than a dollar.

Stock Trader: Less than a $1? But the stock moved $5.

Optionz Traderz: Your far out-of-the-money $110 Call has zero intrinsic value. The only reason such an option exists is that there is a remote possibility that it will have intrinsic value at expiration. When you buy out-of-the-money options, you do not capture the underlying stock’s move in intrinsic value; you only capture the increased value in the odds that it could be worth something at expiration. You only capture Delta, and Delta is very small when you are so far out-of-the-money. Also, your old friends, Theta and Vega, would likely eat up most or all of the increase in value while you were waiting for the move.

Stock Trader: So if I held through to expiration and the stock got to $109.50, I’d still lose 100% of my capital?

Optionz Traderz: That is true, however if it did move that close to the strike price then the Delta would increase because the probability of the option having intrinsic value at expiration increased. As the price move gets closer to the strike price, your Delta gains velocity and your option begins to be worth more faster. If you exited at the right time that could be a profitable trade. However, like you said, if you were convinced that it was not going to end up expiring in-the-money and you held it anyway, you would lose 100% of your capital.

Stock Trader: That is what I would be tempted to do with my trend trading methods, let the winners run; but in option trading I would run out of time.

Optionz Traderz: As you get near expiration, the probability value of your option disappears and you are left with Delta value only, which will increase near expiration if you are in-the-money. That is good if you are in-the-money but bad if you are not.

Stock Trader: What do you mean when you say Delta value expands near expiration?

Optionz Traderz: Just as an example, a one strike deep Call option with three weeks until expiration might have a .70 Delta because the odds are 70% that it will still be in-the-money when it expires. However, the same option with one week to expiration may have a .90 Delta, because the odds that it will end up expiring in-the-money are 90% due to the fact that there is much less time for the underlying price to move in the opposite direction.

Stock Trader: So Delta increases as an option nears expiration, while time value decreases at the same time?

Optionz Traderz: Yes. It may be helpful to think of Theta and Vega as the change in the rent being charged for control of the underlying stock at the strike price of the option. Remember, when you buy options, you are buying time. When you buy options based on Delta, it is like buying the probability of an option keeping its intrinsic value or gaining intrinsic value before expiration.

Stock Trader: So are you saying that in-the-money options have a higher Delta than those that are out-of-the-money, so I should focus on them as a means of converting my trend trading from stocks to options?

Optionz Traderz: Exactly. The deeper in-the-money you go, the higher the odds are that the option will stay in-the-money; so Delta increases as you go deeper in-the-money and decreases as you go further out-of-the-money. There is another Greek, called Gamma, that describes the change in Delta, but as long as you understand how Delta changes, there is no need to add Gamma to your list of things to worry about, at least in my opinion. As long as you understand that Delta increases as you go in-the-money and also increases closer to expiration, you’ll be fine.

Stock Trader: That’s good to know. So even if I buy Calls a few strikes in-the-money I will not capture 100% of the price moves in the underlying stocks because the odds are not 100% that they will close with intrinsic value at expiration?

Optionz Traderz: That is correct most of the time.

Stock Trader: Those are two surprising points. First, even in-the-money options do not move 100% with the underlying stock, and second, Delta increases as expiration gets closer.

Optionz Traderz: That is one reason that weekly dated options cost more in the long run than monthlies and farther-out options. They capture Delta values quicker and lock them in faster. On most weekly options, price discovery at expiration happens every Friday at the close of regular trading. The odds of these options wandering away from intrinsic value are generally 50% less than those of monthly options, given that they have three fewer weeks in which to discover the underlying stock’s price at expiration. Different probabilities associated with longer timeframes cause different price values.

Stock Trader: We are back to tortoises and rabbits, huh?

Optionz Traderz: Similar, but unlike Theta and Vega, Delta is based on the odds of the intrinsic value still being there at expiration. Those odds are determined almost exclusively by the position of the underlying price in relation to the strike price. An at-the-money option will usually have a Delta near 0.5, regardless of the amount of time to expiration or the amount of Implied Volatility. An at-the-money option on a rabbit stock has the same chances of expiring in-the-money as one on a tortoise stock; the odds are always 50-50. The same goes for an option contract that expires in one year compared to one that only has one day to expiration. If it is at-the-money the odds are still 50-50 and both would have a Delta close to 0.50.

Stock Trader: That makes sense. So if a near month Call has a Delta of 0.5, and one several months out also has a Delta of 0.5, why choose to trade one over the other?

Optionz Traderz: Good question. It depends on how you plan to manage the trade. Gamma measures how much Delta is expected to change when the underlying price changes, and Gamma is much lower on options with longer term expirations. So if you opt for the longer term, you will experience much less time decay, but you will get much less move for the money because Delta changes much more slowly.

Stock Trader: So what do you think would be the best way to convert a trend trading stock system to options, with Delta in mind?

Optionz Traderz: I would say if you want to capture maximum Delta, trade a few strikes deep in-the-money on near term monthly options. You will pay much higher premiums than you would on out-of-the-money options, but you will capture Delta much quicker. Not only would the value of your options increase much more on the in-the-money options, but you would have opportunities to take a larger chunk of your profits off the table early if your charts indicated a possible reversal of the trend. Also, when you are wrong about the direction of a trend, Delta would actually decrease as your deep in-the-money options get less deep. As intrinsic value decreases, time value increases at an accelerating rate and that could help cut your losses. Even with reduced losses, you should cut your losses the same way you would if they were stocks.

Options sometimes change in value by much larger percentages than stocks, sometimes 100% or more in a single trading day, so do not let the percentage gains and losses spook you. You are actually using much less capital but shooting for the same dollar gains. Be cautious about increasing position size. If you are used to trading 500 shares of Apple then trade five contracts, you may be tempted to increase to 1,000 shares by using 10 contracts for increased leverage; but you can still lose the same amount, dollar for dollar initially, with larger trading sizes that are in-the-money. This could negatively affect your risk management and your risk of ruin.

Stock Trader: So keep my position sizes the same?

Optionz Traderz: Yes, many are tempted to trade huge positions with all the extra leverage that options allow. If they get lucky the first time and make a lot of money, it makes them arrogant and on track for a blow up. When you have traded options for a few years, you may get to a point where you are comfortable enough to increase your position sizes using options for leverage, but I would not recommend it for beginners.

Stock Trader: So options do not suspend the rules of risk management. LOL.

Optionz Traderz: No, but for many traders options increase the chances of them getting Las Vegas fever. They win big and lose big but inevitably their big losses outweigh their big wins.

Stock Trader: Really?

Optionz Traderz: Amateurs are drawn like moths to a flame to cheap, deep out-of-the-money Call options. Many don’t realize how much the odds are stacked against them, usually 10 to 1 or worse. The sad thing is that, as with all option strategies, they would probably break even over the long term given a sufficient number of trades, but most lose all their money before they get to the one big win.

Stock Trader: So I need to keep the odds in my favor with my stock trading system by buying options that already have intrinsic value, so I do not have to be right about the amount of the magnitude of the move of my stock as much as I need to be right about the direction.

Optionz Traderz: Now you’ve got it.

Stock Trader: I need to keep my position sizing the same and manage my percent at risk like I always have.

Optionz Traderz: Yes. If you have always put 2% of your total capital at risk, then that is all you should be risking with options. Stop losses work with options like they do with stocks. One drawback to options is that you need to be right about direction and also overcome the time value loss; that is a variable that you do not have to worry about with stocks. Theta decay needs to be considered, but proper position sizing and being right with your trade will greatly help this variable. Vega should always be in the back of your mind too. But I think you will find that most of the time it will not be time decay or volatility that affects your trade; it will be the change in the price of the underlying will determine your profits and losses, and Delta will show you what to expect.

Stock Trader: O.K., I think that was some great information. Unfortunately we are out of metaphors so I am going to call it a morning and go surf the web.

Optionz Traderz: For option information?

Stock Trader: No, I think I will study the behaviors of tortoises and rabbits so it will help me in my option trading.

Optionz Traderz: That is funny.

It was now 10 a.m. and Stock Trader was wide awake, although his neck was sore from sleeping in his chair the previous night. He was feeling more confident than ever about trading options. Optionz had given him some valuable advice about Theta and Vega, but if he was going to profit from options, he knew he would need to study Delta a little more. First, he needed to get something to eat. He opened the refrigerator, but found only a stale slice of pizza and some mustard. So he decided to go down to the supermarket and get a pack of energy drinks and a few other supplies so he could study some option tables on a full stomach.

On the way to the market, he got stuck in traffic. “Good Grief, here it is Saturday morning, not rush hour on Monday, and still traffic is only moving at 20 miles an hour on an expressway built for 65,” he thought. As he sat in traffic, his mind drifted back to options and how Delta could help him. Suddenly, something Optionz had said earlier started to make sense. Delta is like the speedometer on a car. He did not need to concern himself with all the variables that controlled the speed of his car. To know how fast he was going, all he had to do was look at the speedometer, and his was pegged at 20.

Stock Trader would much rather be able to drive at the posted speed limit and get where he wanted to be faster. He realized he was probably saving some gas by getting better fuel economy driving at such a slow speed, however, a speed of 20 was not what he wanted. He would much rather pay a little more for gas and get to the supermarket and back home much faster. It would probably be no different with options. To convert his trend trading system to options, a Delta of .20 would probably not be what he was looking for; a Delta of .65 would be more like it, even if it came at a higher cost.

“Finally, a break in traffic,” he said out loud. Soon he was done with his food shopping and on his way home to look up Delta on some of the options for the stocks on his watch list. The traffic was gone now. “It looks like I won’t expire worthless after all, at least not this week,” he thought.

Chapter 7

STOCKS FOR RENT: COVERED CALLS

One evening, as Stock Trader was eagerly scanning for who was online in his Winning Traders group, he looked through the list of people online:

Rookie Trader

Penny Trader

Ghost of Darvas

Penny Pumper

“No Optionz Traderz?” He found himself disappointed.

He looked at the posts on the group’s wall.

He waded through penny stock post after penny stock post.

ELAY .145x .16 keep a close watch on ELAY!!

“What garbage.”

EXTO making some Noise today!!!!

“Wow, four explanation points; that must be a really hot company.”

EXTO churning nicely here and bounced off its support at .009, watch for the consolidation to continue while EXTO sets up for its next leg up!!!

“What the heck is that price? Could I buy 1,000 shares for a penny? Good Grief!”

He was just about nearing the point where he could not take any more of this shameless penny pumping, but out of curiosity he clicked the link.

He read that the quote was indeed .0094, but then he saw the name of the company, “Exit Only Inc.”

He found himself laughing out loud. How ironic that a penny stock, which a trader probably could only get into but not out of, would be named “Exit Only Inc.” He could not help it any longer; he had to post his opinion on the conversation thread.

Stock Trader: This piece of garbage should be named “Entry Only Inc.” Group members, you would be better off just burning your money than buying any of these pink sheet penny stocks; at least the fire would give you warmth for a minute. You con men need to get out of this group.

Feeling complete after his comment, he continued to look at topics and conversation threads.

As he was browsing through the topics and threads of the group, he came across a post from the night before that he found interesting. Then, as he looked down the conversation thread, he saw his trading buddy’s name. The thread really grabbed his interest so he began to read it.

Income Trader: Anyone in this group familiar with selling Covered Calls?

Optionz Traderz: I have studied and traded just about every kind of option strategy.

Income Trader: Do you think Covered Calls would be a good way to generate consistent returns?

Optionz Traderz: I know people who do that. They make great returns in the right market, with the right stocks, when they manage their risk.

Income Trader: Really, how do they do it?

Optionz Traderz: Well, first they have to know their risk; if you want to manage your risk like they do, the underlying stock on which you write an option is the key. That is where your risk lies, in the stock going down not in the option going up. When you sell a Covered Call, you collect the premium. But just because you are generating income doesn’t mean you can ignore the risk of the stock price decreasing. If your stock suddenly experiences a large decline in price, the premium would not be enough to offset your loss. Your underlying stocks should be with companies that you believe are great investments. The stocks you pick will be the key to the whole system working.

Income Trader: What should I look for in a stock before I consider writing Calls?

Optionz Traderz: You might want to look for a stock that you would consider to be a good long term investment; of course, you would need a stock that not only has options available on it, but one which has options that trade on good volume. You really want stability, not volatility. You need a solid price support on the charts from a technical aspect and the company’s fundamentals to be solid. In today’s market, financial stocks, oil companies, and technology stocks are no longer the safe bets they once were. Financial meltdowns, oil leaks, and a company’s technology becoming obsolete are more common than ever.

Income Trader: Wow, good points. What am I looking for? A stock I can call 'Old Faithful' and is always reliable?

Optionz Traderz: I think so, the kind of stocks Warren Buffett likes. Great cash flow, steady dividends, no real competition, at a great price. Low risk ideas.

Income Trader: O.K., once I get all of my superstar stocks, then what?

Optionz Traderz: You can write monthly out-of-the-money Calls, basing the strike price of the Calls on a price target maybe right above the resistance of the current price of the stock. Or if that does not provide reasonable premiums, then you also have the option to write three-month-out in-the-money or at-the-money Calls, over and over, as a means of collecting the premiums with some additional downside protection. With the more recent availability of weekly options on certain stocks, you could write an option at-the-money each week to lock in your return, or one strike out so you would keep all the capital gains between the starting price and the Call’s strike price, and then just write a new one over and over each week.

Rookie Trader: I thought you said this was not the Holy Grail. You talked me out of it; now you are talking him into it?

Optionz Traderz: I am not talking him into anything; he asked me about the strategy. I am getting to the down side. My main argument with you, Rookie, was that you believed it was the Holy Grail, that it couldn’t lose, and also that you were conned by a black box trading system with back fitted historical test results. We never really got past that, so I never got a chance to explain the proper way to use Covered Calls. You exhausted me just trying to make you understand that it was just one of many option strategies. But if you ever get serious about learning the way most traders find success with Covered Calls, I’d be happy to tell you.

Rookie Trader: O.K., I am all ears now.

Optionz Traderz: Then step away from the keypad for a while and read.

Income Trader: So are you suggesting building an investment portfolio of the best and safest stock investments, and then overlaying that with Covered Calls to enhance the returns?

Optionz Traderz: That is how the pros that I know do it. There are money managers that run portfolios that do so exactly the way I explained it. They make great returns over the long term. You’ll probably do best with a diversified portfolio so that if one of your stocks takes a big hit, you will offset the loss with the income from the others. You should also consider diversifying across different sectors for the same reason. Some traders I know use ETFs instead of stocks because they have a degree of diversification built in. Still, you need to be careful with ETFs, especially those that are devoted to one single sector of the economy. By using several safe underlying stocks or ETFs, Covered Calls could put you on a path to much better returns than you would normally expect from trading equities alone.

Income Trader: Now the downside?

Optionz Traderz: Yes, to keep it real. Many traders don’t realize that Covered Calls are equivalent to Naked Puts. With Naked Puts you take on the full downside risk of the stock for a small premium, and this is the same principle as Covered Calls. If Calls are sold in-the-money or at-the-money you get no benefit from any upside movement. Just like Naked Puts, you only get to keep the premium. The key is picking the best stocks. If you pick a stock, then it craters, it is possible to lose a lot of money quickly, even with the continuous selling of Calls into a down trend and using the buying back and selling of new options like a parachute to cushion losses. Sometimes that parachute is just not effective enough to prevent you from crashing into the ground. Choosing the wrong stock early in this system could hurt your capital. That is why I advise you to diversify if you are going with a longer holding period. If you decide to use shorter term options, diversification becomes less of a factor.

Income Trader: Covered Calls are like Naked Puts? I still do not get that. Naked Puts sound too risky. My broker allows me to sell Covered Calls but will not allow Naked Puts. Why would I be allowed to do one but not the other if they both have the same amount of risk?

Optionz Traderz: O.K., say you owned 100 shares of Apple at $400 in September and wrote a Call on it for October at $400 for a $16 premium and it falls to $300 – what do you lose at expiration?

Income Trader: Um… $10,000-$1,600… Crap. $8,400?

Optionz Traderz: Correct, plus commission and slippage. Now travel back in time to September and do the trade again. This time you do not own Apple but instead you sell a Naked Put contract with a $400 strike in October for $16 and it then crashes to $300 at expiration; what do you lose this time? Remember, you have to buy Apple at $400 even though the market price is $300, so it will be worth only $300 the moment it is ‘put’ on you. But you get to keep the $16 premium. Also remember, 100 shares is one contract.

Income Trader: $400x100=$40,000, $300x100=$30,000, $40,000-$30,000=$10,000, $10,000-$1,600=$8,400

Optionz Traderz: I was getting worried you would have to open a spreadsheet to figure that out.

Income Trader: Sorry, I was never great at math. $8,400, that is truly weird, that a Covered Call acts like a Naked Put at the same strike. I never thought of that. They have the same risk profile of a Naked Put. I would never have considered selling Naked Puts, even if my broker allowed it, because I thought they were much riskier than Covered Calls.

Optionz Traderz: A Covered Call is like a prequel to a Put; you are getting paid for a stock you have already ‘put’ on yourself. Brokers know how risky these trades are and prefer you to take the risk on yourself, as a Covered Call, instead of exposing them to the Naked Put risk. That is why Naked Puts require a higher level of privileges with most brokers. It is not that Covered Calls are less risky, it is that you are covering the risk yourself, not the broker.

Income Trader: Wow, very insightful! You should write a book.

Optionz Traderz: Maybe I will one day.

Income Trader: What about overall market risk?

Optionz Traderz: While this system may feel like the Holy Grail of systems and like you can’t lose in bull markets, bear markets will gobble this system up. Calls and Puts become more expensive when a sharp downtrend causes volatility to spike. That might sound like a good thing because you can collect higher premiums, but the higher premiums also come with added risks. First, you would be taking on more risk by holding shares of stock when the market is predicting a generalized downturn. Second, Delta shrinks with an increase in volatility, so Calls change in value much more slowly in relation to the price of the underlying. So if prices did continue to decline, Implied Volatilities would likely rise, and with the resulting contraction of Delta, you could suffer a significant loss on the underlying stock, but make almost no profit buying back the Call. The slower rate of Delta would cause the Calls to decline in value much more slowly than they would in times of low volatility. With the underlying price declining, you would likely be able to buy them back at a lower cost than when you sold them, but you probably wouldn’t see much profit unless you kept them open until expiration. Waiting for expiration day would mean risking even greater losses on the stock, unless you had the ability to un-cover them. And I’m assuming you don’t have the ability to carry Naked Calls with your broker because they present an even greater potential risk to a broker than Naked Puts.

Income Trader: So if volatility suddenly rose, I might be better off staying away from Covered Calls for a while, at least until I got a signal that the market was nearing support.

Optionz Traderz: That would depend on the degree of volatility. A slight increase shouldn’t scare you away. If there was a minor correction in the market and it temporarily drove up volatility, you might try shortening the term of your contracts, maybe to as short as a week or two. Shortening the term would allow you to profit faster from the Calls in case the trade started to go against you and could allow you to get out of the market much earlier in a scenario in which that ‘minor correction’ turned out to actually be the beginning of a bear market. Another thing to consider would be selling the Calls slightly in-the-money to give you some additional downside protection. You are correct, though, that in a market which has fallen through support levels and volatility has increased significantly, it is probably best to avoid the temptation of the higher premiums on Covered Calls, at least until things settle down.

Income Trader: So it sounds like Covered Calls are a great way to trade. All I need to do is be careful about what stocks I pick, adjust the length of the contract and the strike price based on volatility, and stay out of the market when it turns bearish. That seems like it should provide consistent profits year after year.

Optionz Traderz: ‘Consistent’ depends on how you define it. This system will almost certainly have losing years, but it wins over the very long term through discipline. You will usually have to follow this system long term in order to see the benefits. Another part of this system that may seem strange is that you give up huge potential profits in runaway bull markets. In such markets, you are collecting your premium but missing the big uptrend runs that your stocks may experience. I knew one person who called the Covered Call system a stop gain, because your short option limits your upside. In runaway bull markets you only collect the premium; in vicious bear markets you take the full drawdown minus the Call option premium.

Income Trader: Well, that doesn’t sound good.

Optionz Traderz: Well, it is not that I am trying to be overly negative. All option strategies work well under certain market conditions, but not in others. They are profitable based on whether the market environment is conducive to that particular strategy. A big key with the Covered Call system and all other option strategies for that matter is controlling risk. All the stocks in your portfolio should have stop losses predetermined. They could be at a price that is under what you perceive as support in a chart, or they could be a percentage of loss you are willing to accept. If there is a major negative breaking-news announcement about the stock on which you have Short Calls, by all means cut your losses; sell the stock and buy back the Calls. After the storm has passed and everything has settled down, you may be able to buy it back at a great price and start all over, writing Calls.

Income Trader: I really did not even think about controlling risk; it hadn’t even entered my mind. I was so focused on the Call premiums.

Optionz Traderz: Controlling risk is one of the most important parts of any successful option trading system. Do not forget when you look at historical charts that if your stock had a huge run up before an earnings announcement and you had to give that up to the option buyer when you bought back the Call, then it subsequently tanked after you wrote a new Call, you would have given up all of the gain and taken on all of the loss, with only the two premiums to offset it.

Income Trader: I never thought of that either.

Optionz Traderz: Another cost of the strategy is that you have to pay a commission to buy the stock, then a commission to sell the Call, and yet another commission to either buy the Call back before expiration or allow it to be exercised. You should consider all of these expenses and make sure the options you are selling have enough premiums to make it worthwhile. You will need to sell Calls at the right timeframes to collect enough premiums to offset commissions. With many stable big cap blue chip stocks, the relatively low premiums caused by their low Implied Volatilities might require selling two- or three-month-out options in order to get a big enough premium.

Income Trader: Wow! That is a lot to think about.

Optionz Traderz: The good news is that great companies tend to have stable prices, and historically the overall stock market has trended up more than down. If you buy the right stock at the right price and trade Covered Calls on it in a bull market, you could potentially remove the underlying cost of the stock in a matter of a few years, sometimes less, and thereafter be playing with the house’s money. With Covered Calls, you win if the stock goes up or stays the same. You also break even as long as it does not go down as much as the Call premiums you received. You only lose if it goes down more than the Call premiums you collect.

Income Trader: Better odds and more ways to win? But with less potential upside profits and the full downside still open after the premium.

Optionz Traderz: You got it. And here’s one more thing to think about. Because a Covered Call behaves exactly the same as a Naked Put, you might find it helpful before you trade a Covered Call to ask yourself: “Would I place this same trade if I was using a Naked Put instead?” Say you wanted to sell a Call on those 100 shares of Apple stock you owned in September, when it was trading for $400. You might be tempted to sell a Covered Call at the October $410 strike for $12; but would you sell a Naked Put at the same strike and expiration for $22?

Income Trader: Wow, I never thought of it like that before. I guess I would be much more cautious about selling the Naked Put, but in reality, I would be opening a trade that had the same potential profit or loss as a Naked Put.

Optionz Traderz: Exactly. Like most traders, if you chose to sell a Naked Put, you would probably choose one that was out-of-the-money to avoid some of the risk of having it get exercised. You wouldn’t collect as much time premium as selling at-the-money, but you would lower your risk of assignment considerably. If you were going to sell a Naked Put on Apple, maybe you would choose a $390 strike if it was trading at $400. If a Naked Put at that strike makes sense, then a Covered Call at the $390 strike should also make sense. So let’s say you chose to sell one Call contract for October at the $390 strike and collected the $22 premium; how would this affect your loss if the price fell to $300?

Income Trader:  Give me a minute… I think I can do this one without a spreadsheet too. $400x100=$40,000, $300x100=$30,000, $40,000-$30,000=$10,000, $10,000-$2,200=$7,800. Crap, that’s still a $7,800 loss, but is better than the $8,400 loss I would have had on an at-the-money Covered Call.

Optionz Traderz: Now for the best part: damage control. Let’s say Apple immediately falls from $400 to $390 the day after you sell a Covered Call at the $390 strike. You could roll the Call down to $380 and maybe collect an additional $6 premium. What do you think would happen if you continued to roll down and the price continued to fall $10 every day for 10 days?

Income Trader: Hmm… Well, I would ultimately lose $10,000 on the stock, but I would collect $600 in premiums each time I rolled down, so I would get back $6,000 there, plus I would keep the original $2,200 premium $10,000-$6,000-$2,200 =1,800. So by managing the trade, I could cut my loss from $7,800 to $1,800?

Optionz Traderz: You got it! And at the expiration of the final contract, you could roll it out to the following month and cut your loss almost to zero, if the price had finally found support; or you could simply choose to hold onto the shares that you now owned at a very favorable cost basis. The only scenario where you will lose money rolling Calls down in a down trend is one where the stock price falls too quickly to be able to capture enough additional premiums.

Income Trader: You’ve given me some great ideas. I never would have thought to consider selling Covered Calls in-the-money. I have always looked at the out-of-the-money ones.

Optionz Traderz: That is a viable system for an investor who is looking to simply supplement the growth of a portfolio with some extra income. But for an option trader whose priority is to generate income, in-the-money Covered Calls are a much better choice, in my opinion. You give up all of the increase in intrinsic value in an uptrend, and although you do run a slightly higher risk of early assignment, such an assignment would result in you keeping the entire premium. All you would need to do would be to buy the stock back and start selling Calls again. But you give yourself a much better chance to be able to cut your losses by rolling in-the-money Calls down during a down trend.

Income Trader: I’m not sure I understand that. Wouldn’t I be able to roll down out-of-the-money Calls the same way?

Optionz Traderz: Yes and no. You would be able to roll them down, but Delta on out-of-the-money options is much lower than those that are in-the-money, so each time you rolled, you would capture less of the move of the underlying than you would with in-the-money Calls. You should keep in mind that the time value on a Call that is $10 out-of-the-money is the same as the time value on one that is $10 in-the-money. For example, with Apple at $400, the $390 strike October Calls on Apple might have $12 in time value and $10 in intrinsic value for a total of $22; meanwhile the Calls at the $410 strike would only have $12 in time value.

So, you can see the effect Delta would have if you consider the process of rolling Calls from at-the-money, where the premium is $16 to a strike $10 lower where the premium is $22, in this case netting you a $6 credit. But rolling them down the same amount when they are $10 out-of-the-money only gets you about $4 which is the difference between the $12 out-of-the-money premium and the $16 at-the money premium. When you are rolling Calls down there is a big difference between a Delta of 0.6 and a Delta of 0.4.

Income Trader: That’s a good point. So I guess it comes down to whether I am trading options strictly for income, or whether I am using them as a means of supplementing the income on my stocks.

Optionz Traderz: Exactly. Every trader is different, so you have to choose which method makes you more comfortable. When times are good and prospects for growth look favorable, you might feel more comfortable simply collecting the $12 time premium on the out-of-the-money Calls and then realizing some gains in the underlying stock during an uptrend. However, if the market is questionable, you should at least consider the fact that selling them $10 deep in-the-money would generate the same $12 in time premium. In-the-money Calls not only give you extra downside protection, but they offer a much better opportunity to roll them down to cut losses when necessary. Either method has an equal potential to be a winning long term trading system, but it’s up to your individual preferences to choose which style best fits your personality and the current condition of the market.

Income Trader: You’ve given me a lot to think about. Thanks for all of the advice.

Optionz Traderz: Before you go, you should also consider another method of damage control. It is not possible when you are trading a high priced stock like Apple, where you are only trading one contract; but on lower priced stocks you can reduce the number of contracts when the price moves against you. Let’s say you bought 600 shares of Xerox in September for $27 and sold six Calls at the $25 October strike for $3 each. Again, assume the price immediately starts dropping and ends the first week at $25. While you are safe for the moment because the price is still higher than your net cost basis, you would have an opportunity to lower your risk. To do so, you could buy back two of the Calls, probably at a profit of about $1 each and then sell 200 shares of the stock at a $2 loss per share. To make up for the $1 net loss, you can then roll the remaining four Calls out to November, still at the $25 strike, and probably collect an additional $1 per contract.

Income Trader: That makes a lot of sense. I would be lowering my risk by cutting the number of shares I owned from 600 to 400 in case the price continued to drop. And by rolling the remaining contracts out for an additional month, I would collect enough premiums to not only cover my loss on the 200 shares I sold, but also give myself some added downside protection on the ones I still owned.

Optionz Traderz: Exactly. It sounds like you’re really starting to understand what Covered Calls are all about. I’m glad I could help.

Income Trader: Very much so. Thanks again.

Optionz Traderz: You’re welcome. Oh, I almost forgot, there’s one more thing I wanted to tell you before I go. Try not to let any initial losses scare you away from sticking to your system. I once met a guy who sold in-the-money Covered Calls on a stock that immediately started dropping in price. The story, as he tells it, is that he was able to continuously roll the Calls out and down, and although it took him ten months, he was eventually able to get out of the trade with a small net profit when the stock eventually bottomed out.

Income Trader: Wow, that really makes Covered Calls seem like a great system.

Rookie Trader: Maybe they truly are the Holy Grail.

“That guy never stops,” said Stock Trader out loud.

Chapter 8

SELLING LOTTERY TICKETS: NAKED OPTIONS

“Up and at ‘em!”

Stock Trader had gotten into the strange habit of talking to himself in the early morning hours as if he and his body were two different people.

He would know he needed to get up and get to work each morning. He would know he needed his paycheck to pay bills. Unfortunately his body would not be cooperative. It loved sleep.

“O.K., I need to get up now,” Stock Trader said as the alarm droned on.

Snooze.

“Good, another ten minutes.”

Ten minutes later he was up, getting dressed while consuming an energy drink (not a small one, but one of the double-sized big boys).

“I wish my energy drink came in a Big Gulp size,” he thought, only half joking.

After throwing a little fit in his mind about working today, he was eventually on the road, showered and shaved, with tie locked in place.

“Crap, I need gas!”

He discovered that he was not the only one running on empty this morning. His gas tank was dangerously dumped on “E”.

He stopped at his favorite gas station and pumped gas until his tank was full.

“Good grief, over $50 to fill the tank of this little truck?”

He walked into the gas station for his second energy drink of the morning, a new personal record for caffeine consumption so early in the morning. As he waited in line he thought it would be a good idea to break this habit; it couldn’t be good for him.

It was a busy morning. The station had three lines open, one apparently for lottery tickets only. The multi-state power ball jackpot was up to $400 million now and people grew more interested and greedy by the day.

Stock Trader started to think about this.

“What a ridiculous plan, spending hard-earned money for a 1 in a 100 million shot to win. Or were the odds even worse than that?”

He had once heard that the odds were much more in favor of getting killed in a car wreck on the way to purchase the lottery ticket than to actually win a big jackpot.

The popular phrase, “Somebody’s got to win,” was even less impressive. His thought was: “That is not really true; the only reason the jackpot is so high is because week after week has passed without a single winner; and even though somebody’s got to win eventually, millions and millions have to lose too.”

Contrary to the opinions of his co-workers, he did not gamble in his trading; he played in favor with the odds. In the lottery, everyone thought they would be that one person who beat the odds. Most of his co-workers played the lottery, where they had no control over the odds.

He was getting closer to the front of the line now. It seemed like every person in front of him was buying lottery tickets. Some were buying just one. Others, like the older lady who he was behind in line, were buying several.

“What a bunch of suckers,” he thought.

When he finally got up to the front of the line to pay, he asked the clerk a question. “Are you always this busy with the lottery?”

“The bigger the jackpot, the busier we get,” the cashier replied.

“So the more money they think they will win the more they spend for a chance?” asked Stock Trader.

“Correct,” the cashier responded.

As Stock Trader turned towards the door, he saw that the line now snaked all the way down the bread aisle and past the dairy cooler. He thought to himself, “They really have no regard for the odds. The odds of winning aren’t any better when the jackpot is higher. The jackpot is so ridiculously high anyway; why would they wait in line to play for 400 million dollars, but avoid playing when the jackpot is only 40 million? Isn’t 40 million enough for the lifestyle they want? The states are able to make billions with this game. These customers would make much more money if they were able to sell lottery tickets, not buy them,” Stock Trader concluded.

As he walked to his truck he thought, “Hmm, selling lottery tickets. I am sure that Optionz would have some opinions about how to do that most effectively by using options. It makes sense though. How profitable would it be to take the other sides of bets where the bettor has no regard for the odds against them?”

Stock Trader had trouble focusing on his work and getting through the day. His mind kept trying to figure out the best way to profit from selling options. He pictured himself selling reams of scratch off lottery tickets and making far more money than he paid to the winners.

On his drive home at the end of the day he kept trying to remember option pricing on the far out-of-the-money options.

When he got home he followed his tradition of going straight to his computer and to his online world.

He first looked at the option prices for Apple. Over the past six months Apple had only penetrated its 200-day moving average once. If he sold front-month options at the 200-day moving average, would he win five out of six months?

“What is that, about an 83% win rate?”

“What is the price of next month’s Puts at the 200-day $350 level? Let’s see… With three weeks left to expiration, it is $3.00 for the $350 strike, while Apple is at $400, and it has a Delta of -.13. So that would imply an 87% chance that they would expire worthless? I like those odds,” Stock Trader thought, viewing the online option calculator. “Even if I only sold two contracts, I would have an 87% chance of making $600; much better odds than the folks at the gas station had of winning the lottery.”

He thought about how selling Uncovered Calls at the $450 strike would probably get him the same premium as the $350 Puts. “I would not want to sell Uncovered Calls on a hot stock like Apple, though; this thing could go to the moon at any earnings announcement.” Still, it was something to think about.

“I wonder if Optionz is in action online.”

As Stock Trader signed on he saw that Optionz Traderz was online; he decided he would cut to the chase.

Stock Trader: Optionz, what are your thoughts about selling far out-of-the-money Naked options for cash flow and returns?

Optionz Traderz: Hey, I didn’t see you join in. Ooh, options ‘au nat-u-rel.’

Stock Trader: I was considering whether it would be worthwhile selling Naked Puts on Apple near the 200-day moving average, which have a Delta of about .10. Thoughts?

Optionz Traderz: The good news is that the odds are way in the sellers favor with the far out-of-the-money options, especially with the .10 Deltas. That means you win nine out of ten times. The bad news is that you do not get paid very well for taking on the full risk of a major move going against you.

Stock Trader: What do you mean?

Optionz Traderz: Well, everything is great when you have those nine wins in a row; you may think you have found the Holy Grail of trading. Then that darn 1 in 10 loss could take back the other nine wins. One huge move against your position can wipe out the entire sum of the nine little profits; or worse yet, a 1 in 100 loss could blow up your entire account. Black Swans are vicious.

Stock Trader: Huh? First turtles, then rabbits, and now there are birds involved in option trading?

Optionz Traderz: Ha ha, sort of. For most of the history of Western civilization people thought black swans did not exist and were impossible; all swans were white. This was generally accepted as fact until explorers stumbled upon the first black swans. Oops, they were wrong. 2008 was a Black Swan year in the financial markets. Many of the things that happened were thought to be impossible. Didn’t housing prices consistently go up following World War II? Citigroup and Ford could never trade for under a dollar; Bear Stearns and Lehman Brothers survived the Depression; they could never go bankrupt; AIG and General Motors were DJIA components they could not go bankrupt, and on and on. Black Swans are discovered more often than investors would suspect. You have to be eternally vigilant when selling Naked options, so the first ‘impossible’ event will not be your account’s last trade.

Rookie Trader: You are always so negative.

Optionz Traderz: I am being negative for a reason. You must always consider risk first and go from there. But once you understand the risk, there are ways to make money trading Naked options.

Stock Trader: Go on.

Optionz Traderz: Some traders start winning with Naked Puts and get the seductive siren call to keep increasing their position sizes. They start believing the unthinkable can’t happen, until it does.

Stock Trader: Besides 2008?

Optionz Traderz: Well, for another example, the 1987 Black Monday crash. That day not only blew up traders' accounts but some of them took down brokerages with them. The reason that the margin requirements are so different for Naked options versus Covered options is that the risk is on the brokerage if the trader can’t cover it.

Stock Trader: Yes, 1987 was not a good time for Naked Puts.

Optionz Traderz: That year was a rocket ride up and seemed to be a Put seller’s paradise until October.

Stock Trader: So October took everyone off guard? That is why risk management is #1 again? How did you do that year?

Optionz Traderz: I was way too young to have been a trader then. I was in elementary school in 1987. I learned this from books and studying charts. The Flash Crash of 2010 was another Black Swan, and I was in the market during that one. Fortunately, I was trading Naked Calls at that time and none of my trades were affected.

Stock Trader: You are a young gun, huh?

Stock Trader had always pictured Optionz as a 50-something, middle-aged man; it was surprising to him that someone under 40 had this level of knowledge on trading. He wondered if Optionz was younger than Stock Trader himself.

Optionz Traderz: Young and strong. Anyway, like all other systems, it is not about how much you make but how much you keep. Before you sell any Naked option, you need to go ahead and have a stop loss where you will buy it back if you are wrong. Or you may want to place a contingent order to buy or short the underlying shares if the price reaches a dangerous level, or even trade another option to offset the risk. You need an ‘abort’ plan or adjustment plan for that eventual bad move against you.

Stock Trader: O.K., what to sell?

Optionz Traderz: The methodology in selling Naked options is no different than stock trading. You could sell Naked Puts under what you believe is a price support and sell Naked Calls above what you believe is resistance. You must consider the timeframe also. If you are selling one-month-out options, you might consider selling your Naked option at a price that is unthinkable for the stock to get to within a month. In selling options you are dealing with both price and time. While selling a one-month-out Naked Put at the 200-day moving average, in a hot market’s leading stock that is making all-time highs, the buyer of your Put may have no chance of the stock getting to that strike. If you sell it a year out, then you suddenly have a much better chance of your strike being hit sometime during the year.

Stock Trader: Price and time must both be considered.

Optionz Traderz: You should keep in mind that the options are always priced at fair value at the precise moment that the contract is opened. In today’s world, there are few if any options that are over-priced or under-priced. Taken at face value, options are a zero-sum game; the premium of every option reflects the odds that it will create neither a profit nor a loss for both the buyer and the seller upon expiration. That’s not to say sellers don’t have an advantage over buyers because they do.

Stock Trader: Wait a minute! You said options were a zero-sum game. How can the seller have an advantage?

Optionz Traderz: Actually, sellers have several advantages. First, taking into account all options at every possible strike price, statistically sellers will profit about twice as often as buyers; sellers, as a group, win about 67% of the time. Sellers of out-of-the-money options have even better odds. Even the lowest performing options for sellers, those that are deep in-the-money will statistically be winners more than 50% of the time.

Stock Trader: But as you have said before, sellers win more often, but when they lose, they lose more.

Optionz Traderz: That is correct, but sellers have much better odds of starting with a profit right out of the gate, whereas buyers often begin with a string of losers and then have to run the race playing a game of ‘catch up.’ Sellers then have the option of quitting while they are ahead, while the only choice for a buyer is to keep trying or take a loss. Of course, I’m not implying that this statistical advantage is a reason to choose selling over buying; in my opinion that preference should depend only on the market conditions at the time of the trade. But I find it reassuring to consider the advantages when I sell Naked options.

Stock Trader: Good point. If I know I have an advantage when I trade stocks, it gives me confidence. I guess the same would be true of options.

Optionz Traderz: Here’s another advantage of selling that may boost your confidence when you sell options: premiums are often inflated to account for Black Swans. Just as an example, I looked up those Puts on Apple that you were talking about. The closest ones I could find to a .10 Delta for next month were at the $350 strike and the last trade was $3.00. That means the $3.00 premium reflects the probability that Apple will be trading at a price somewhat higher than $347 one month from now, a point where the seller makes a small profit.

Stock Trader: O.K.. That first part makes sense. So with Delta being 0.13 on those Puts, there is a 13% chance that the underlying price will be $347 a month from now. So why are you now saying that the Puts at the $350 strike would be priced in favor of the seller?

Optionz Traderz: You are correct that in theory the premium is based on the probability of the underlying price falling to $347, which would be the point where buyer and seller both break even. However, that $347 value is not based on the Black-Scholes model, which assumes that stock prices can generally predicted by a bell curve. In reality, over extended periods of time prices do not conform to a perfect bell curve but one that has fat tails. The fat tails are caused by Black Swan events and also by unexpected earnings or other good news that causes unprecedented run-ups in a company’s stock price. Over a period of 10 or 20 years, such unpredictable events are likely to occur several times, so the stock actually spends more time at the edges of the bell curve than would otherwise be expected by purely theoretical models. That’s what gives the bell curve its fat tails. Emotions do have an effect on trading, and those emotions occasionally do not fit an un-emotional statistical model.

Stock Trader: This is really interesting. Go ahead.

Optionz Traderz: Well, we already talked about Black Swans, like the Crash of 1987, and I know you know about Darvas because I saw you chatting with another trend trader about his methods a while back.

Stock Trader: Wow. You have a great memory. O.K., go on.

Optionz Traderz: Well, Darvas noticed that stocks tended to rally after they had broken through a resistance level, or ‘box.’ So someone selling a far out-of-the-money Naked Call might not realize that they were taking on a hidden risk, that if the stock had broken through to such an ‘unthinkably’ high price as the strike price of that Call, there was a good chance it was out of its box and headed for further gains. Likewise, if a Naked Put seller saw the underlying fall to their ‘unthinkable’ strike, it would mean that the ‘unthinkable’ had already occurred and it is quite likely the price would fall even further. That concept was pretty much ignored until 1987. A lot of Naked Put sellers had not considered that if a Black Swan event occurred and their far out-of-the-money strikes had been hit, there was a good chance they were headed for significant losses.

Stock Trader: I had never thought of that. So I guess I should expect far out-of-the-money options to be priced based on the stock either enduring a 1987-style Black Swan or a Darvas-style rally.

Optionz Traderz: Exactly. The further out-of-the-money you go, the more likely it is that the stock price is headed for a radical move if it surpasses your strike. You can actually see the effect on historical charts. Prior to 1987, Implied Volatilities basically ran in a straight line from very high volatilities for deep in-the-money options to very low volatilities for far out-of-the-money options, what many call the ‘Volatility Skew.’ After 1987, Implied Volatilities have taken on a curved appearance that some traders call the ‘Volatility Smirk.’ Implied Volatilities are higher at the edges than would otherwise be expected by purely statistical models. The result is that deep in-the-money and far out-of-the-money options have premiums that reflect the added risk of events that only occur rarely, maybe once every few years or even as much as twenty years. The end result is that today’s options have premiums which are more reflective of real-life trading. I’m sending you a chart that shows the Implied Volatility Smirk for the November 2011 Calls on IBM.

Stock Trader: That makes a lot of sense. The options market is truly efficient, so much so that it adapts and learns from changes in the market. So why did it take the Crash of 1987 to change the way option premiums are determined?

Optionz Traderz: In early 1987, options were still a relatively new product for the general public. The premiums of out-of-the-money Puts were mostly based on the opinion that if a strike was hit, the underlying price probably wouldn’t go very far beyond that point. Then the Crash of 1987 showed traders that they had been wrong; if an out-of-the-money Put strike is hit, especially one that is far out, there is a good chance that the price could go well beyond that strike.

Stock Trader: I never thought of it that way before, but you’re right. If a stock was performing well and something suddenly had such a negative affect that the price fell through the 200-day moving average, I guess there would be no reason to expect that my strike price still represented a support level.

Optionz Traderz: You’ve got it. Today’s options market, having learned an important lesson from past Black Swans, prices out-of-the-money options at a higher premium than would normally be predicted by a purely theoretical model, to guard against losses that sellers would endure if there was a repeat of those events.

Stock Trader: I think I see what you are getting at. In theory, the $3.00 premium of the $350 Puts on Apple is based on the probability of the stock price falling to $347 on expiration day, but that probability takes into account events that rarely occur. So every month that one of those rare events does not occur, the seller has better odds.

Optionz Traderz: You nailed it! I think that’s another reason for the widespread perception that option sellers make more money than option buyers. Sudden, unexpected rallies and Black Swans are priced into every option, and if you consistently sell these options over a long enough timeframe, you should accumulate enough of their ‘bonus’ premiums to pay for an occasional radical price move. So most of the time, option sellers make more profits than option buyers. In addition, experienced option sellers take steps to protect themselves, so they collect the extra premiums, sometimes for years at a time, while also limiting their losses when a Black Swan plays out. Successful sellers of Naked options are like lottery agents who collect money from selling tickets and then shut down the entire lottery at the first sign that one of those tickets contains the jackpot numbers.

Stock Trader: That’s a great point. We seem to be on the same wavelength here. I was thinking just this morning that selling Naked options is like selling lottery tickets. I guess what you are saying makes sense. If I am collecting lots of income by selling options at-the-money that have lots of time premium, it’s like I am the government running a lottery when the jackpot is $400 million. Because of the large number of people buying tickets, there is likely to be a sufficient amount of premiums to pay all of the winners. But if I sell options far out-of-the-money, it is like I am selling lottery tickets when the jackpot is small. Although the odds of having to pay a winner are much lower, with fewer people buying tickets, there is a much greater chance that I will end up paying out on a winning ticket before having collected much money in sales. So if I am going to sell Naked Puts on a stock at a price far out-of-the-money that I believe represents support, how do I manage the trade to protect myself from a Black Swan?

Optionz Traderz: First, if the odds are very small that the price will be reached in the allotted timeframe, then the price you will get for the option will also be very small. You have to always ask yourself: “Is it worth the risk?” There’s no need to sell a Naked Put for ten cents if it means you are risking thousands of dollars; sure, you will most likely get to keep the $10 premium per contract, but how many times would you need to do that to cover the losses on even one bad trade?

Stock Trader: So, I guess I need to sell far enough out-of-the-money to give me good odds, but not so far that the premium is too small to make up for my losses.

Optionz Traderz: Again, yes and no. It might sound counterintuitive, but you may actually find that it is more profitable to sell Puts that are deep in-the-money.

Stock Trader: Huh?

Optionz Traderz: I know it sounds crazy, but hear me out. Assuming you were still interested in trading those Puts on Apple that you were talking about when it was trading at $400, you would sell Naked Puts at the $350 strike for $3.00. As long as the underlying price stayed above $347, you would make a profit. The most profit you could make on that trade would be $3.00. Now, consider that the time premium on the $450 Puts is also $3.00. So, why not sell a Put at the $450 strike instead?

Stock Trader: You’re right so far, that does seem counterintuitive.

Optionz Traderz: O.K., so let’s walk this though. Say you sell a $450 Put for $53.00 and then short 100 shares at $400. Now, if the stock does fall to support at $350 you still get the same $3 profit, because when the stock is put on you at $450 it will cover the shares you shorted at $400 for a loss of $50, but you will keep the $53 premium.

Stock Trader: I never thought of that, shorting a stock and selling an in-the-money Put. I guess it would behave the same as a Naked out-of-the-money Put, but I would be protected if the stock fell through support and kept on going.

Optionz Traderz: That is true; you would have much more downside protection. But always remember what I said about options and risk: the risk never goes away, it just gets shifted somewhere else. In this case you have totally eliminated your downside risk, but only because you have shifted it to the upside If Apple suddenly climbs above $453, you have used up all of the gains you would receive when the Put expires worthless, but you now are in a position where you will have to buy 100 shares at a higher price in order to cover your short.

Stock Trader: Wait a minute, isn’t that exactly like a Naked Call?

Optionz Traderz: Bingo! Any position you can create with a Put can also be synthetically created with a Call at the same strike price. Shorting a stock and selling a Put, which is often called a Covered Put, is equivalent to a Naked Call.

Rookie Trader: That’s stupid. If it is possible to use a Call to trade the same position as a Put, why are there both kinds of options?

Optionz Traderz: It’s not stupid, although I have to admit, you have finally asked a really intelligent question. For many traders, Naked options are not available, so they have no choice but to use the equivalent synthetic position. But mostly, it all comes down to whether you want to tie up your assets with one strategy or free them up for use in other trades. It also involves your psychology and how you plan to manage the trade once it has been placed. If you sell a Covered Call and the underlying price falls, you might not mind owning the underlying shares. On the other hand, someone selling the equivalent Naked Put might not want to own the stock at all. In fact, a Naked Put seller might be prepared to short the stock if the strike price was hit.

Rookie Trader: I’m sorry I said it was stupid. I really thought options were going to be easy to learn, but sometimes they just seem so complicated.

Optionz Traderz: Apology accepted. There are also margin requirements to consider. If you buy a Call, your account only needs to have enough equity to cover the premium; but if you buy the underlying and buy a Put you will need a lot more equity, not only to purchase the shares but also the Put. But I don’t want to mislead you here. Just because you can buy a Call with very little equity doesn’t necessarily mean you shouldn’t have enough purchasing power to buy the underlying shares. If the Call goes in-the-money and you don’t have enough equity to buy the stock, you will be forced to sell the option before it expires in order to avoid a margin call, and that would mean you would give up any future gains you might have realized on the stock.

Rookie Trader: That makes sense. I just wish I could learn this all much faster so I could start making big time money.

Optionz Traderz: You can make a lot of money, but you really owe it to yourself to educate yourself first; otherwise you risk losing everything. When you trade options, there are also commissions to consider. Except for day trading, stock trading normally involves holding onto winning trades and only selling when a stop loss gets tripped or a technical indicator points towards a reversal. But with options, you can start racking up commissions and fees very quickly, especially if you trade weekly options. If you are selling a Covered Call because you are bullish on a stock, and you are correct, you will end up paying three commissions: one to buy the stock, one to sell the Call, and another when the Call is assigned. Some brokers charge inflated commissions for exercise, so you might end up paying the equivalent of four commissions. But the same position opened using a Naked Put would only incur one commission, the one to sell the Put, which would then expire worthless.

Stock Trader: I really admire the patience you have with Rookie.

Optionz Traderz: I was once a rookie too. If he is going to fail as a trader, at least I will have a clear conscience that it wasn’t my fault.

Stock Trader: Now that I think about it, Naked Calls might actually be a better fit for my trend trading. When I trend trade with stocks, I like to buy when prices are going up, not down. If I sold Naked Calls at a resistance level, I could then buy the underlying shares if my strike was hit.

Optionz Traderz: That is also a good plan. You could also consider selling Naked Calls at a moving average. Just as an example, if you sold Calls one week out, you might want to use a 20-day moving average as a strike price, and then buy the underlying shares if the price hit the moving average. Not only would you be buying when prices were on their way up, but you would have some downside protection against whipsaw.

Stock Trader: I’ve always considered Naked Calls to be too risky. Doesn’t the risk of unlimited losses outweigh the income they generate?

Optionz Traderz: It is true that losses are theoretically unlimited. But try thinking about it this way. How often do you see the Dow Jones rise 500 points in a week? Compare that to the number of times the index has fallen by that amount.

Stock Trader: That’s another great point. I read somewhere that prices ordinarily fall twice as fast as they rise. That means I should have many more opportunities to hedge my trade if prices started climbing towards my strike on a Naked Call than I would to control my losses on a Naked Put.

Optionz Traderz: Exactly! Even though the risk on a Naked Put is limited to the maximum loss that would be sustained if the stock price went to zero, the likelihood of a Naked Put trade quickly going bad is much higher than a Naked Call doing the same. Even if you sell Naked Calls around news events, such as right before an earnings announcement, the collapse of volatility after the announcement will likely limit your losses if the announcement happens to surprise investors with great news. On the other hand, if you sell Naked Puts prior to earnings and the news is disappointing, the increase in Implied Volatility could cause you to lose money very fast, as the options are not only increasing in intrinsic value but also picking up time value due to Vega.

Stock Trader: I never thought of it like that before. Given the same amount of change in the price of a stock, Naked Calls don’t lose money as fast as Naked Puts because volatility usually drops when prices are rising.

Optionz Traderz: Yes, and when you look at it that way, Naked Calls are actually less risky than Naked Puts, despite the theoretical possibility of unlimited risk. This is especially true on ETFs where diversification makes a sudden upward move less likely than it would be on an individual stock. And you always have the option of buying a Call at a higher strike to protect you from the occasional takeover announcement or some other news release that suddenly sends the stock soaring. Say you decided to sell Naked Calls on Apple at the $450 strike; you might be able to buy Calls at the $500 strike for $1.00, essentially turning the position into a Vertical Spread.

Stock Trader: That’s a good idea. I would limit my potential profit, but I would have some added protection in case the stock really took off. So I could tie my Naked option selling into my stock trading, selling Puts when I am bullish and Calls when I am bearish? Sell Puts on market leaders and Calls on market laggards? Sort of just overlay option selling on my pre-existing profitable systems?

Optionz Traderz: Those are all good strategies. Many people sell options for a living. The secret to successfully selling options is to not get greedy and over-sell, and also to manage the big losses when they begin to occur. That is another reason that option sellers have an advantage over option buyers. Sellers can manage their losses, sometimes even turning losses into gains, but the only choice for a buyer is to cut losses.

When you buy an option and it expires worthless, it is dead, that is the end. But when you sell an option and it ends up in an unfavorable position, there will be times when you can bring it back to life. Just as we discussed with Covered Calls, when a Naked Put trade starts to go the wrong way, you can either roll the options out to a lower strike or keep the same strike and roll them out with a lower number of contracts.

Stock Trader:  I would have never thought of it that way. If I buy options, I really have no recourse when a trade goes bad except to watch them slowly die or put them out of their misery early. If I sell options and they go down the wrong path, I will sometimes get the chance to keep them alive for another month or so, giving them a second chance at living a prosperous life. What other considerations?

Optionz Traderz: It’s up to every option trader to decide how much risk is too much. The potential reward is always proportional to the amount of risk. A trader who has never owned Apple might be more comfortable with a Put Spread, while a trader who bought shares of Apple when it was trading at $200 might feel more comfortable risking those gains by selling his shares at $400 and then Selling Naked Puts. Option trading is very flexible.

Stock Trader: I agree with you again. I have to choose a trade that makes me comfortable so I won’t be tempted to allow my emotions to influence my decisions. Any other ideas?

Optionz Traderz: I have met some traders that sell Naked Puts and Calls at the same time. Many times, both options expire worthless and they get double profits.

Stock Trader: But aren’t they taking double the amount of risk?

Optionz Traderz: At first glance it might appear that way. But in the long run, that risk is offset because they are also collecting double the amount of premiums. One of the options will always expire worthless, and over time that will eventually offset the losses on the other option.

Stock Trader: So how would I manage a trade involving both Naked Calls and Puts?

Optionz Traderz: There will be times when the underlying price starts to move against one of your positions. In those cases, you have lots of choices to manage the trade. Sometimes it is possible to take the profits on the winning position and roll the losing position to a more favorable strike. Other times, if the price is not too close to overtaking one of the strike prices, it might be better to turn the winning position into a Spread.

Let’s say you sold $350 Puts and $450 Calls on Apple, each at $3.00, and the price suddenly shot up from $400 to $410. You should then be able to buy a $360 Put for $3.00, in effect turning that side of the trade into a ‘free’ Put Spread. You’d still have $40 of play before the price hit your Naked Call strike; but if the price whipsawed, the Put Spread could see some nice gains.

There are times when the price whipsaws enough that it is possible to turn both sides of the trade into Spreads. Say the price moved again, but this time fell from $410 back to $390; you would then be able to buy the $340 Calls for $3.00. The good news is that neither Spread would cost you anything because you would be opening the long position at a time when the premium was less than, or equal to, the premium you received on the short position. If either Spread realized its full potential, you would see a profit of $10 per share, and at the very worst, everything would expire worthless.

Stock Trader: Those sound like great ways to manage risk. I guess I would also have the option of rolling the Naked Calls out, if I turned the Naked Put into a Vertical Spread and the underlying price continued in a steady uptrend that placed it in danger of reaching my Call strike. Any more thoughts?

Optionz Traderz: Once again I will reiterate position sizing. If you are comfortable trading no more than 200 shares of a stock, then only sell 2 contracts of the Puts or Calls short. Do not suddenly start selling 20 contracts of Naked Puts just because your margin requirements allow it. You would be asking for trouble when that one unexpected event occurred, and those events occur more often they you would expect. Even if you manage to make it ten years without a Black Swan, if your position size is too large, you could wipe out your entire account, including those ten years of profits, very quickly.

Stock Trader: There is nowhere to hide from correct position sizing.

Optionz Traderz: Many traders who sell options for a living sell Naked Puts for stocks that they want to own. For example, if a trader wanted to be long 200 shares of Apple and wanted to buy in at the 200-day moving average, he could repeatedly sell 2 contracts of Puts each month. So if it took 6 months to get the stock put on him, he would make about $600 a month selling Puts, and he would see $3,600 in profits before he finally got the stock at the price he wanted. The $3,600 profits would reduce the cost basis of the 200 shares of stock by $18 a share, and they likely would then go on to make capital gains in the stock itself, after it was put on him at his wish price. Even if they did not, he would be in a position to use a very generous stop loss order.

Stock Trader: I guess another scenario would be if the Naked Puts went in-the-money the first month. He could roll them down and out to the following month and keep doing that until there were no more options with sufficient premiums to cover the loss on the previous month’s Puts, at which point he could allow the shares to be put on him at a nice discount, and then wait for the stock to rebound.

Optionz Traderz: Yes, that would be a good choice in some circumstances, where the company was still strong but had just hit a soft patch, or when the price was being weighed down temporarily by the broader market. But other times, when chances for the price to recover are in question, it would probably be better to cut the losses and move onto something more promising.

Stock Trader: Great advice, as always.

Optionz Traderz: I know some traders that also use options as an indicator to predict whether a stock price is headed up or down.

Stock Trader: How is that possible? Aren’t the odds of a stock going up or down in price always equal?

Optionz Traderz: Actually, the odds of a diversified portfolio of stocks experiencing upward movement are historically slightly higher than the chances of prices falling. Even when markets are stagnant, inflation usually adds some upward pressure.

Stock Trader: O.K., so even if prices normally rise over the long term, how would options help me predict what was going to happen in the future?

Optionz Traderz: Well, the stock market is efficient, but the options market is super-efficient. While the prices of stocks are determined by all of the combined sentiment of investors and institutions all over the world, they only represent the value at which buyers and sellers are willing to settle at a single moment in time. In contrast, the premiums of options take into account an extra layer of information, the performance of the stock over an extended period of time. Options, because more information is required in order to determine a fair price, are much more sensitive to news and changes in the market than stocks; options actually help drive stock prices.

Stock Trader: O.K., I follow you so far.

Optionz Traderz: So some traders find it useful to study a stock’s options before they actually trade shares of that stock. Options themselves are a sort of technical indicator, and they can be used not only to trade stocks but options as well. Just as an example, if there is a large amount of open interest in Call contracts compared to Puts, the market is indicating a bullish sentiment on that stock. If the underlying price does start to move up, the large number of Call options can help give it momentum. As the price rises, Call buyers are more likely to exercise their contracts, which results in increasing demand for the underlying shares. At the same time, Call sellers are more likely to buy shares in order to limit their losses.

Stock Trader: Wow! That is a really good observation. I’m assuming it works the same way with Puts. When there is a much larger amount of open interest in Puts, those options could actually help reduce demand for the stock if the price starts to fall, which would only exacerbate the drop in price. If I am going to sell Naked Puts, I should probably check the Put/Call ratio first, to see if the market is predicting bearish days ahead.

Optionz Traderz: Exactly! Implied Volatility is another indicator that you can use to your advantage. Volatility normally rises fairly quickly when prices fall, and then drops much more slowly when they recover. If prices are rising, you might choose to wait for volatility to fall to a predetermined level before you decide to sell Naked Puts, even though you will receive a smaller premium, to ensure that you are in agreement with the sentiment of the rest of the market.

Stock Trader: I see what you’re saying. If volatility suddenly went from 30% to 50%, I could consider holding off on selling Naked Puts, even if the stock was showing signs of strength because the options market would be providing evidence of some uncertainty about the price continuing to climb.

Optionz Traderz: There are other ways you can use Implied Volatility to help you trade. You know that graph I sent you that showed a Volatility Smirk? Well, some traders have found that the steeper the sides of the smirk are, the worse the stock will perform. Sometimes this bad performance continues for weeks or even months after these options expire.

Stock Trader: That sounds confusing. I thought I understood Implied Volatility as being a sort of measure of fear. When volatility is high, it means traders are more worried that prices will fall. But why would lower volatility at-the-money be a predictor of change?

Optionz Traderz: I have seen studies showing that a persistent smirk is often present on many widely traded options, sometimes for months, before a Black Swan event. When a normal graph of Implied Volatility starts to take on a smirk-like appearance, it could mean that traders are anticipating violent price swings in that particular stock.

The best stock options to purchase if you want to profit from a big price increase in a stock are deep-in-the-money options. These options are already profitable with a strike price below the current market price, so they already contain intrinsic value. These deep-in-the-money options move closer in value dollar for dollar than far out-of-the-money options since far-out-of-the-money options have a low probability of expiring with any intrinsic value. Higher than normal demand for deep in-the-money options can sometimes be an indicator that speculators are anticipating a major change in the stock price.

If far out-of-the-money options start increasing in price more than they should, based on the Delta of the option, this is also a clue that traders are anticipating a big move in the underlying stock. Just as with deep in-the-money options, speculators often control the demand for far out-of-the-money options.

You may want to think of such a smirk as a warning sign that it might not be such a great environment for selling Naked Options. Instead you might want to consider that with at-the-money options being relatively cheap compared to those at other strikes, it might be a better time to use a Long Straddle or Strangle instead.

Stock Trader: That is fascinating. You’ve been really helpful, but I think I’m going to have to take a break and digest some of this. I guess if I can use options to help me predict the future price of a stock, they would also help me choose what options to use if I am going to sell Naked ones.

Optionz Traderz: You’ve got it! Studying all of the options on a particular stock can give you additional information you would not get from a traditional fundamental and technical analysis. That additional information may prove helpful in deciding what and when to trade, whether it is stocks or options or both. Speculation is much more profitable with options than it is with stocks due to the large amount of leverage they provide. As a result, speculation often causes option pricing to change long before the stock makes any significant moves. Before you place any trade, you should at least look up option tables to find out what kind of speculation is occurring, even if it is just for a second opinion to back up your other technical indicators.

Stock Trader: You are full of good ideas tonight. Well, it’s been nice chatting with you. I’ll need to study Naked Calls a little more to see if they will work for me, but I really like the idea of Naked Puts, of being able to choose the prices I pay for my favorite stocks and get paid for buying them.

Rookie Trader: Now if that is not the Holy Grail, I do not know what is. You get paid to buy a stock at your dream price? So you either keep the premiums or get the best price for a hot stock. How do you lose?

Optionz Traderz: Easy. Apple continues to fall by 50% after it falls through the 200-day moving average, just like it did back in 2009. You need to follow up that system with a stop loss on the stock itself, after it is put on you, and you need to keep in mind that it could be put on you at a price that is already significantly higher than the price at which it is trading on expiration day. There are no free rides in the market, and once again, no Holy Grails. Anything can happen, so you have to always be ready.

Stock Trader: As always, amazing food for thought. You must trade a lot or read a lot to know a lot. You have a good night.

Optionz Traderz: Options are my business. Good night to you too.

Rookie Trader: Finding the Holy Grail in trading is my business.

Penny Pumper: Hey, Rookie Trader, I can help you find the Holy Grail. Just check out EXTO. I read a closely guarded report this afternoon which indicates that some sources are saying there will be a huge announcement tomorrow morning that could send this stock up over 800%. But if you want to get in, you should consider doing it early, before the big-time traders scoop up the remaining shares.

Rookie Trader: 800%, of course I’m interested. I’ll be up first thing in the morning. Then wait till I show Stock Trader and Optionz Traderz how well a rookie can do!!!

Penny Pumper: If you give me your email address, I’ll send you a copy of the report.

Rookie Trader: I’m sending my address to you now. I better get to bed, though. I don’t want to oversleep and miss out on an opportunity like this. Thanks for helping me out.

Penny Pumper: Great to hear it. I know I’ll be watching EXTO first thing tomorrow.

Chapter 9

BUYING LOTTERY TICKETS: DEEP OUT OF THE MONEY OPTIONS

Saturday... Relaxing, peaceful, and B-O-R-I-N-G; what to do?

Stock Trader found himself in his favorite book store, perusing the little investing section. He was not impressed.

He sat at one of the small, sticky tables with his favorite energy drink and a chart of his favorite stock – his beloved Apple. He loved his iPhone, his iPad, and his Macintosh, along with the money the stock had made him over the years. He could have bought a few nice cars with his trading profits.

Charts courtesy of FreeStockCharts.com

Stock Trader liked to view stock charts with the Bollinger Bands and moving averages.

In his stock trading method, the Bands established a logical trading range of two standard deviations with the 20-day moving average as the mean value. The 50-day moving average was the first stop of support for a hot stock and the 200-day moving average was the final place where buyers would come in and buy a hot stock at a bargain. This was his primary system. Now the question was:

“How can I use my stock trading methods to profit the most from trading options?” He felt a sense of déjà vu.

He stared at the chart; it was making a new run at all-time highs. Would it break out? He didn’t think the price base was long enough yet, but he could be wrong. Apple was a powerful stock that was known to climb up a Bollinger band like a monkey up a tree.

His next thought was, of course, how to trade it with options.

He wrote on a piece of paper next to his iPad:

1) At-the-money Calls

2) Out-of-the-money Puts

He thought the two best trades would be to buy Calls now, at-the-money, and if the breakout to all-time highs happened and the stock rocketed up to a whole new trading range, he would do very well. He would have his Calls at what should be the new support, at the level of the price breakout. However if the breakout failed he could lose most or all of his capital as the stock moved back to the 50-day moving average.

His other thought was to bet this was resistance and buy Puts at the price level of the current 50-day moving average. The probabilities were good that if the breakout failed, the price would go back to test that level. It would require less capital to bet on a retest.

Apple was trading in at $422.

Dec. $420.00 Calls were $26.00 a contract.

Dec. $385.00 Puts were $12.00 a contract.

“Wow,” he thought, “I would need either a quick move up or down in either direction, while the options still held their time value, or a move to $446 by December for the Calls to break even, or a down move to $373 for the Puts to break even. These options are definitely priced efficiently to break even based on expected moves.”

How could he get the odds back in his favor?

He was deep in thought, watching the barista in the bookstore’s coffee shop efficiently waiting on customers.

Stock Trader was thinking.

Besides the coffee shop franchise, the store was really empty, customers having migrated to online booksellers for reviews and better pricing. A couple of touches to his iPad and he was looking at the chart for Amazon.com.

Charts courtesy of FreeStockCharts.com

“I wonder if hot stocks in up trends would be the best underlying stock to use for option bets.”

Now that I know the dangers of selling lottery tickets, I wonder how I can get on the winning side of buying lottery tickets, with the odds slightly in my favor.

“I bet both Apple and Amazon made some option buyers big winners when they bought out-of-the-money Calls, betting that the stocks would not roll over and die at the 50-day or 200-day moving average just because the market was in a downtrend. These were market leaders, companies with growing earnings dominating their sectors; they came back with a fury when the market as a whole returned to an uptrend,” he thought.

“It is time to send out the signal and call the Bat Phone.”

Stock Trader got home, and as always, went to his designated computer spot. He was lucky. Optionz was online.

Stock Trader: You may need to go to Social Networkers Anonymous.

Optionz Traderz: Look who’s talking, ‘Mr. Social Networking at Midnight’ himself.

Stock Trader: LOL.

Optionz Traderz: What are you up to today?

Stock Trader: I just got back from the book store ghost town.

Optionz Traderz: Tumbleweeds in the aisles?

Stock Trader: Yep, but in the coffee shop I was looking at a few charts of my favorite stocks, AAPL and AMZN, and wondered what the best way to buy lottery tickets on them would be. With the dangers of selling out-of-the-money options in mind, I wondered how I could flip the odds more in my favor if I bought them. I spend a little and the seller risks a lot. I like the risk/reward ratio, just not the odds. What are your thoughts?

Optionz Traderz: You just never stop, do you? You are like an option vampire, always thirsty for more. LOL. That's O.K., though, me too.

O.K., if you want to buy an out-of-the-money option I would follow a few principles:

1. The underlying price normally remains within a range of one standard deviation about two-thirds of the time. A quick way of estimating this range is to look at the strike prices of Calls with a Delta near 0.8 or 0.2. Any options outside of this range represent a stock price that is outside of the market’s consensus of what that price will be at the expiration of the contract; they truly are ‘lottery tickets.’ When you buy a lottery ticket, you are a contrarian, you are betting against the odds. It's O.K. to bet against the odds, but you need a good reason to do so.

2. Do not go too far out in price; ideally you want a price that the stock has been to before, the all-time high for a Call or the last major support level for a Put. That gives you better odds of the stock actually getting back there.

3. Give yourself enough time. You may need to spend the extra money to go at least three months out; the odds are much better for you if you get more than 60 trading days to be right instead of just 20. The farther out you go, the more random prices become in the future, and the better value you get for the time value of your option on the ‘buy’ side because of this uncertainty.

4. You need to buy the options on a stock that has the potential to make the big move and get where you are betting on it going. Of course, the price premium will be higher if it is volatile; but you need a stock that has the potential to move, not an old tired blue chip that has its price move as if it were trudging through mud. You don’t need to avoid low-volatility stocks entirely, but the chances for a big win are much better with companies that have a potential for explosive earnings growth.

Stock Trader: So an old all-time high may be a good Call option to buy when the stock is down at a support level, and an old support may be a good place for a Naked Put when a stock is at all-time highs?

Optionz Traderz: Yes, out-of-the-money options are best played by being a swing trader or a contrarian. I think it is much more difficult to bet on a new all-time high or low, places where the stock price has never been before or at least not in a long time. Investors have memories, and old levels cause exits and entries from the current holders of the stock and also from the traders waiting on the sideline. Many times, new price levels create whole new patterns that are hard to predict.

Stock Trader: O.K., so right now Apple is at $422. Would it be a good play to sell a December $385 Put?  That is very close to the 50-day moving average and the Delta is 0.25?

Optionz Traderz: How many times has AAPL hit the 50-day moving average in the past three months?

Stock Trader: Let me look…four times. That looks like a good bet!

Optionz Traderz: Hold your horses! What was the difference in the price level of the 50-day from three months ago until today?

Stock Trader: The 50-day was at $338 in July when it touched that level, and it was at $380 in October, the last time it bounced most recently.

Optionz Traderz: It is a moving target when the stock is in such an uptrend. By the time it touches again, it may be at $410; that is what the chart is telling you.

Stock Trader: Well, that seems very obvious, now that you pointed it out.

Optionz Traderz: If you were trading the shares, how would you trade them?

Stock Trader: Well, I would buy them as they either bounced at the 50-day moving average or went under it and retook it. I would sell after they broke out and found support at a new price level, which would likely be at the breakout point.

Optionz Traderz: Then that is probably your best option play. You sell a Covered Call with a strike at the likely breakout point, when the stock finds support at the 50-day moving average.

Stock Trader: I was hoping to find some way to buy options instead of selling them and without needing to purchase the underlying shares.

Optionz Traderz: Well, I was going to suggest you might try selling a Put at the 50-day moving average and also a Call at the current resistance level, but if you are interested exclusively in buying options, I think I can help.

Stock Trader: I’m listening.

Optionz Traderz: O.K.. It would probably be easier to focus your trade on the all-time high instead of the 50-day moving average. The high is not a moving target like the moving average is. Buying Calls at a strike near the all-time high would be one strategy. They are far enough out-of-the-money that the premiums are reasonable, but they are at a strike price that the stock has proven it has the ability to achieve. You may lose on a few of these trades, but when the stock breaks out after an earnings announcement or in the run up to the earnings, you could make a huge return on your capital at risk. We are talking 100%-400% or more returns on out-of-the-money Calls in 3 months, with one of those wild $75 runs like it has made in the past.

Penny Pumper: Hey, Optionz Traderz and Stock Trader, 100% is not enough of a return! I can help you find the Holy Grail. Just check out EXTO. I read a closely guarded report this afternoon which indicates that some sources are saying there will be a huge announcement tomorrow morning that could send this stock up over 800%. But if you want to get in, you should consider doing it early, before the big-time traders scoop up the remaining shares.

Stock Trader and Optionz Traderz simultaneously pushed the block button for Penny Pumper and then both wondered why they didn’t do so sooner; but neither one knew the other had done so.

Stock Trader: But if Apple doesn’t break out, I lose it all.

Optionz Traderz: Not necessarily. If you were trading three-month-out options and a month went by without any price movement, you would have alternatives. If you remained confident about a breakout and the options were liquid enough, you could roll them to the following month and might be able to keep 50% or more of your capital intact, as long as the stock had not moved wildly against you. Due to the acceleration of time decay, rolling during the last month before expiration would cost you much more, but you could still benefit nicely if the breakout finally happened.

Stock Trader: So I would still have a chance to profit if the stock did break out, but I would be buying myself more time for that to occur?

Optionz Traderz: Yes, and it works the same way when you end up with a winner. Sometimes, if it is the ‘big win’ and it is in-the-money, you may want to let it run into the final month and capture some huge Delta that will easily pay for the lost Theta.

Stock Trader: But wouldn’t I be giving up a lot of my potential profit by allowing Theta to take away some of the value?

Optionz Traderz: LOL, slow down; you’re learning faster than I can type! I was just getting to that. When you buy options, it is like you are buying insurance. If you buy automobile insurance and the car subsequently gets totaled in an accident, there is little reason to continue paying the premium. You take your payment from the insurance company and you move on.

Stock Trader: So options are like insurance policies?

Optionz Traderz: You’ve got it exactly. Every buyer of an option is purchasing insurance; that’s one reason why the price is called a premium. Every option provides two types of protection, one against rising prices and one against falling prices.

Stock Trader: Wait, how could buying a Call protect me from falling prices?

Optionz Traderz: Technically, it wouldn’t, but I’m comparing option trading to stock trading. If you are buying Calls, it is most likely because you are attempting to use options as a replacement for buying stocks. So compared to buying stocks, Calls give you insurance against rising prices as well as falling prices. Call options do provide a limited downside in that the risk is only in the price of the contract, not the full price of the 100 shares of stock.

Stock Trader: So how do I know when to cancel the policy?

Optionz Traderz: You cancel it when it is no longer necessary, just like canceling your auto insurance policy. If you are driving a beat-up old truck, there is no reason to keep paying premiums on a policy that protects against theft. At some point you need to accept that all those premiums you paid over the years were wasted; you got peace of mind, but your truck was never stolen. When you find yourself driving a truck that nobody in their right mind would ever steal, it’s time to cancel the theft insurance.

Stock Trader: O.K., this is getting a little abstract, but your analogies have not failed in the past, so go on.

Optionz Traderz: I’m glad you like my analogies. I find they are the best way to understand options. So, let’s say you bought those Calls on Apple at the all-time high, when it was trading at the 50-day average. Then, assume the price fell through the average and did not retake it. Now you are driving the beat up old truck. The ‘insurance company,’ the Call seller, would love for you to keep paying the premium for the length of the contract, but the insurance is no longer necessary. The risk you were insuring against, the possibility that the stock would surpass its all-time high, would be almost non-existent. That is the time to cancel, either by selling the Calls or rolling them. I should point out that it is not always necessary to sell Calls that have little chance of being profitable. It usually makes sense to do so on a high priced stock like Apple, where selling early might cut your loss significantly. But on low priced stocks with low priced options, it often isn’t worth the effort.

Stock Trader: I see what you’re saying. But what about when the price rises and the options go in-the-money?

Optionz Traderz: That would be the equivalent of crashing your truck.

Stock Trader: Now I’m confused. If I buy an out-of-the-money Call and the underlying price surpasses the strike, isn’t that a good thing?

Optionz Traderz: If you buy an option and it goes in-the-money, the event for which you purchased the insurance protection has already occurred. That is the point where you need to ask yourself if the insurance is still necessary. If you bought those Calls on Apple and the stock broke through its all-time high, they would have served their purpose. At that time you would need to re-evaluate the upside potential of the share price. If the stock had hit resistance, the truck is totaled; it’s time to take the money and go buy a new vehicle. If the stock was still climbing, you would have to ask yourself whether it was worthwhile to continue paying the premium. If the amount of time value remaining on the Calls was small, it might make sense to keep the trade open. But if there was a large amount of time value remaining, it could make more sense to just sell the Calls and buy the underlying shares.

Stock Trader: That makes perfect sense. Why keep paying the premium if my indications were that the stock was headed up? I could do much better by simply buying the shares.

Optionz Traderz: Exactly. And it works the same way with Puts. Say you bought a stock and also purchased out-of-the-money Puts as protection. Once the stock falls through the strike price, the trade can only lose money over time, as long as the stock never rises above that price. At that moment, you would either believe the stock was on its way back up, in which case the Puts would no longer be necessary, or the stock was not going to retake the level of the strike price, in which case the entire trade should probably be closed.

Stock Trader: So I guess that’s why early exercise doesn’t make sense. If I bought a Put for protection and it went in-the-money, I would lose all of the remaining time value if I chose to exercise it early. And if I held on through expiration, I would also lose all of the remaining time value. However, if I sold the Put and the underlying shares as soon as the Put went in-the-money, I would cut my loss by the amount of time value remaining.

Optionz Traderz: You nailed it again! Early exercise almost never makes sense; the only reasons to do so are usually associated with capturing dividends or to alter the tax liability. When you buy an option and it ends up in-the-money, you need to ask yourself, “Would I exercise this option early?” If the answer is no, you need to immediately consider whether it makes sense to keep that trade open. If you bought those Calls on Apple and the shares suddenly hit their all-time high, would you exercise them early?

Stock Trader: Of course not, because I would be losing all of the remaining time value; and because I had picked a winner, I would be hoping to let it run.

Optionz Traderz: But if it really was a winner and you did let it run, it would perform exactly the same as if you had exercised it early.

Stock Trader: I never thought of it that way before. When the strike price is hit on an out-of-the-money Call that I own, it really is like a car accident. The only reason to keep the Call as insurance against further upside movement is if the remaining time premium is low enough to justify the downside protection.

Optionz Traderz: Whenever you own an option that ends up in-the-money, you need to re-evaluate the position so that you can let your winners reach their full potential. The same concept applies when you own an option that ends up losing money. At some point, the cost of the insurance will often be unjustifiable for the amount of protection it provides. That is the time to cancel it, and that is the basis of all successful trading: increasing your profits and decreasing your losses.

Stock Trader: Hmm, letting winners run and cutting losers short that sounds familiar.

Optionz Traderz: Trading is trading, in all its forms; some rules are universal. And you should keep an open mind about selling options as well as buying. Buying Calls at the all-time high on Apple when the stock is hot could be very profitable, but that trade is based only on that particular stock and chart. With a stock in a nasty downtrend, you may have to reverse it and sell Puts at the all-time low, when the stock rallies and hits resistance at the 50-day moving average.

Stock Trader: I really never thought of trading options like this. Another interesting system for me to think about…

Optionz Traderz: You shouldn’t limit yourself to just one strategy. Buying Calls can work very well in a bull market, and so can the selling of Puts. Naked Puts are just another way to put the odds in your favor – bet that a hot stock is not dead and will rise again to an all-time high. When you get the rare opportunity that one of these monster stocks goes all the way to the 200-day moving average, after the Puts you sold caused you to buy in at the all-time low, you could make a killing.

Stock Trader: As long as the market stays in an overall bullish trend and these stocks stay as leaders, these systems will work.

Optionz Traderz: That is true. These systems work best in bull markets, and there are other options systems that are tailored for every other type of market.

Rookie Trader: If there are options systems for every type of market, that truly is the Holy Grail.

Optionz Traderz: ATTENTION, Rookie Trader. This is not the Holy Grail!

Rookie Trader: Darn.

Optionz Traderz: I say it is not the Holy Grail because there are hidden risks for every one of those systems. For example, if you are buying out-of-the-money Calls in a bull market, you should keep in mind that Call options usually become cheaper as stocks begin to trend upward. As fear dissipates from the market, Implied Volatility decreases. The decrease in volatility causes all options to lose some of their time value, sometimes to such a degree that it overshadows the increasing probability that they will end up expiring in-the-money. When you buy far out-of-the-money Calls, you need to be prepared for occasions when the underlying price increases significantly while the premium on those options actually decreases.

Stock Trader: So I guess if I buy out-of-the-money Calls, I should be looking for returns only in intrinsic value, because Theta and Vega are both working to take away much of their time value.

Optionz Traderz: Correct. The reason that out-of-the-money options are relatively cheap is that they expire worthless most of the time. Even when a trend does materialize, it often takes so much time for the underlying to reach the strike price that Theta removes much of the time value. When you buy options, try to think of the premium as the cost of doing business; whatever amount you spend will probably be totally lost to Theta and Vega. The only money you will make will likely be in intrinsic value.

Stock Trader: That is an interesting way to think about it. Buying out-of-the-money options really is like buying lottery tickets; even if I win the lottery, the seller gets to keep the original cost of the ticket.

Optionz Traderz: Again, that is another reason for the perception that sellers have an advantage over buyers. Even when everything goes right for the buyer, the seller usually keeps most, if not all of the original premium.

Stock Trader: Your negativity is starting to make me feel depressed again.

Optionz Traderz: As always, I’m being negative for a reason. You must understand the risks involved before you enter any option trade. If you understand the risks, you are much more likely to be able to protect yourself. Also, when you understand the risks you will be less likely to be influenced by emotion. When a trade does not perform as expected, it is often tempting to close it and take the loss. But if you know what to expect beforehand, your decision of whether or not to close a trade will be based on your proven system, not emotion.

Stock Trader: Point taken. Are there any other risks to consider?

Optionz Traderz: Well, you need to always remember that the options market is more efficient than the stock market. Stock prices only take into account the information available to traders at a single moment in time. Options prices are determined not only by information that is currently available, but by historical information, as well as predictions about information that will be available in the future.

Stock Trader: O.K., I’m with you so far.

Optionz Traderz: Just as an example, if you were to buy shares of Apple prior to an expected announcement regarding sales of its latest iPhone, they would likely be priced at a level that reflected the sales estimates of analysts. When analysts predict favorable sales, there is often a run up in price before the announcement and occasionally a sell-off afterwards, even when a company meets or exceeds the estimates.

Stock Trader: Yes, I have seen the old ‘Buy the rumor; Sell the news’ effect on stocks. What effect would there be on options?

Optionz Traderz: Option premiums are based almost entirely on time and volatility. Normally, that volatility is a reflection of a fear that the underlying price will fall over time. But announcements of sales, earnings, or new products can cause a different kind of volatility, a ‘fear’ of rising prices. Sellers of Naked Calls are vulnerable to a huge rally occurring if a company reports something that exceeds the market’s expectations. As a result, they demand higher premiums as compensation for the added risk.

Stock Trader: That makes sense. So if I am going to buy Calls, I should check to see whether there is any upcoming news that might be inflating the premiums.

Optionz Traderz: Exactly. When you trade stocks, it is possible to profit using a purely technical analysis of indicators such as price, volume, and moving averages. But when you trade options, you need to remember that there are also traders who base their trades on a fundamental analysis of a company’s current value and expected future earnings. Option premiums reflect the combination of both methods of trading.

Stock Trader: I would never have thought of that. If I bought an option based on my technical analysis alone, I would run the risk of the trade moving unexpectedly if I did not pay attention to the way it might be affected by other traders who were using a fundamental analysis. I guess I’ll have to start looking at the fundamentals and paying more attention to the news if I am going to convert my stock trading system to options.

Optionz Traderz: That is a good idea when you are buying options. When you sell options, you don’t really need to do as much research because the premium on every option reflects all of the combined sentiment of both technical and fundamental traders; you always receive a fair premium based on the amount of risk you are taking. That’s not to say that buyers aren’t also paying a fair price; they are. But buyers have fewer alternatives as far as managing the trade if it moves unfavorably, and those unfavorable moves could be caused by fundamental traders.

Stock Trader: Now you are starting to make me think that buying the out-of-the-money ‘lottery tickets’ is not such a good idea.

Optionz Traderz: They might or they might not; it all depends on your trading personality. Basically, it boils down to this. Option sellers have peace of mind when they open a trade because they are letting the market predict what is going to happen. Sure, they might do some analysis beforehand, but once they open a trade they know that they have received compensation that was calculated by the market’s prediction of the underlying price’s future movement. Then they can sit back and relax and simply react to the market by cutting their losses when the market’s prediction was incorrect. Option buyers need to be able to predict the future. When you buy an option, especially one that is out-of-the-money, it is like you are saying that you know something the market doesn’t – and maybe you do. If you have a proven system of technical trend trading that works for you, there’s no reason you can’t apply that predictive power to a system of buying options. You just need to be careful you are not ignoring those hidden risks I described that might not be uncovered by a purely technical analysis.

Stock Trader: That makes me feel a little better. I guess it wouldn’t hurt to do a little bit of extra research after I had found a trade that my system was predicting would be profitable.

Optionz Traderz: You can’t out-wit the options market; the market will almost always win. But there are ways to make money with options if you take the time to inform yourself of any hidden risks. If you think you have found a good trade on a pharmaceutical company, check for any expected upcoming regulatory rulings that might be driving up Implied Volatility. Likewise, pending resolution of lawsuits such as those involving patents can have the same effect. With stocks, such events usually get slowly baked into the share price in the days and weeks leading up to the expected announcement.

With options, the anticipated news does not get baked into premiums in the same manner. All options expiring after a predictable event will have premiums which reflect the uncertainty surrounding that event very soon after it becomes public. The options market, because it depends on predicting the underlying price at a future date, does not have the luxury of waiting around. The event gets baked into Implied Volatility almost immediately.

Stock Trader: So that is another reason to choose the right timeframe for my trade. If I wanted to buy Calls on a stock in September and the company was releasing its earnings report in November, I would be taking on the added risk of the effect of that report if I chose the December expiration.

Optionz Traderz: Exactly. If you had no other reason to keep the trade open for that length of time, you would likely find much more attractive premiums on Calls expiring before the report was due.

Stock Trader: Anything else I should watch out for?

Optionz Traderz: There is always the unpredictable, the Black Swans, but you can’t do anything about those except cut your losses when you are able to do so. However anything that has uncertainty associated with it and also a predictable timeframe is worth noting. As we already discussed, earnings, product releases, pending litigation resolution, regulatory decisions, but also upcoming changes in a company’s leadership and even political elections and pending legislation can sometimes have an effect.

Stock Trader: That’s a lot to think about.

Optionz Traderz: In my opinion, it is not necessary to study all of these events in depth; they are all just things to consider so you can avoid as many unwanted surprises as possible. You wouldn’t want to buy Calls, then wake up the day after an election and be startled to find that volatility had evaporated and taken a lot of their value along with it. But if you understood that risk going into the trade, it wouldn’t cause you to lose faith in your system.

Stock Trader: Having faith in my system and feeling comfortable trading it are very important. I’m not yet sure whether I would be more comfortable selling options and generating income, or spending my money buying options like lottery tickets, looking for the big winners.

Optionz Traderz: Many traders do both. And you don’t have to limit yourself to just buying or selling Calls or Puts. There are many different strategies you can use that entail combinations of options, like the Straddles and Strangles we talked about a while back. There are also many, many different types of Spreads – everything from Vertical, Calendar, and Ratio Spreads to Butterflies and Condors. But we’ll have to wait for another time to discuss those. The pizza I ordered just got here and I’m starving.

Stock Trader: As always, thanks for the advice. Enjoy your pizza.

Stock Trader had a lot to think about. Options were such simple things, and yet trading them was turning out to be utterly complex, not unlike stock trading. Still, he remained confident that having found a method of trend trading that allowed him to conquer the complexities of the stock market, with help from Optionz, he would be able to conquer the options market.

He now had Theta, Vega, Delta, and all of the other Greeks under his belt, and that made him feel a lot more confident. He also had Covered Calls, Naked Calls, Puts, and out-of-the-money ‘lottery ticket’ options in his tool box, and knew how to use each one. But there were so many variables in the market, and the tools he had were mostly designed to be used during very specific market conditions. How would he deal with range-bound markets, volatile markets, and the like?

Maybe Optionz would have answers next time they talked. Maybe those other strategies that Optionz talked about, the Spreads, Butterflies, and Condors, would be the additional tools he needed to trade in every market.

It was all just too much to digest for one day. The same could not be said for his stomach. The energy drink he had at the coffee shop earlier in the day was not going to be enough to sustain him now. He needed some real food, like the pizza Optionz was probably enjoying. In fact, a pizza sounded like a good idea. He quickly tore some leftover pizza coupons out from underneath a magnet on his refrigerator and picked up the phone to order one for dinner.

While he was waiting for his pizza to be delivered, Stock Trader kept thinking about options. It was difficult for him to concentrate, being so hungry. He felt his stomach grumbling, but he knew he would survive. After all, the pizza shop had promised him that his order would be delivered in 30 minutes. The minutes seemed to tick by ever so slowly. He looked up at the clock on his microwave oven. “Just 10 minutes to go,” he thought.

Maybe it was the hunger, maybe it was the barrage of analogies that Optionz had thrown at him, but Stock Trader was now thinking of his stomach in terms of option trading. He knew he would not starve to death in the next ten minutes. He knew he would soon be full, probably overly-full, after finishing off more pizza slices than he should have eaten. “If my stomach was a stock, it would have found support at the 200-day average and would soon be headed for all-time highs,” he thought. “This would be the time to buy an out-of-the-money Call.” As Stock Trader was getting deeper and deeper into thought, the doorbell rang and brought him back to reality.

“The pizza!”

“Your total comes to $26.50.”

“O.K., keep the change. Thanks. Have a good night.”

“$30 for a pizza? Now I literally am out-of-the-money,” he chuckled out loud.

Chapter 10

TRENDS DETERMINE WHO WINS: STRANGLES AND STRADDLES

Stock Trader woke up and glanced at quotes on his phone before even getting out of bed.

The Dow was up over 400 points.

“Wow, what a move!” he thought.

Once again he was on the sidelines, due to the wild swings in the market and all the doubt surrounding the debt problems in Europe.

He figured that he could not predict what would happen or even follow a trend with all the uncertainty. He figured that the European Union would do whatever it took to avoid a systemic financial meltdown. However, anything could happen when that many countries got together to agree on what to do.

The stock market was being held hostage by government decisions, and he just did not want to be on the wrong side. It was apparent, from the magnitude of the move, that the markets got what they wanted overnight in Europe.

“I wish there was a way for me to bet on a huge move both ways,” he thought.

Then he thought about the option strategy Optionz Traderz had used in the past.

“What was that option play we talked about? Was it an option Stripper? No. Striker, Strangle, Straddle; yes, that was it! How did I forget about that play? Of course, the option strategies of Strangles and Straddles. Crap!”

“Surely he didn’t use that again and win, while I sat here looking dumb and scared in cash.”

“I wonder if Optionz is online this early in the morning?” he said out loud.

He checked the Winning Traders group on Facebook and found that Optionz was indeed online, but he was engaged in a conversation with another trader. Stock Trader sat quietly, watching a very interesting discussion going on in the group. He felt he would be showing poor manners if he interrupted.

Trend Trader: So you won even though you had no idea which way it would go? How in the world is that possible?

Optionz Traderz: I bet both ways.

Trend Trader: So were you bullish or bearish?

Optionz Traderz: I was ‘trendish.’

Trend Trader: What?!

Optionz Traderz: I believed the news out of Europe would cause a sharper than anticipated move one way or the other. So I bought both Call and Put options, one strike out, on the Dow Jones Industrial Average ETF (DIA).

Trend Trader: So didn’t they even out?

Optionz Traders: The thing about option contracts is that they capture the upside and limit the downside. After the 400-point rally, my Call options were worth far more than my Put options had lost.

Trend Trader: Your Put options still had value?

Optionz Traderz: Yes, even though they are now far out-of-the-money, they are not worthless; with the high volatility in the market they still have some Theta value. In the past I have even left the losing option side open and then been able to exit that side when the market had another strong reversal move, a few days later.

Trend Trader: That is crazy, I have never heard of that kind of trading. I focus on trend identification and going in the direction of the predominant trend in whatever markets I am trading.

Optionz Traderz: I profit from options. I trade different strategies based on the current market behavior.

Trend Trader: So you have option strategies that allow you to bet on a trend, not a direction, just that there will be a trend?

Optionz Traderz: Yes, they are called Strangles and Straddles.

Trend Trader: That sounds complicated.

Optionz Traderz: They are not really that complicated. Strangles are formed when you buy both a Put and a Call out-of-the-money on the same equity. A Straddle is created when you buy both a Call and a Put at-the-money. Strangles require less capital outlay, so there is less risk of loss if you are wrong. But you need a strong move to bring one of them deep enough in-the-money before expiration to make enough profit to offset the cost. A Strangle can expire 100% worthless when neither side makes it into-the-money. It can also have a huge percent return on the capital at risk by one side going deep into-the-money.

The Straddle captures the full move of the equity in-the-money. One of the options will be in-the-money almost instantly and will always be worth the amount of the move in intrinsic value. Also, the odds are, after a strong move the losing side will still be worth something. However, although the Straddle requires more capital, it requires a smaller move than an option Strangle to make enough on the winner to pay for the loser.

Trend Trader: So during this European crisis, I could have structured a trade based on what I thought was the velocity of the move either way?

Optionz Traderz: You could have also picked which trading vehicle would be the one to move – a specific bank, sector, index, maybe even gold – the one you thought would have been most impacted.

Trend Trader: If I was betting on a 200-point DJIA swing, I could have bought a Strangle using the ETF DIA, out-of-the-money $2 both ways (equivalent to 200 points) and made a very good percentage return.

Optionz Traderz: Not only can you capture that strong move without prediction, but you would own the complete upside from that point, with no additional investment until the options expired.

Trend Trader: How does this work? It seems like the losing side would even out the profit on the trade.

Optionz Traderz: Straddles are built to capture one side of an estimated move for a set period of time, for a premium. They are contracts, not investments, part ownerships, or equities. They have limited downside but unlimited upside.

Trend Trader: Like built-in stop losses?

Optionz Traderz: Sort of. You pay a bull to sell you the downside and a bear to sell you the upside. Your profits come when it becomes evident that one of them did not charge you enough to participate in the trend when it happens. They both took the risk of a bigger trend occurring than what they had anticipated.

Trend Trader: So profits in this strategy come from bigger than expected trends?

Optionz Traderz: Yes, like stock trading, sometimes the trend happens and then reverses so many times that you have to take your profits while you have them. The value of the option reflects the probabilities of the value of the option at expiration, so they may not go up as much as you expect because the option may be pricing in the chance that the trend may reverse before the option is exercised.

Trend Trader: So what happens if I bet on a 200-point move, and after the announcement there is only a 100-point move?

Optionz Traderz: You will lose in the short term. After the catalyst passes, both sides of the option strategy lose time value, to reflect the lower expectations of volatility.

Trend Trader: What if it drops 500 points while I am in the option Strangle?

Optionz Traderz: Then you are in-the-money. I have actually been in one before when that happened and returned 5% on my whole account in one day with only 5% of total equity at risk. That was a 100% return on my options in 24 hours.

Trend Trader: Wow, those are amazing risk-adjusted returns. In what other events would you use the Strangles/Straddles, besides national crisis news?

Optionz Traderz: On a more normal basis, when entire nations are not discussing their solvency, they can be used for company earnings reports. Unexpected earnings can spike a stock far more than is anticipated when after-hours traders scramble to get in or out. Emotions can drive a stock farther than was anticipated when earnings cause greed or fear to run wild.

Trend Trader: That is the truth. There have been many moves that are just unbelievable when a hot stock disappoints or when everyone piles in after the company knocks the cover off the ball in an earnings report.

Optionz Traderz: You want an epic event in the market or a stock. If you find out that a company has any upcoming news event that may determine its entire future one way or the other, that may be the time to put on a Strangle or Straddle, to capitalize on a trend that could be far stronger than is anticipated.

Trend Trader: What are the risks?

Optionz Traderz: There is always the risk that the market does not make the sharp move that you anticipated and the value of volatility built into the options collapses, or the market only moves far enough for you to break even. Also, like I said, if you hold on and wait for a move that never comes, both sides of your Strangle expire worthless. Worse yet, you could have a Straddle that expires right at-the-money where you started – a total loss.

Trend Trader: How can you help manage these risks?

Optionz Traderz: When you are wrong, the best thing to do is just get out early and go look for a new play. Never hold until expiration unless you are just so deep out-of-the-money that the liquidity has dried up in that contract and you would lose too much in the bid/ask spread to justify selling it. Also, sometimes a bigger move than you expect may be priced-in and the options are just too expensive to be able to profit. This has happened to me many times. When I buy Straddles, I am looking for the under-estimation of the seriousness of an event to move the market.

Stock Trader did not want to appear as if he was rude, but his curiosity was increasing. The Dow had soared more than 400 points in one day, a move that could have given him thousands of dollars in profits. But his trend trading system did not work efficiently in volatile whipsawing markets, so he was on the sidelines, waiting for the market to settle down. Meanwhile, Optionz seemed almost as if he welcomed the recent volatility. It was time to get some answers.

Stock Trader: Sorry to interrupt. You are a good teacher. Did you pull off another Long Strangle money heist?

Optionz Traderz: Yes, I started building a position when all the drama began in Europe. I bought when the options were more affordable, when volatility was lower. As volatility grew and the down trend deepened, my options also grew in value, with both increasing Vega and my Put side going in-the-money. I closed out my first play, then opened up a new one, and lost with the market being range bound. My latest short term play on the EU bailout announcement worked well, with the 400-point pop in one day.

Stock Trader: So what is your Strangle/Straddle system win rate?

Optionz Traderz: Only about 50%.

Stock Trader: Big wins, little losses?

Optionz Traderz: Exactly. My wins pay for my losses and leave me a profit.

Trend Trader: So to win in an option Strangle or Straddle I have to be right about the timing of the trend and the velocity?

Optionz Traderz: Yes, they are only for times of massive uncertainty, with outcomes that have the potential to move violently one way or the other. You have to overcome the priced-in volatility of the options to win. When you buy Straddles or Strangles, you are betting that volatility will change. Either Implied Volatility will increase significantly and stocks will sell off or Implied Volatility will fall significantly and stocks will surge.

Trend Trader: What about exits?

Optionz Traderz: Just like in trend trading, you might want to exit on a stop when the trend reverses, or you might have a time exit, where you exit after the event catalyst has passed and you presume that the move has already happened.

Stock Trader: What is true in stocks is also true in options. The only difference is just a few more moving parts.

Trend Trader: I need to look at some option chains and really get the feel for how this works. I think I have the basics now.

Optionz Traderz: Good for you. Glad I could help.

Stock Trader: So how do you decide when to use a Straddle and when to use a Strangle?

Optionz Traderz: Often, the outcome of both strategies is similar, especially on more volatile stocks. If you consider an at-the-money Straddle on a stock, Delta on both of the options will likely be close to 0.5. That means that lowering the strike price of the Put by $1 should save you about 50 cents in premiums, while increasing the strike of the Call by $1 would do the same. All together you would save $1 in premiums, but be entitled to $1 less of any trend that developed. In a case like that, I would choose the Strangle over the Straddle because I would have the same potential profit with much less capital at risk.

Stock Trader: That is interesting. The Strangle would cause me to miss out on the first $1 of the move in the stock price, but would save me $1 in premiums compared to the Straddle.

Optionz Traderz: Exactly, so why put yourself at risk of losing the additional premium if no move ever occurred? You would lose a lot more money on the Straddle, but have nearly the same profit potential as a Strangle.

Stock Trader: So if I went out $2 in price on the strike of both options, wouldn’t I save $2 in premiums and then miss the first $2 of any change in the stock price?

Optionz Traderz: Not necessarily. That may be true on very volatile stocks, but those with lower volatility have Deltas that drop off considerably with strike prices that are out-of-the-money. So it is possible that moving out both options by $2 might only save you $1.50 or so in premiums. On stocks with very low Implied Volatility, you might save even less. But you are correct when you are talking about Strangles on highly volatile stock.

Just as an example, Trend Trader had asked me about a Strangle on the DIA ETF. With the shares currently trading around $116, a Strangle consisting of a $114 Put and $118 Call with November expiration would have a combined premium of $4.31 and would pick up any movement of the share price in excess of $2.00. Meanwhile, a Straddle consisting of a Call and Put, both at the $116 strike, would cost $6.17 and pick up every penny of movement in either direction. So while the Straddle would have an additional $2.00 gain compared to the Strangle, the Straddle costs $1.86 more to open; you really aren’t getting much added benefit from a Straddle versus a Strangle, but you are taking on a lot of additional risk.

Stock Trader: So a Strangle would be better on volatile stocks. What about less volatile ones?

Optionz Traderz: That’s a choice you need to make based on what your indicators are telling you about the market and how confident you are about that information. Straddles are very expensive, so it takes a big move to offset their cost. Strangles are less expensive, but it actually takes a bigger move in the underlying price to generate a profit than would be necessary with a Straddle.

Stock Trader: That seems strange. I would have thought a Strangle would perform better because of the lower initial outlay.

Optionz Traderz: If you consider that the premium on an at-the-money option is equal to approximately 40% of one standard deviation of the underlying stock price, based on the amount of time to expiration, then a Straddle will generally cost you about 80% of one standard deviation. So the stock price would need to move 80% of a standard deviation just to get to the break even point. That might seem like a lot, but stocks generally only stay within such a tight range around half of the time.

If you compare that to a Strangle, with strikes that are out-of-the-money by half of a standard deviation, they will usually cost about half as much as those required for the Straddle. Because they cost half as much, their combined premiums are about 40% of one standard deviation. So the underlying price needs to move 50% of a standard deviation just to get to the strike price, then another 40% of a standard deviation to get to the break even point, which would likely be near 90% of one standard deviation – slightly more than is required for a Straddle.

Stock Trader: So if I was confident that my technical analysis was pointing to a strong trend, a Straddle would be a better choice because it would have a better payout. But if I was less sure of a trend, I could cut my risk in half if I chose a Strangle with strikes about half a standard deviation out-of-the-money.

Optionz Traderz: That is true. The profit from the Strangle would be slightly lower, but with about half as much capital at risk. As always, you need to make sure the options have enough liquidity at the strikes you are choosing. Strangles are much more vulnerable to liquidity issues than Straddles because out-of-the-money options almost always have larger bid/ask spreads, and you are exposed to that risk on both legs of the trade.

Stock Trader: Good point. Anything else to consider?

Optionz Traderz: Well, you don’t need to confine yourself to buying Straddles or Strangles; you can also sell them.

Stock Trader: That seems riskier than the Naked Puts we were talking about.

Optionz Traderz: Yes, they do have risks, but like every option strategy, the key is managing that risk.

Stock Trader: So how would I manage the risk on a short Straddle or Strangle?

Optionz Traderz: The first thing to do is to make sure you are selling them at the right time, to give yourself better odds. When the markets are losing value and volatility is rising quickly, Straddles and Strangles can be very risky. Not only would you be risking a big loss on the Put side if the downtrend worsened, but Implied Volatility would probably rise too, and that would likely increase your loss. Short Straddles and Strangles both have a slightly bullish bias; many times they perform better when prices are rising, due to Vega causing them to lose some of their time value.

Stock Trader: So when prices are starting to recover, but volatility is still high, would that be a good time? I’d still be getting some good premiums, but if the uptrend continued and volatility declined, I’d be able to cut any losses on the Call side of the trade and take profits on the Put side, because volatility would be working in my favor on both.

Optionz Traderz: Exactly. Bear markets, with increasing volatility, are usually more dangerous for Short Straddles and Strangles than bull markets. So once you have picked a good time to open the trade, the next thing to do is to choose the right strike price. You might be tempted to sell a Strangle instead of a Straddle because of a fear of having one of the options immediately being in-the-money.

Stock Trader: Yes, that is probably what I would do.

Optionz Traderz: It is definitely unnerving to have short option positions that have intrinsic value, even for me, after all these years of trading. But I find it is best to avoid letting that fear influence my trades. The strike prices should be based on the probability of the entire trade being profitable and whether the premium received is worth the risk.

Stock Trader: That’s a good point. I would be tempted to sell a Strangle with strike prices so far out-of-the-money that there was no chance of either strike price being hit. But the premiums that far out are usually tiny. The higher premiums I would get on a Straddle might make it a better trade.

Optionz Traderz: Yes, like we talked about earlier, some Straddles and Strangles perform almost identically, especially on very volatile stocks. If the market was volatile enough and there was sufficient time to expiration, you might be able to collect $1 more by selling a Straddle than you would receive for a Strangle with the strikes moved out by $1. In that case, when you planned on selling options instead of buying, the Straddle could make more sense. If we use the DIA example again, you could collect $1.86 more on a Straddle than a $2 out-of-the-money Strangle.

Stock Trader: That makes perfect sense. I would be obligated for an additional $2.00 in intrinsic value when the stock price moved, but I would receive an extra $1.86 in premiums. So I would only be taking on an additional 14 cents of risk but I would have a potential additional profit of $1.86 if the ETF’s price didn’t move at all.

Optionz Traderz: You nailed it! Why leave that extra money on the table when it isn’t causing you to take on much additional risk? It’s all about risk and reward. If it makes sense to buy a Strangle instead of a Straddle because the small amount of additional reward does not justify the risk of a trend not occurring, then selling a Straddle instead of a Strangle could also make sense. All you need to do is weigh the risk against the reward and decide whether the potential increased reward justifies the additional risk.

Stock Trader: That is fascinating. A Straddle can behave almost the same as a Strangle when the underlying price moves, but the profit or loss is much different when the price remains flat. So if I combined the two, say by buying a Strangle and selling a Straddle, wouldn’t that guarantee that I would make a profit no matter what?

Optionz Traderz: Hold on a minute; you’re learning too fast for me again There is actually a name for the strategy you described: an Iron Butterfly. But like all option strategies, it doesn’t win under all conditions. The Strangle that you are buying will always cost somewhat less than the Straddle you are selling, a net credit trade. Whenever you trade Straddles or Strangles and receive a net credit, you are betting against a trend. The opposite is also true; when you pay a net debit, you are betting on a trend. You receive a net credit when you open an Iron Butterfly, but if either of the options you sold expired with intrinsic value greater than that credit, you would have a loss. I’d be happy to explain Butterflies to you in detail, but it would probably be less confusing if we got through Straddles and Strangles first.

Stock Trader: O.K., you’re the teacher

Optionz Traderz: When choosing strike prices for a Strangle, some traders prefer buying a Put at a strike price near a recent support level and a Call at resistance. The premiums are much lower with these options being so far out-of-the-money, so there is much less capital at risk. The downside is that both options will usually expire worthless. But when they do pay off, the profits can be huge.

Stock Trader: And the same would go for selling a Strangle; a Put at support and a Call at resistance would probably both expire worthless most of the time.

Optionz Traderz: Yes, whether you sell a Straddle or a Strangle, you are betting that a stock or the market as a whole is range bound. How wide that range is will be determined by the strike prices of your options; the further out-of-the-money you go, the wider the range. There may actually be times, like when the Dow was whipsawing violently recently, that Implied Volatility increases to a level that makes it possible to sell a Straddle and still keep your range of profitability in between support and resistance. Other times you may have no choice but to use a Strangle, if your goal is to include support and resistance levels within that range.

Stock Trader: I think I understand now. Buying Straddles or Strangles is a ‘trendish’ strategy and selling them is a range bound strategy. The strike prices determine how ‘trendish’ or range bound I am predicting future prices to be.

Optionz Traderz: Correct. So now that you understand when to use each strategy, you need to consider the timeframe of the trade. Option combinations react much more slowly to changes in the underlying price than single options. For example, when you open a Straddle, Delta on the Call is normally close to 0.5 and on the Put it is about -0.5; the position is initially nearly Delta neutral. So even if the underlying price did move, the combined position wouldn’t change in value much due to Delta, unless the magnitude of the move was great enough. In the meantime, Theta would be eating up some of the value.

Stock Trader: I guess we’re back to matching the expiration date of the options with the expected time frame that any prediction about a stock’s price would be valid.

Optionz Traderz: That is one way to look at it. But you don’t need to limit yourself to that timeframe. As with all option strategies, Straddles and Strangles behave much differently depending on their expiration date. A Straddle with a near month expiration will be much more sensitive to time decay than one a few months out, but it will capture moves in the underlying price much more closely. Also, the near term Straddle would be much less sensitive to changes in volatility. You need to weigh the risks associated with each.

Stock Trader: So if a stock was range bound and I sold a Straddle one month out, I would benefit much more from time decay than if I used options two or three months out, but I would be taking on more risk if the stock broke out.

Optionz Traderz: That is true, so you may want to adjust your position size to compensate for the additional risk.

Stock Trader: Good point! If I am making more profits from faster time decay by selling options with shorter terms, I don’t need to sell as many contracts.

Optionz Traderz: You can also use the faster time decay another way. Let’s say you noticed that one of your favorite stocks normally remained range bound for about three months after each earnings announcement. Perhaps after the announcement in October you were looking to sell ten Strangles with January expirations. Let’s assume each Strangle would get you $2 per share in premiums. Also assume that they would lose about 10% of their time value in the first month, if the underlying price and volatility remained stable. How much of a gain would you have at the end of the first month? As always, there are 100 shares in one option contract.

Stock Trader: LOL, another math problem. O.K. $2 x 10 x 100 = $2000. 10% of $2000 is $200. So I would only have a gain of $200 after the first month?

Optionz Traderz: You are getting better at math. Now assume that the premium on the November options was approximately half that of the January options with the same strike prices. How many November Strangles would you need to sell in order to earn $200 by expiration day?

Stock Trader: I think I can do this. Each Strangle would have a premium of about $1; so $100 per contract. That means I could sell two Strangles with the November expiration and potentially have the same $200 profit after the first 30 days as if I had sold ten Strangles with the January expiration.

Optionz Traderz: Exactly. The good news is that if the stock remained range bound and the November options expired worthless, you could probably still sell ten Strangles at that point with the January expiration and get the remaining $1,800 in premiums you were originally seeking.

Stock Trader: That is really interesting. The profit would be the same, but I would have substantially decreased my risk during the first 30 days.

Optionz Traderz: That’s what trading is all about, seeking out the best profits with the least amount of risk possible.

Stock Trader: So how would you suggest managing a Short Straddle or Strangle once the trade is open?

Optionz Traderz: Just treat each leg of the trade as if it were a single Naked Put and Naked Call. Cut your losses on the losing side when you are able to do so, and take your profits on the winning side when your technical indicators tell you that the time is right. Just as with any Naked option, you also have the choice of rolling the losing leg to a farther-out expiration date and a smaller number of contracts or a more favorable strike price.

Stock Trader: I think I’m starting to see a theme here. It doesn’t matter what strategy I am using; the basic rules are the same. All I need to do to succeed is choose the correct strategy for the current market conditions, increase my probability of a profit by choosing the appropriate strike prices, limit my losses by selecting the best expirations, manage the trades with stop losses or by rolling, and take my profits off the table the same way I would if I was trading stocks.

Optionz Traderz: That is there is to it. When you trade options, the current condition of the market is always a concern, but never a major problem.

Stock Trader: Professional option traders really have the good life.

Optionz Traderz: It can be a good life, but it takes some work. My Long Straddle on DIA worked out very well this week, but it could just as easily resulted in a big loss. In fact, it was such a big win that my girlfriend and I are going out in my Cadillac later today to celebrate.

Stock Trader: So you celebrate all of your winning trades?

Optionz Traderz: Oh, by no means. I have winning trades all the time. But some trades take a lot of work. I started working on my DIA options trade weeks ago and endured some initial losses. There were times that it looked as if it would be a total loss. But my system told me to stick with it and I did, and the result was a big win. I’m not going out to celebrate the win itself; I’m going out to celebrate the success of the system.

Stock Trader: I know how you feel. I like it when my stock trading system has a big win. It makes all of the previous losses tolerable.

Optionz Traderz: Yes, losses are part of the business, and they are frequent. When the hard work finally pays off and the system proves that it works, why not celebrate?

Stock Trader: I agree. Enjoy your night out and congratulations on a nice trade…again.

Optionz Traderz:  Thanks.

Chapter 11

THE TWINS: EVERY POSITION HAS A SYNTHETIC RELATIVE

Stock Trader was simply having fun learning from Optionz online. He felt at times like he was studying a foreign language. Stock options contained a lot of moving parts and could be combined for a dizzying amount of different strategies.

Stock Trader pondered some of the things he had learned.

“Option sellers could make money from the deterioration of an asset they sold short.”

“Traders could bet on a trend in either direction.”

“Traders could make money betting there would be no trend.”

Catching the full upside of a move with an automatic limited downside was something he really liked.

“With options, traders could be in control of huge blocks of stock with little money invested.”

“Stock trader could use stock options as hedges or insurance policies.”

Stock Trader just couldn’t get enough option talk. He went right back into the fray.

He signed on and went to the group online that was getting to be a regular hang out for him.

It appeared a new student was being schooled. “This should be interesting to watch,” he thought.

Income Investor: I heard you were the group’s resident guru on stock options. I sell Call options for income on my investment portfolio. The strategy is not working out as well as I had hoped.

Optionz Traderz: Why don’t you just sell Naked Puts for income instead?

Income Investor: I would never sell a Naked Put; that is way too much risk. It makes my stomach queasy just thinking about it.

Optionz Traderz: Well, I have some news for you. They are the same thing, technically.

Income Investor: What? That is crazy they are completely different, Covered Calls are for income and Naked Puts are a wild gamble with huge risks.

Optionz Traderz: How is the risk in a Naked Put different from a Covered Call?

Income Investor: A stock could crash and you would still have it put on you at a set price much higher than what it was worth currently at the market price.

Optionz Traderz: But you receive income for the Naked Put.

Income Investor: That is a small fee for taking on the risk of a stock crashing and possibly causing me to be left holding the bag. This could cause me to have to buy a stock for way over the market value.

Optionz Traderz: How is that different from Covered Calls?

Income Investor: I already own the stock on which I am writing the Call. I do not have the risk of having it put on me.

Optionz Traderz: That is because you already put it on yourself.

Income Investor: It is an investment.

Optionz Traderz: Then why would you not sell Naked Puts on stocks you would want to own, and if they were put on you, it would be initiating an investment?

Income Investor: I do not like the idea of offering to buy a stock at a set price.

Optionz Traderz: With a Covered Call you are offering to hold a stock for a set price and risk the entire downside. What is the difference?

Income Investor: I already own the stock.

Optionz Traderz: Correct, you already own the downside.

Income Investor: I own the downside? I never really thought of that.

Optionz Traderz: In a Covered Call you get paid a small fee to take on the downward risk of the stock that you own. In a Short Put you collect a small fee to take on the downward risk of a stock you must buy at the strike in the future if exercised. It is the same trade, same risk.

Income Investor: O.K., that makes my head spin. I can’t believe that a Covered Call option has the same risk profile as a Naked Put.

Optionz Traderz: Say you own Apple at $385 and you sell a Covered Call option at $390 and collect $15. You make money from $370 and up in price. If you sell a Naked Put at $390 for $15 you make money from $370 and up in price. Your risk is to the downside in both strategies. The difference is that you already put Apple on yourself before you entered the trade on the Covered Call, and in the Naked Put you will have it put on you later.

Income Investor: I am taking on the same risk in both of these trades?

Optionz Traderz: Exactly the same risk; the only difference is whether you or the brokerage firm is exposed to the downside. I have discussed this in the group a few times. It is one of the greatest misunderstandings in the option world. The risk embedded in the Covered Call, the infamous ‘stop gain,’ is the same as a Naked Put, to the trader. If you sell a Naked Put and some unforeseen event results in a loss that is greater than the entire value of your brokerage account before a margin call can be executed, it is the broker who is on the hook.

Income Investor: I really thought I was an informed investor, but that just blew my mind.

Optionz Traderz: In investing and trading financial markets, all we are doing is trading risk. Each instrument has an upside and a downside and generally an equal chance of the trade moving towards or against our bet when we enter any position. The market’s current behavior determines if we win or lose, not our own genius.

Income Investor: What else do I not understand about options? I am a stock investor, not an option trader.

Optionz Traderz: Options have twins that have the same risk profile.

Income Investor: Really? What is a Long Call option’s twin?

Optionz Traderz: A Married Put is the same as a Long Call option. In a Married Put you get the full upside and protect the downside by paying a small fee. In a Call option you get the full upside while the downside is protected by limiting losses to the small fee for the option.

Income Investor: Then why would anyone use a Married Put and pay two commissions?

Optionz Traderz: Married Puts are used for a short term hedge on a long term position, sometimes to avoid the tax consequences of short term capital gains. Other times they may be used to protect gains on a stock an investor already owns.

Income Investor: So when I sold Covered Calls on the stocks in my portfolio I was selling the upside of my stocks for the small fee and keeping the downside risk for myself? Is that what you are saying?

Optionz Traderz: You were essentially writing Puts, but the stock had already been put on you. Calling a stock from you or putting a stock on you is simply a manner of time sequence; they are not different principles entirely.

Income Investor: So that explains why I lose so bad in bear markets, I have already put the stock on myself. I still have the losses as if someone had put it on me. I do not know why I didn’t realize this.

Stock Trader: Sorry for butting in, but I'm curious. What other option parallels exist? I can’t wrap my brain around what other option twins are out there.

Optionz Traderz: Well, let me think. How about Synthetic Stock positions? Buying a Long Call and selling a Short Put, both at-the-money, will give you a Synthetic Stock. It behaves the same as if you owned the stock itself and requires no capital. You get the upside if it goes up due to your Long Call, and lose on the downside with the Short Put if it goes down. But you have little to no capital outlay because the short option pays for the long option.

You can also create a Synthetic Short Stock position, a Long Put and Short Call at-the-money, and it will give you the same returns and losses as if you were short the stock itself.

Stock Trader: I see you play with options like they are a box of building blocks.

Optionz Traderz: Only they are more colorful and fun.

Income Investor: O.K., I believe you guys have gone way over my head. Synthetic Stock trading? I am out.

Stock Trader: So you are saying that there is a free trade. By combining a Short Put with a Long Call, you will have a Synthetic Stock position that costs nothing?

Optionz Traderz: There is always risk, and don’t forget commissions. Also liquidity risk can become an issue with lightly traded option chains or as your winner goes deep in-the-money.

Stock Trader: That may be the coolest thing you have talked about yet. It is like going to a build-a-bear workshop and getting a free bear built just the way you want it.

Optionz Traderz: Just make sure it is not flammable – it could burn your house down.

Stock Trader: Well, I guess it may be a freebee position but a Synthetic Stock has the same potential of loss as a regular stock would.

Optionz Traderz: Yes, always remember position sizing and the risk of ruin if you are tempted to play with these building blocks. Trade the same size as you would with real stock and risk the same amount of capital based on your system, probably like 1%-2% of total equity per trade. There are also margin requirements that can be significantly higher than those required for stocks. When you open a Synthetic Stock position, a portion of your account will be on margin from the very start. That means you will be paying interest on that amount. Depending on the movement of the stock price, that requirement can increase, so it is a good idea to check your margin balance when you trade options.

Stock Trader: You know how to throw a bucket of cold water on my head when the adrenal glands get pumping and my greed starts growing.

Optionz Traderz: Synthetic Stock is good for creating extra trades without tying up any additional capital, but it does tie up some of your margin. And don’t ignore liquidity. You need to watch the bid and ask price closely when a Synthetic Stock position has options that are deep in-the-money and far out-of-the-money. Liquidity can dry up quickly, and you would be left with a position that you could not close, even if you wanted to do so. Some traders use a set limit, such as $0.05 or $0.25, where they will close the position when the bid price reaches that level. Once the bid price of the out-of-the-money option goes beyond that, you would likely be stuck with the position until expiration day. In a position that went in your favor, you’d be vulnerable to a gap down that reversed the trend and wiped out your gains. Worse yet, in a position that went against you, you would have no way to cut your losses if the short options went so deep in-the-money that they lost their liquidity.

Stock Trader: I really like this idea. I could trade 100 shares of Apple but instead of tying up $28,500 to trade 100 shares I could sell an at-the-money Put contract for $15 and then buy an at-the-money Call contract for $15. Then I own the upward movement in Apple for the cost of commission.

Optionz Traderz: And the downward risk. The Delta rules still apply. No matter what the price of the stock, Delta on the Call minus Delta on the Put will always equal 1. If the stock price drops and Delta on the Call goes to 0.75 then Delta on the Put will be –0.25.

Stock Trader: I hadn’t thought of that. 0.75 – (–0.25) =1

Optionz Traderz:  So you will see a full reflection of value at any given moment. Unlike most option strategies, you don’t need to wait until expiration to see the full value because the Theta is paid for. You sold Theta to buy Theta, so Synthetic Stock positions do not experience time decay.

Stock Trader: Selling Theta and using it to buy Theta, clever. Now I have heard it all.

Optionz Traderz: Sorry to disappoint you, but you haven’t heard it all yet. Understanding synthetics will open up a whole new set of tools for you.

Stock Trader: So there are more synthetics?

Optionz Traderz: Yes, I don’t usually use formulas, but there is only one formula that you need to remember to understand synthetics. Do you remember when I gave Rookie Trader that option trade that was a guaranteed winner every time?

Rookie Trader: Hey! Are you guys making fun of me?

Optionz Traderz: I’m not making fun, but I am using your inexperience to make an important point. You should pay attention here; you could learn something important.

Stock Trader: So, if I remember correctly, the trade you gave him was to sell a Covered Call and then buy a Put at the same strike price.

Optionz Traderz: Exactly. Buying a stock, then selling a Call and buying a Put, yields a trade that cannot win or lose. And that will give you the formula for all synthetic positions. Here it is: STOCK – CALL + PUT = 0.

Stock Trader: I’m not sure I understand how to use that formula though.

Optionz Traderz: O.K., it takes a little bit of algebra. Are you up for some math?

Stock Trader: LOL, here we go again with the math problems. O.K., go ahead.

Optionz Traderz: Well, just leave the equal sign where it is. What happens if you subtract a PUT from both sides?

Stock Trader: Let’s see. STOCK – CALL + PUT – PUT = 0 – PUT

Optionz Traderz: You really aren’t as bad at math as you think. Now consider the left side of the equation for a minute; you have a Long Put and a Short Put, so they cancel each other out. And on the right side you have nothing, minus a Put, so that’s just a Short Put.

Stock Trader: So I’d be left with STOCK – CALL =  – PUT

Optionz Traderz: You got it! Stock minus a Call equals a Short Put; a Covered Call equals a Short Put.

Stock Trader: I never would have thought of it that way. That’s amazing.

Optionz Traderz: It doesn’t end there. If you take the original equation and add a Call to both sides you get:  STOCK + PUT = CALL. If you do the math for every possible combination, you will end up with this list:

POSITION     SYNTHETIC POSITION

STOCK   =      CALL –  PUT    (Long Stock = A Long Call and a Short Put) –  STOCK   =  –  CALL +  PUT    (Short Stock = A Short Call and a Long Put)

CALL   =      STOCK  +  PUT      (A Long Call = Long Stock and a Long Put)

–  CALL   =  –  STOCK  – PUT       (A Short Call = Short Stock and a Short Put)

PUT    =      CALL  –  STOCK   (A Long Put = A Long Call and Short Stock)

–  PUT    =  –  CALL +  STOCK   (A Short Put = A Short Call and Long Stock)

Stock Trader: Now that you put it that way, it seems much simpler. So, there are only six synthetic positions?

Optionz Traderz: That’s it. Those are the basic six.

Rookie Trader: I’m glad you’re not making fun of me. I took your advice and went to an options seminar at a hotel last weekend. I really learned a lot. So I found the problem with the Covered Calls I was trading; all I need to do is buy Puts three months out, and then sell monthly Covered Calls three times to offset the premium.

Optionz Traderz: How much did you pay to get in to the seminar?

Rookie Trader: It was $150, but it was worth every penny. Now I finally do have the Holy Grail.

Optionz Traderz: I hate to break it to you, but it is not the Holy Grail. If there was one, with all of the traders on Earth, somebody would have found it by now. I could have saved you the $150. Were you paying attention to the formulas for synthetic positions?

Rookie Trader: Yes.

Optionz Traderz: What is the synthetic position for a Covered Call?

Rookie Trader: A Short Put.

Optionz Traderz: So by selling a near month Covered Call, you were opening the equivalent of a Short Put. If you combine that with the far month Long Put, you have the equivalent of a Calendar Put Spread.

Stock Trader: What? There’s actually a name for the trade he described?

Optionz Traderz: Yes, although the exact trade he described doesn’t have a name that I know of, what he would be doing is the equivalent of a Calendar Spread. When you buy an option with one expiration and sell the same option with a different expiration, that’s all there is to a Calendar Spread. There are times when such trades work well, but they definitely are no Holy Grail.

Rookie Trader: Rats!

Stock Trader: I think I’m starting to see the value in learning about synthetics.

Optionz Traderz: Yes, many of these seminars and expensive black-box trading systems do nothing more than take simple trades and make them look overly complicated by substituting the positions with their synthetic equivalents.

Stock Trader: I guess that’s something to watch out for if I see a trading system being touted as having some ‘secret formula’ for success.

Optionz Traderz: Definitely. In the past, I actually made the mistake of buying one of those systems. It sounded so sophisticated that it certainly would be worthwhile. The method involved searching the market for stocks with the lowest correlation; when one stock goes up, the other goes down. Once the stocks were chosen, all that was necessary was to sell Covered Calls on both stocks.

Stock Trader: That does seem like it would be a good system. What went wrong?

Optionz Traderz: First, there are no stocks that have an exact 0% correlation, so there were times when both stocks lost value. More importantly, though, when one of them hit the strike price of the Call, the price of the other was still dropping. If the price of the losing stock fell beyond that point, by more than the amount of the premiums I received, I lost. The Short Call caused me to give up all of the gains on the winning stock while I owned the full downside of the losing stock.

Stock Trader: So was this one of those simple trades that they had just made more complex in order to get traders to purchase the system?

Optionz Traderz: Exactly. The two Covered Calls are equivalent to Naked Puts. And because of the low correlation, one Put behaves the opposite of the other, so it is more like a Naked Call. When you put them together, it is nothing more than a Naked Call and Put, a Short Strangle. In fact, I probably would have lost less capital if I had just opened a Short Strangle instead.

Stock Trader: That’s a good point. These marketing guys really know what they are doing to make a profit for themselves, not their customers.

Optionz Traderz: You nailed it. So whenever you are considering opening a trade, it is helpful to consider the synthetic equivalent. Like we talked about with Covered Calls, before you open one, ask yourself if a Naked Put at that strike price would make sense. If not, why open it? If you are thinking of buying a stock and then using a Married Put for protection, ask yourself if you would still open the trade if you were simply buying a Long Call at that strike price.

Stock Trader: Now you’ve given me something to think about. When I own a stock that has done well, I sometimes buy a Put instead of using a stop loss if a Put is inexpensive enough, at a strike that will get me out of the trade with a profit. But if I consider that buying a Put is the same as selling the stock and buying a Call, I’d probably never buy a Call at a strike that deep in-the-money.

Optionz Traderz: As always, understanding options is all about understanding risk. You don’t need to trade synthetics in order for them to help you. In the trade you described, I don’t think either of us would choose to sell the stock and buy a deep in-the-money Call; the additional commissions involved would eat up a lot more of the profits than buying a Put. But thinking about the equivalent synthetic position might make you reconsider the risks of keeping the trade open.

Stock Trader: Any other thoughts?

Optionz Traderz: Well, as I was telling Rookie Trader, just because a trade looks good on paper doesn’t mean it is. When you think about synthetics, it may help you decide if the trade you are planning is correct for the current market conditions. Some complex trades are difficult to study; thinking of them in simpler terms may make it easier.

Stock Trader: That is true. Rookie’s trade sounded O.K. until you let the air out of it by saying it was just a Calendar Spread in disguise.

Optionz Traderz: The good news is that there are conditions when his trade would be an appropriate choice. Even though his position was nothing more than a synthetic version of a Calendar Spread, it would work well on a stock that was going through some consolidation in its price.

Stock Trader: That’s interesting. I never would have thought to trade two options with different expiration dates.

Optionz Traderz: And that’s just one of many ‘Spread’ strategies. There are plenty of them to choose from.

Stock Trader: So Rookie’s comments have opened up a whole new toolbox? Now I really have heard it all.

Optionz Traderz: Oh, we are just getting started in the wonderful world of options. I will let you mentally digest that until next time. Optionz out.

Stock Trader got up for an energy drink, but sat back down at the computer a minute later. Optionz was right; he really did have a lot to digest. Every option had a twin. Every option, and even stock positions, could be created synthetically.

To top it all off, just when he was thinking he was getting to know all of the option strategies he would need, Optionz goes and says that there are many Spread strategies to learn.

What were they?

He needed to look them up.

He did a Google search and quickly found a link to a site that listed a whole host of option strategies.

Sure enough, there was the Calendar Spread they had talked about. There were also Vertical Spreads, Ratio Spreads, Butterfly Spreads, and Condors. A Strip and a Strap; what the heck could that be? Guts? Ladder?

“Wow, he was right. We truly are just getting started,” he thought.

Stock Trader was looking through all of the strategies when something caught his eye – an advertisement for a credit card with bonus airline miles. He suddenly realized that he had been so busy talking to Optionz over the past month that he had forgotten to book the airline ticket for his vacation. “Crap. I only get one two-week vacation a year,” he said out loud. “I hope they aren’t sold out.”

“With only ten days to go until my vacation starts, even if I can find tickets, they will be overpriced,” he thought.

Sure enough, there were still tickets available, but at much higher prices than he would have paid if he had booked the flight weeks ago. “$1,000 for the round trip; I guess I don’t have a choice,” he thought. “It’s too late to get a refund on the hotel room.” He clicked the ‘buy’ button, finished his energy drink, and was off to do some errands.

Chapter 12

SPREADS: RATIO, CALENDAR, DIAGONAL

No alarm this morning. Stock Trader looked at his cell phone. It was 8 a.m. and he felt rested.

His morning ritual was to get quotes on his phone before he even got out of bed, but there were no quotes on Saturdays. It had been an exciting and fast-paced week in the financial markets. He had taken short positions and done very well as the market trended lower. It was not his favorite way to make money, but he would take it.

Now, with the market well beneath its 200-day moving average and even the best of stocks at or below their own 200-day moving averages, the market appeared to be perched on the edge of a cliff ready to roll over into the abyss. Where would the next support for the market be, the 350-day moving average? Would it fall all the way to the 600-day moving average? It was looking bleak.

He was sure Optionz probably had on some low-risk high-probability trade he had built. Learning these newest synthetic and Spread strategies made him think of Optionz in a laboratory, like Dr. Frankenstein bringing a monster alive.

He needed more option knowledge if he was going to be able to transition into option trading or at least dabble in it when stock trading just wasn’t diverse enough to take on the more complicated bets he saw an opportunity to make.

Would Optionz be conducting class on a Saturday morning?

Again Optionz was online, and again he was engaged in a conversation with Rookie. “I wonder how long it will be before Rookie mentions another Holy Grail?” he thought to himself.

Rookie Trader: So a Vertical Put Spread is much safer?

Optionz Traderz: Yes, Covered Calls expose you to the entire downside movement of the underlying stock price; a Vertical Put Spread only exposes you to the difference in the strike prices.

Rookie Trader: So if I wanted to sell a Covered Call on Caterpillar, I would be better off selling a Put Spread?

Optionz Traderz: Not necessarily better off. Each strategy has its own risks and potential rewards. All I’m suggesting is that a Put Spread has much less risk. For example, with Caterpillar trading at $94, say you could sell a Put at the $92.50 strike for $5.90 and buy a Put at the $90 strike for $4.90. On one contract of 100 shares, you would collect $1.00 per share, or $100. As long as the price stayed above $92.50 at expiration, you would keep the $100, and as long as it stayed above $91.50, you would have a profit.

Rookie Trader: Wouldn’t I lose money if the price went below $91.50?

Optionz Traderz: Yes, you would, but your loss would be limited by the Long Put. Once the price fell below $90, the Put you bought at that strike would pick up the entire move in intrinsic value. So if that happened, the increase in intrinsic value of the Long Put would offset the increase in intrinsic value of the Short Put. If the price stayed below $90 at expiration, you would buy 100 shares of Caterpillar at $92.50 and sell 100 shares for $90. You would lose $250, but get to keep the $100 credit you received when you opened the trade.

Rookie Trader: I see. The maximum amount I could lose would be $150. That really does seem better than a Covered Call.

Optionz Traderz: I wouldn’t say it’s better, just less risky. If you sold a single Covered Call at the $90 strike for $8.90, you would collect $890 in premiums, but you would own the entire downside risk below $90, with only the premiums you received to offset your loss.

Rookie Trader: So I guess Vertical Spreads aren’t the Holy Grail either. I could make a lot more money selling a Covered Call, but I could lose a lot more than selling a Put Spread.

Stock Trader: 2 minutes and 10 seconds. I think that may be a new record for the time it took to mention the Holy Grail.

Optionz Traderz: LOL, you were timing him?

Stock Trader: Yes, but it looks like you’re making progress in getting him to understand a little bit about how all options involve risk.

Rookie Trader: The two of you really should get a room, the way you always get together to gang up on me. But thanks for the help with Vertical Spreads.

Optionz Traderz: You are welcome. However, there are more Spreads than just Verticals.

Stock Trader: That’s what I wanted to ask you about. After we talked last time, I looked up option Spread strategies and there are a lot of them.

Optionz Traderz: It might seem like a lot, but many of them have similar behaviors so it isn’t necessary to memorize each one. Once you learn the basic Spread strategies, you will likely also understand the more complex ones. Most complex Spreads are nothing more than modifications of basic Spreads.

Stock Trader: So what Spreads should I concentrate on studying?

Optionz Traderz: Well, first there are three types of Spreads: net credit, net debit, and net even. Every Spread you open fits into one of these three categories. Spreads are created when you purchase one option and sell one option to create a spread in price between the one you sold and the one you bought. Since they differ in price three scenarios can occur. You will either receive more premiums than you are paying out, ending up with a net credit to your account; or you will pay out more premiums than you receive, so your account will have a net debit. You could also have an option trade where the amount of the premiums will be equal, a net even trade.

Stock Trader: Wait, how can I have a net even trade unless I sell the same option I am buying?

Optionz Traderz: I think I can explain. Let’s start with the simplest Spread, a Vertical Spread. A Vertical Spread is just a fancy name for a trade where you buy an option at one strike and sell an option with another strike and the same expiration.

Stock Trader: That one makes sense to me. If Apple is at $375 and I think the price has found support, I can buy a $375 Call for $13.00 and sell a $390 Call for $6.50, both with December expiration. I make a profit as long as the price goes up enough to cover the difference in premiums, the net debit.

Optionz Traderz: O.K., so what if you bought one $375 Call, but sold two $390 Calls?

Stock Trader: I would pay $13.00 for the Long Call and receive $13.00 for the two Short Calls. So I would have a profit as long as the Short Call strike wasn’t hit?

Optionz Traderz: Actually, the range of profitability would extend well beyond the Short Call strike. If it was hit, you would have intrinsic value in the Long Call, from $375 on up. At prices above $390, the intrinsic value of one of the Short Calls would increase by the same amount as that of the Long Call. However, you would have $15 of additional intrinsic value in the Long Call.

Stock Trader: I see what you’re saying. I would only be exposed to upside risk on one of the Short Calls, so the breakeven point would be $15 above the $390 strike at $405.

Optionz Traderz: Exactly, and that’s all there is to a Ratio Spread. It is nothing more than a Vertical Spread using a ratio of options that is anything other than one-to-one. It doesn’t necessarily need to be a net even trade like the one I described on Apple. Ratio Spreads can also be net debit or net credit trades.

Stock Trader: I thought Synthetic Stock was a great idea, but Ratio Spreads seem just as promising. If I bought one Call at support and sold two Calls at resistance, and was able to open it exactly net even, I would only lose the commissions if the price fell through support.

Optionz Traderz: That is one of the great things about Ratio Bull Call Spreads; they are very low risk when the price falls through support. Also, if the price did break through resistance, you could buy the underlying shares. Doing so would turn one of the Short Calls into a Covered Call, and the intrinsic value of the remaining Short Call would give you a nice buffer for your stop loss.

Stock Trader: This seems like the ultimate way to trend trade. If I thought $390 represented resistance and the price shot through to $395, I could buy 100 shares and set a stop loss at $390. If the trend reversed, I would be out $500, but still turn a profit as long as the Long Call in my Ratio Spread expired with at least $5 of intrinsic value.

Optionz Traderz: The only real risks with this style of managing a Ratio Spread are that the price gaps up or it breaks through resistance and then begins to whipsaw. Even so, with the underlying Apple shares at $390, there would still be $15 of intrinsic value in the Long Call. You might get another chance to be stopped out with a $5 loss and still manage to break even on the trade as a whole.

Stock Trader: So a Ratio Spread is like whipsaw insurance?

Optionz Traderz: That’s one way to look at it. You would also have the choice of simply buying one of the Short Calls if Apple hit the $390 strike. Even if it happened immediately after opening the trade, it would likely only cost you $13.00 to buy it back, a $6.50 loss. What you would be left with would be a basic Vertical Spread. However, instead of paying a $6.50 net debit to open the Spread when all of the options were out-of-the-money, you would be paying the equivalent of the same net debit for a Spread that was completely in-the-money.

Stock Trader: I guess it would be rare for the price to hit resistance that quickly, so I would probably pay even less than $13.00 because in the meantime there would be some time decay. Plus, Implied Volatility might be lower if the stock was showing enough strength to climb to that price level. The combination of Theta and Vega could cause the premium to be much less than $13.00.

Optionz Traderz: Correct. Also, you don’t need to limit yourself to a two-to-one ratio. Depending on the strike prices you choose, you can choose three-to-one, three-to-two, or any other combination that gives you the debit or credit you are seeking.

Stock Trader: So how do I choose between debit, credit, or even?

Optionz Traderz: With Ratio Debit Spreads, there is upside risk as well as downside risk. Lowering the net debit decreases your risk if the trend goes the opposite way you expect, but only by adding risk in the other direction. If you lower it all the way to zero or net even, you eliminate the risk in one direction entirely, but only by adding it to the other side. If you keep lowering it by making it a net credit trade, the risk in one direction is not only eliminated, but profit potential is added, again by adding more risk in the other direction.

Stock Trader: That makes sense. So I need to decide whether the potential profit and risk in one direction are justified by the potential profit and risk in the other direction.

Optionz Traderz: That’s all there is to it. If the economy is showing weakness but you have found a company that is doing well in spite of the conditions, a net even or net credit Ratio Call Spread would protect you in the event your stock got weighed down by a downturn in the broader market.

Stock Trader: That’s a good point. I could still make a profit if the company continued to do well, but I wouldn’t be taking on the risk of a recession or some other event that was bad enough to affect all companies, even the strongest performers.

Optionz Traderz: Ratio Spreads can be tailored to fit almost any market. Ratio Bull Call Spreads, those with long options at a lower strike and a greater number of long options at a higher strike, tend to work better in bull markets as net debit trades than those opened with a net credit, due to the increased upside protection. The same is true of net debit Bear Put Spreads in a bear market.

Ratio Bull Call Spreads opened with a net credit can work well on stocks that are doing well when the rest of the market is not. If the general downtrend eventually begins to have an effect on the price of an individual stock, the net credit might still result in a profit.

Net Even Spreads are good when there is a high level of uncertainty in the market. In the past, I have used Ratio Put Spreads around earnings. Sometimes I buy at-the-money Puts and sell enough out-of-the-money Puts to balance the premiums. If the underlying price takes off after the report, everything expires worthless and I’m only out the commissions. When earnings are disappointing, I profit from the Long Put, all the way down to the strike of the Short Puts. When everything expires, I end up buying the underlying shares and keeping the profit on the Spread.

Stock Trader: Wouldn’t that also work if I sold a Put at-the-money and then used the premium to buy out-of-the-money Puts? It seems like it would be the same, except I wouldn’t have any downside risk.

Rookie Trader: Now who’s looking for the Holy Grail?

Optionz Traderz: LOL, he’s got you there! There is some downside risk because the short option can be in-the-money when it expires while the long options expire worthless. However, if you open the trade very close to the earnings report, there won’t be much time decay. If the short option ends up in-the-money after earnings, even if the long options did not have any intrinsic value, they could increase in time value. If that was the case, you could close the trade soon after earnings were released and might get out with a small loss and possibly a small profit. It would depend on whether the increase in fear over the poor report was enough to offset the decrease in volatility due to the disappearance of uncertainty about the contents of that report.

Stock Trader: So the risk is small, but there might be times when I could still be able to get out with a profit, even when the underlying price moved to a point that would be a losing scenario at expiration. Some might consider that to be a Holy Grail of sorts.

Optionz Traderz: I guess you’re right. There is another use for Ratio Spreads; they can help you recover from a poorly performing stock trade.

Stock Trader: Now this I have to see! Are you saying I can own a stock that has lost value and then use options to turn a loser into a winner?

Optionz Traderz: Anything’s possible, but it’s more likely you could cut your loss enough to break even if the conditions were right.

Stock Trader: Go on.

Optionz Traderz: O.K., let’s say you bought 100 shares of Apple last summer when the price broke through the $400 resistance level. If you held them into November, they would only be worth $375, so you would have a loss of $2,500 if you sold them. Assuming the price had found support at $375, rather than hold on and wait for a rebound, you could open a net even Ratio Bull Call Spread. If you bought one in-the-money Call, at the $355 strike for $26, and sold two at-the-money Calls at the $375 strike for $13, both with December expiration, how would the trade play out if the underlying price remained just above the $375 support?

Stock Trader: Let me see… Everything would expire in-the-money, so I would buy 100 shares at $355 and sell them for $375, and I would sell the shares I already owned for $375. So I would make a $2,000 profit on the shares I bought with the Long Call and lose $2,500 on the shares I already owned.

Optionz Traderz: Yes, so your combined loss would be $500, still much better than the $2,500 loss you would have needed to take to get out of the trade without using the Ratio Spread. This may seem like a great way to recover from a big loss, but it only works when a stock has truly found support. The Ratio Spread I described would do nothing to provide any protection if the underlying price fell through support. It only works when prices have fallen and then stabilized.

Stock Trader: I would never have thought to use Ratio Spreads on stocks I already own. Great advice, as always!

Optionz Traderz: There is another form of a Ratio Spread called a Ladder. The only difference with a Ladder is that all of the options have different strike prices. For example, a Long Call Ladder would be opened using a Long in-the-money Call, but rather than selling two Calls at-the-money, only one would be. The second Short Call would have a strike out-of-the-money. Depending on the strike prices and Implied Volatility, a Long Call ladder might be a net credit, debit, or even trade. Given the higher strike price of the second Short Call, it may be possible to reduce some of the upside risk when compared to a traditional Ratio Bull Call Spread. You can also create a Short Call Ladder by just exchanging the long and short positions. Ladders can also be opened using Puts instead of Calls.

Stock Trader: That’s interesting, a Ladder can sometimes work as well as a Ratio Spread, but with a little less risk.

Optionz Traderz: It all depends on the premiums at the particular strike prices of the options you are trading. If you are considering a Ratio Spread, it is often worth comparing it to a Ladder before opening the trade to see which one is the better choice. If you do compare them, don’t forget to include the additional commissions and fees in your calculations, as well as slippage due to the bid/ask spread.

Stock Trader: Yes. Those commissions, fees, and liquidity risks can be silent but deadly.

Optionz Traderz: So now that you know how to use Ratio Spreads, we can move on to Calendar Spreads. Like we talked about last time, Calendar Spreads are nothing more than trades using two options with the same strike price and different expiration dates.

Stock Trader: You mentioned that Calendar Spreads could be used when a stock was going through a period of consolidation.

Optionz Traderz: That is correct. The only way a Calendar Spread can result in a loss is if the long option loses more time value than the short option. Say you sell a near month at-the-money Call and buy another Call at the same strike a few months out. If the underlying price breaks out, in either direction, the long option can lose more time value than the short option.

Stock Trader: I’m not sure I understand that. Isn’t Theta the highest in the final month of a contract? If the Short Call expired with intrinsic value, I would also have the same amount of intrinsic value on the Long Call, plus I would still have the remaining time value.

Optionz Traderz: It can be confusing. So I like to think of it this way. There are only three major influences that can cause an option to experience a change in time value: Implied Volatility, time, and moneyness.

Stock Trader: O.K., I’m with you so far.

Optionz Traderz: Volatility normally has a greater effect on the longer term option of a Calendar Spread, but it also has some effect on the shorter term option. The result is that most of the time changes in volatility will have minor effects on the combined value of a Spread.

Stock Trader: So we are left with time and moneyness as factors?

Optionz Traderz: Those are usually the two most important influences. You are correct that Theta causes the greatest amount of time decay in the final month of a contract, but that effect can be overshadowed by the change in moneyness of the longer term option of a Calendar Spread. If that option ends up deep in-the-money or far out-of-the-money it could lose most or all of its time value. Because it had a greater amount of time value than the shorter term option when the trade was opened, it is also possible for it to lose more. The loss of time value on the longer term option due to changes in moneyness can be greater than the loss of time value of the shorter term option due to time decay.

Stock Trader: If I understand correctly, the options with longer time to expiration have higher premiums because there is more uncertainty about what the price of the underlying will be when they expire. But if the underlying price moves violently in one direction or the other, they might either end up so deep in-the-money that they will be trading at par with the underlying shares, or they will be so far out-of-the-money that they will be nearly worthless. In either case, they will have very little time value. Meanwhile the options with nearer expiration will expire with intrinsic value only, having lost 100% of their time value. The intrinsic values of the long and short options in a Calendar Spread are always the same, so if I lose more time value on the long options than I gain on the short options, I will experience a loss on the trade.

Optionz Traderz: You’ve got it. You can also do a Calendar Spread trade in reverse – buy a near month option and sell a far month. If the moneyness of the far month option causes it to lose more time value than the near month option loses due to Theta, you will have a profit.

Stock Trader: So a Calendar Spread with long options in the near month is betting that a breakout will cause consolidation to end, and the same Spread with the short options in the near month is betting that consolidation will continue.

Optionz Traderz: Both can work well if either scenario plays out. But both strategies depend on the same initial setup; the stock is going through a consolidation phase when the trade is opened. If a stock is in a strong trend, a Calendar Spread is usually not the best choice.

Stock Trader: I think I see where you are going with this. If a stock is in a strong trend, a Calendar Spread with the long options having a shorter term than the short options might result in a profit, but a Vertical Spread or a Ratio Spread could be much more efficient at capturing the trend.

Optionz Traderz: As I mentioned earlier, it’s all about choosing the best tool for the job. When you have a toolbox full of option strategies, it is much easier to pick the one that will give you the best results for the current market conditions.

Stock Trader: So a Vertical Spread is best when a strong trend is likely, but there is a risk of loss if the trend goes in the wrong direction. A Ratio Spread can be used to profit from a trend with little or no risk if a trend fails to develop or if it reverses, but there is a risk of loss if the magnitude of the trend does not meet expectations. And a Calendar Spread is best when a stock is going through consolidation, but there is a risk of loss if the prediction of whether or not a breakout will occur is correct.

Optionz Traderz: You can also combine strategies. For example, you can combine a Calendar Spread and a Vertical Spread to form what is known as a Diagonal. In a Diagonal Spread, you are trading options with two different expirations at two different strike prices.

Stock Trader: So if I bought November Calls on Apple at the $375 strike and sold December Calls at the $390 strike, that would be a Diagonal Spread?

Optionz Traderz: It’s that simple. Diagonal Spreads are meant to capture a trend with limited upside and downside risk. The difference between a regular Vertical Spread and a Diagonal is that the far term options have higher premiums than the near term ones. That gives you a chance to open the trade very close to net even, something that is not possible with either a Vertical Spread or a Calendar Spread. Just as with a net even Ratio Spread, if you open a net even Diagonal Spread and the trend goes the wrong way, your loss is usually limited to the commissions.

Stock Trader: So when would be a good time to use a Diagonal Spread?

Optionz Traderz: I know of some traders who use Diagonals as an alternative for Covered Call writing. By buying a near month at-the-money Call and selling an out-of-the-money Call for the following month, the result is a trade that behaves similarly to that of a Covered Call, but without as much downside risk. If the underlying price falls considerably, there is a chance that both options could eventually expire worthless. If the price rises and the near month Long Call is exercised, the trade truly does become a Covered Call. The only difference is that the stock was purchased in a bona fide uptrend, at a bargain price that was determined by the strike price of the Long Call.

Stock Trader: That seems like another option strategy that would work well with my trend trading system. If the Long Call is exercised, I not only get to keep the full amount of any move, up to the strike price of the following month’s Short Call, but I also have a cushion on the downside, having bought the shares at the strike price of the Long Call.

Optionz Traderz: The good news is that Spreads are very slow to react to changes in the underlying price. Unlike stock trading, where your account changes value with every tick, Spreads can take days or weeks to show any real movement. Even when a trade goes against you, the slow pace may give you the time you need to re-evaluate the trade and cut your losses.

Stock Trader: I really like the idea of using Spreads as whipsaw insurance. In my stock trading system, I often get stopped out of an otherwise good trade when whipsaw trips my sell order. As disappointing as it is to get stopped out early, my system requires that I always, always, honor my stops. With the value of a Spread being much more stable than the underlying stock, I should be able to reduce my whipsaw losses.

Optionz Traderz: Option strategies can be tailored to almost any trading method. If controlling whipsaw losses is a major goal, then Spreads can be very helpful.

Stock Trader: I wish I had known about Spreads back when the Dow was making hourly triple digit swings a while back. I opened several trades that week, and every one of them got stopped out.

Optionz Traderz: Ouch! That’s something you’ll rarely see in the world of options, if you are careful to set up your trades in a way that minimizes your risk. I only keep a handful of trades running at any given time, and there are some weeks when I don’t need to place any trades at all. In fact, when the market was performing its recent stunts, I was sitting by the pool, confident that my option strategies would be unaffected.

Stock Trader: Any other thoughts on Spread trading?

Optionz Traderz: There are many Spread strategies, but a lot of them are just altered versions of the ones we have already discussed. There really is no need to memorize them, but it may be helpful to see the wide range of option combinations available. Here are a few of them:

Guts: This strategy is nothing more than a Strangle, but with a Long Call and a Put, both in-the-money, with the same expiration. It will turn a profit only when a very strong trend develops. A Short Guts is just the opposite – a Short Call and Put, both in-the-money. In my opinion, a Guts trade is no better than a Strangle. The amount of intrinsic value gained on the Call will be lost on the Put until the Put strike is hit, and vice versa. Profits do not start until the underlying price goes beyond one of the strikes by an amount equal to the combined time premiums, the same as with a Strangle. The only difference is that a Guts trade has a better chance of both options expiring in-the-money, requiring additional commissions. Just as with Strangles, Long Guts trades are trendish strategies and Short Guts trades are range bound strategies.

Ratio Write: This is one of those trades that can be simplified using synthetics. A Ratio Call Write involves buying 100 shares of stock and then selling two at-the-money Calls. To simplify it, it can be broken down into a Covered Call and a Short Call. The synthetic position for a Covered Call is a Short Put, so the trade becomes equivalent to a Short Put and Short Call – a Short Straddle. Interestingly, a Ratio Put Write, which is opened by shorting 100 shares of stock and selling two at-the-money Puts, also breaks down to a Short Straddle when the synthetic positions are substituted. Because they are both equivalent to a Short Straddle, they both work best on tightly range bound stocks.

Variable Ratio Write: For a Variable Ratio Call Write, 100 shares of stock are purchased, followed by selling one in-the-money Call and one out-of-the-money Call. The stock combined with the in-the-money Short Call is equivalent to an out-of-the-money Short Put. Combining an out-of-the-money Short Put with the out-of-the-money Short Call is the equivalent of a Short Strangle. Just as the Ratio Call and Put Write are identical, a Variable Ratio Put Write is the same as a Variable Ratio Call Write. Both are equivalent to a Short Strangle, and both would be appropriate for a moderately range bound stock.

Strip: This strategy is a ratio version of a Straddle. Usually it involves a Long at-the-money Call and two Long at-the-money Puts. So it behaves the same as a Straddle, but with one-third more risk, which allows it to perform better in a downturn. Strips are slightly bearish, strong trend strategies.

Strap: A Strap is the same as a Strip, but with two Long Calls and one Long Put, all at-the-money. Again, it is slightly riskier than a Straddle, but performs better if the underlying stock rallies. That makes a Strap a strong trend strategy with a bullish bias.

Stock Trader: As always, you’ve given me a lot to digest. I think I need some time to wrap my brain around all of this.

Optionz Traderz: Don’t let all of the terminology scare you away from Spreads; there are no set rules for trading them. Just because a Spread has a name doesn’t mean it’s better than one you design yourself. The most important thing to remember when you trade Spreads is that you can move the risk wherever you want it. If you don’t want any downside risk, choose a strategy and strike prices that eliminate that risk by moving it to the upside. If you want neither upside nor downside risk, just move it to the center.

Stock Trader: The center? Are you talking about Long Straddles and Strangles?

Optionz Traderz: Exactly. And there are two more Spreads where the risk can be moved to the center: Butterflies and Condors.

Stock Trader: And how many more strategies are there?

Optionz Traderz: Just Butterflies and Condors; after that, your toolbox will be full.

Stock Trader: Well, thanks for the all of the advice about Spreads. You could write an option book with all your knowledge. Good grief, I will have to save and read this conversation thread a few times to really understand all the dynamics of Spreads. This sounds like how the big boys do it.

Optionz Traderz: Yes, Spreads done correctly can lead to income with very controlled risk. Talk to you soon.

Stock Trader found himself sitting at his computer trying to think through the option plays that Optionz had discussed. They were a little mind bending.

Buying an at-the-money Call then selling twice as many out-of-the-money Calls to pay for the Long Call? A free Call option as long as the Short Calls do not go in-the-money too deeply. This was simply amazing to him.

Buying a near term in-the-money Call then selling a longer term out-of-the-money Call to create a sort of precursor to a Covered Call with much less risk of capital.

These were so mind bending he felt like he had taken the red pill and woken up from the Matrix.

How could combining options result in completely different option plays than what the individual options represented? By combining Longs and Shorts, Puts and Calls you could create what seemed like endlessly different option plays.

He was pondering this while sitting at his computer, sipping his daily requirement of caffeine in liquid form.

He was looking at his trading records and thinking about different ways to use options to play to his beliefs.

He wrote notes as he thought.

Trading in a range bound market: Short Strangle sold at resistance and support.

A hot stock breaks out on high volume: At-the-money Call option.

The market bounces off support: At-the-money Call option.

Market topping out and reversing on high volume: At-the-money Puts.

If an event is expected that will move a stock, sector, or the market in one direction in a big way: A Long Strangle.

I want to open a trade without needing additional capital: Create a Synthetic Stock position; Call and Put at-the-money, one Long, one Short, depending on the direction bias.

I am invested in a hot stock I believe in, but want to generate some income: Covered Calls, write Short options out-of-the-money over and over again.

I want to be paid to buy a stock at the price I want: Write Short Puts at the strike price I want to pay for the favorite stocks on my buy list.

Volatility is very high but I don’t believe the market will really move as much as is priced-in: A Short at-the-money Straddle.

He was impressed with his own list. He had been listening.

As he thought of this new tool box, he looked at a box of building blocks that he kept for his niece to play with when she visited; they were the interlocking kind that you could build things with.

As he took a few out and put them together absentmindedly, he made a little dog. He thought for a minute, “When these blocks were lying separately in the box they were just individual blocks, but when interconnected they became something different. A small block became an ear, slightly bigger blocks the legs and head. The blocks did not change, just how they were used together did. They were the same exact block as they were before, but when put into position with other blocks they became a small part of a whole new thing.”

Stock Trader believed this had to be like option strategies, combining options together to create new things. The options themselves stayed the same but the combination made them part of a new strategy.

All this thinking was stimulating, but at the same time exhausting. Stock Trader settled on to the couch for an afternoon nap. His tickets to San Diego, California lay next to him on the coffee table. As he dozed off, images of blocks, options, and beaches danced through his head.

Chapter 13

THE WIND BENEATH THE PRO’S WINGS: BUTTERFLIES AND CONDORS

Stock Trader awakened on Sunday morning, reflecting on the pleasant Saturday he had passed. He had done pretty much nothing but watch a little television and study charts of stocks on his watch list. He had also played on a few social network sites. Since he had signed up for them, they had doubled his ‘wasting’ time on the Internet. He did enjoy connecting with likeminded people, although maybe a little bit too much.

He truly loved the fact that he could talk to people around the world who thought the way he did.

He would definitely be keeping his eye on any social networking sites that went public. He believed social networking was heading into the age of Internet 2.0, with much of what excited investors in the late nineties coming to pass this time around.

Stock Trader believed eyeballs on the Internet were beginning to really have true value, similar to the belief in the go-go Internet boom years that saw the NASDAQ climb to 5,000 points.

While stumbling onto Internet friends, he found it odd that so many traders were free market capitalists; many held the same political beliefs as he did, even reading many of the same books and supporting the same political candidates.

He believed his communications with Optionz Traderz had grown into a true mentoring friendship, even though some had thought they had a blossoming ‘bromance’ in the group, whatever that meant.

With the markets closed and Stock Trader bored of surfing the Internet, he thought he had done well to not bother Optionz yet. But by 11 a.m., he could take no more; it was time to get in the mix and learn something about options.

Stock Trader saw that Optionz was online. Not wanting all of the rest of the group to butt in with nonsense, Stock Trader sent Optionz a direct message so they could chat online privately.

Stock Trader: Hey, how are you doing today?

Optionz Traderz: I am great, just catching up on some e-mails before I go for a run.

Stock Trader: Do you have time now or later to run through the last of the option strategies?

Optionz Traderz: Sure, I am in no hurry. I have all day.

Stock Trader: What were the last two strategies you teased me with yesterday?

Optionz Traderz: Correct me if I am wrong, but I think the only two main option strategies we have not discussed are the Butterfly and Condor.

Stock Trader: Yes, the bird and the bug; you have not explained the flying ones.

Optionz Traderz: LOL, I have never thought of them as the ‘flying ones.’ That is funny!

Stock Trader: Most options and strategies have some reasoning behind their names. A Call option is so named because it enables you to call a stock away from someone;  a Put option allows you to put a stock on someone; a Straddle option play allows you to straddle a price in both directions; creating a Synthetic Stock position through a Long and Short option mimics the underlying shares. But why name an options strategy after a bird or a flying bug?

Optionz Traderz: Well, the reason is that these strategies have a ‘body’ of short options and ‘wings’ of long options. The wings ensure that the losses are controlled if the option trader is wrong about the market’s trading range. Condor and Butterfly Spreads are just combinations of a two Vertical Spreads. The most basic of these, a Long Call Butterfly or Long Call Condor, is a Vertical Bull Call Spread combined with a Vertical Bear Call Spread. I’m sending you diagrams of the possible profits and losses at expiration. Maybe that will help clear things up.

Stock Trader: That looks simple enough. A Butterfly has a much narrower range than a Condor where it is profitable, but the potential profit is much lower for the Condor.

Optionz Traderz: As always, it’s all about risk and reward. The higher potential reward of a Butterfly is balanced by the very high risk of a small loss. The Condor has a much higher probability of turning a small profit, but that is balanced by a higher potential loss. The potential profit and loss is also affected by the width of the body. Butterflies and Condors with wide bodies are much more likely to return a profit, and the potential profits are higher than would be expected from those with small bodies. However, the higher probability and higher potential profit comes with an increase in the potential loss.

Stock Trader: That makes sense. Does it work the same way with Puts instead of Calls? It seems like if I bought an in-the-money Put and sold two Puts at-the-money and bought another Put out-of-the-money, it would react the same as if I used Calls.

Optionz Traderz: That is correct. Many traders use the term ‘Butterfly’ to refer to a Spread formed entirely from Call options. Others like to use the term ‘Long Call Butterfly’ to distinguish it from the one you described, which is often called a ‘Long Put Butterfly.’ There are also Iron versions that combine Calls and Puts. The Iron versions of these are nothing more than a Short Straddle surrounded by a Long Strangle as insurance against being wrong.

Stock Trader: Iron? Like an Iron Butterfly or Iron Condor? That sounds ridiculous but I think I have heard of an Iron Condor before. I must have lived a sheltered stock trading life. With putting Spreads inside of other Spreads or Straddles inside of Strangles it reminds me of Thanksgiving ‘Turducken,’ a chicken inside a duck, inside a turkey.

Optionz Traderz: You could say that, I guess.

Stock Trader: It is almost like a football team, with an offense being the Short side and the defense being the Long side.

Optionz Traderz: LOL, you are really letting the analogies fly today. I think you are accurate in your examples though.

Stock Trader: It helps me to grasp your concepts when I put them in terms I can understand.

Optionz Traderz: Iron Butterflies and Iron Condors don’t behave much differently than standard Butterflies or Condors. I’m sending you a payout diagram of an Iron Butterfly on Boeing that you can compare to the Long Call Butterfly.

Stock Trader: I see what you mean; the profit and loss on the Iron Butterfly is almost identical to that of a regular Butterfly. I guess if the payouts were very close, it would make more sense to use a regular Butterfly because it would require fewer trades and therefore lower commissions.

Optionz Traderz: It’s always a good idea to compare and cut your commission costs when possible.

Stock Trader: Any other ideas?

Optionz Traderz: You should also consider the commissions on the closing trade. An Iron Butterfly will always expire with at least one but no more than two options in-the-money, whereas a Long Call Butterfly can expire with all options being completely worthless, or as many as four options in-the-money.

Stock Trader: That’s a good point. Iron Butterflies cost a little more in commissions at the open, but can be less expensive to close.

Optionz Traderz: You should also check your broker’s commission schedule for exercises and assignments; often the cost is much higher than regular option trades. If you open a Long Call Butterfly and the underlying price suddenly shoots way up, the options you traded might lose their liquidity. In that case, you would not only be stuck with a losing trade until expiration, but also be required to pay the commissions for two exercises and two assignments. It could also come back to haunt you at income tax time; even if the exercises and assignments did not increase your tax liability, it could be an accounting nightmare.

Stock Trader: There you go again, pouring a bucket of cold water on me just when I was warming up to the idea of trading Butterflies and Condors.

Optionz Traderz: Despite the downfalls, many professionals love these strategies as a means of generating consistent returns in normally functioning markets. However, they lose money in strong sustained trends. It has been my experience that sustained trends occur about 20% of the time. That percentage provides Butterflies and Condors with a long term winning probability of about 80%. The profits are made in a price zone, where the price of the underlying stock does not move consistently in only one direction. They do very well in range bound markets, sometimes giving the false appearance of the Holy Grail. They can also be profitable in volatile markets, as long as the market keeps swinging and does not take off in either direction.

Stock Trader: So maximum profits are made if the stock goes nowhere and ends up at expiration trading at the same price as it was at the time the trade was opened. The profits are the short option premiums minus the long option premiums?

Optionz Traderz: Condors have wider bodies than Butterflies, hence the name. They are both structured to capture profits in a range bound market and at the same time have insurance to avoid any huge losses due to unexpected epic trends in either direction.

Stock Trader: And an Iron Butterfly or Iron Condor is like a Short Straddle or Short Strangle, with insurance both ways?

Optionz Traderz: What a Butterfly Spread does is combine a Bull and Bear Call Spread. This option strategy uses four options at three consecutively higher strike prices. For a Long Call Butterfly, the lower two strike prices are used in the Bull Call Spread, and the higher strike price in the Bear Call Spread. As I mentioned earlier, Puts can be used instead of Calls and the performance is usually similar. Either way, a Long Call Butterfly or Long Put Butterfly strategy has limited risk but also limited profit.

Stock Trader: Sort of a trade for income, not big wins.

Optionz Traderz: Exactly. The Iron Butterfly is also created with four stock options at three consecutively higher strike prices. This option strategy is different from the standard Butterfly Spread because it uses both Calls and Puts, as opposed to all Calls or all Puts. However, as you observed on the payout diagrams that I sent, the performance of an Iron Butterfly is often very similar to that of a standard Long Call Butterfly.

The two options located at the middle strike in the Iron Butterfly strategy create a Short Straddle – one Call option and one Put option with the same strike price and expiration date. The stock options at the ‘wings’ area are at higher and lower strike prices and are created by the purchase of a Strangle – one Call and one Put at different strike prices, also with the same expiration date.

The Iron Butterfly strategy does a great job of limiting the amount of risk and reward because of the insurance the Long options give to the Short positions. If the underlying price falls due to a big down trend in the market, and the investor holds a Short Straddle at the center strike price, the position is protected to some extent, thanks to the lower Long Put. On the other hand, if the price of the stock rises, the investor is protected by the upper Long Call acting as insurance.

Stock Trader: O.K., I am going to have to save that post and read it again. But I think I understand the concept. The Long Strangle is the body guard of the Short Straddle, and the Iron Butterfly Spread makes money when the underlying stock is range bound.

Optionz Traderz: It seems like you have the basic idea. A Long Call Butterfly behaves almost the same as a Long Put Butterfly or an Iron Butterfly. The profit and loss potential on each strategy is nearly identical, and each strategy works best when the market or a specific stock is range bound. The only major difference between the three strategies is the amount of commissions required to open and close each trade.

Stock Trader: If all Butterflies are almost identical, how would you suggest choosing which one to use in order to limit the amount of commissions?

Optionz Traderz: That’s a great question. Butterflies can gobble up a lot of commissions, sometimes damaging an otherwise good trade. For example, take the Butterfly on Boeing Co. that I included in the diagram earlier. The maximum profit on that trade is under $200. I know of one ‘discount’ broker that charges about $10 per option trade and $20 for exercises and assignments. So assuming you chose a Long Call Butterfly, even if the underlying price remained a penny above the center strike at expiration, you would pay $30 in commissions to open the three legs of the trade and another $60 if you allowed the exercise and assignment of the in-the-money Calls at expiration. That $90 would eat up a big chunk of your profit.

Stock Trader: I see what you’re saying. If the underlying stock closed at a penny over the center strike price at expiration, a Long Put Butterfly would result in only $50 in commissions: $30 to open the trade and $20 to exercise the single long Put that was in-the-money. That’s still a lot, but much better than the Long Call Butterfly.

Optionz Traderz: Yes, so the Long Put Butterfly would be a better choice if the stock had found support but remained range bound, while the Long Call Butterfly would work better for a range bound stock that was hovering near a resistance level. Both strategies would perform about the same, but the commissions could be much different.

Stock Trader; I guess I could also save some of the commissions if I closed the trade on expiration day rather than allowing it to expire.

Optionz Traderz: That’s how the pros do it. Since Butterflies produce a limited amount of profit even when they work perfectly, allowing them to expire could result in unwanted risk that could quickly erase those profits. Think of it this way. Assume you opened that Long Call Butterfly on Boeing Co. and allowed it to expire with the underlying price a penny above the center strike. Not only would you pay the inflated commissions to exercise the Long Call and for assignment of the two Short Calls, you would also be taking on the added risk of the share price gapping up before the market opened the following week. Even if you were lucky enough that the share price remained steady or declined over the weekend of expiration, you would still need an additional trade to cover the short stock position that was created when the second Short Call was assigned.

Stock Trader: Good point. If I am only making a $200 profit on a trade, why pay $90 in commissions when I could cut that to $60 by closing the trade on expiration day? The added benefit would be that I would get to keep my profits without risking a loss that would occur due to an unfavorable move in the stock price after-hours on Friday or in the pre-market on the following Monday.

Optionz Traderz: The same reasoning applies to a Long Put Butterfly. Unless all of the options expired in-the-money or all of them expired worthless, you would end up with either a Long or Short position in the underlying stock if you didn’t close the trade before it expired. That can be a good thing if you are using Butterflies as a means of entering a stock trade. However, if you are trading Butterflies simply for income, it usually makes sense to close them on expiration day whenever possible.

Stock Trader: I think I understand Butterflies now. A Long Call Butterfly would work best on a range bound stock that was unlikely to push through resistance. A Long Put Butterfly would be more appropriate for a range bound stock that was trading near a strong support level, and an Iron Butterfly would also work well on a range bound stock, but with fewer trades and commissions required to close the positions on expiration day.

Optionz Traderz: The Condor option strategy also has a Bear and a Bull Spread, except that all four strike prices are different. The goal of the Condor Spread is to trade the higher potential profits of a Butterfly for lower sensitivity to small market movements, but with a slightly higher amount of risk than a Butterfly. As with Butterflies, Condors can be created using all Calls or all Puts, and the main difference between the two strategies is the amount of commissions required to close the trades.

The Iron Condor is also created by trading four different options with different strike prices, but it is composed of two Calls and two Puts. In the Iron Condor you are holding long and short positions in two different Strangles. The potential for profit or loss is limited in this strategy because an offsetting Strangle is positioned around the two options that make up the option Strangle at the middle strike prices.

This strategy is used when a trader believes the movement of the underlying stock will be range bound within the Strangle strike prices. An Iron Condor is very similar in structure to an Iron Butterfly, but the two options located near the center of the option strategy do not have the same strike prices like they do in the Iron Butterfly. Having an option Strangle instead of a Straddle at the two middle strike prices widens the area for profit, but at the same time makes the potential profits lower.

Stock Trader: These are some of the most interesting of all the option strategies you have shared. Very fascinating, low risk, and could generate consistent profits.

Optionz Traderz: Like with all option strategies you will have to be mindful of liquidity in your options and commission costs. With four options to buy and then sell, you want to ensure that you still have profits to make it worth your while after accounting for the loss of the bid/ask spread and possibly paying eight commissions to enter and exit. This strategy is used best with low commission costs and traded with size that makes it worth the trader’s time and effort.

Stock Trader: So that’s it. Butterflies and Iron Butterflies for a tightly range bound stock, and Condors and Iron Condors for a wider range of profitability. I’ll have to read through your posts again to really wrap my head around these strategies, but I think I have a good understanding of how they work now. Thanks for your help.

Optionz Traderz: I don’t mean to scare you, but there are still six more strategies for your toolbox.

Stock Trader: You’re joking, right?

Optionz Traderz: LOL, I’m not joking. But the good news is that they are all related to the Butterflies and Condors we have already discussed, so they won’t take long to explain.

Stock Trader: O.K., go ahead.

Optionz Traderz: As you noticed, Butterflies and Condors work well on range bound stocks. Just as with all of the other option strategies, there is an opposite strategy that works well under the opposite conditions.

Stock Trader: That makes sense. So what would be the opposite of a Butterfly?

Optionz Traderz: Many traders refer to such a strategy as a Reverse Butterfly. There is also a version called the Reverse Iron Butterfly. The same goes for Condors; there are Reverse Condors and Reverse Iron Condors.

Stock Trader: I’m guessing by the name ‘Reverse’ that they work best on stocks that are not range bound.

Optionz Traderz: Exactly. To create the Reverse Butterfly or Condor, all that needs to be done is switch the long and short positions. For example, a Long Call Butterfly consists of Long Calls at the wings and Short Calls in the center. A Reverse Butterfly, which is sometimes called a Short Call Butterfly, is formed with Short Calls at the wings and Long Calls in the center.

Stock Trader: So a Reverse Butterfly results in a profit if the underlying stock price moves outside of a very tight range?

Optionz Traderz: That’s all there is to it. With a Reverse Butterfly created using all Calls, it is like selling a Call Spread and buying a slightly less expensive Call Spread; the trade results in a small net credit. If all of the options expire worthless, the trader gets to keep the net credit, and if all of the options expire in-the-money, the trader is left with a Vertical Bull Call Spread with profits that exactly cancel the loss on the Vertical Bear Call Spread, again keeping the net credit. The only losing scenario for a Reverse Butterfly occurs when the underlying price remains unchanged at expiration.

Stock Trader: That seems like a great way to generate income, so there must be a downside you are about to mention.

Optionz Traderz: You know me too well. In theory, Reverse Butterflies are a great way of generating income no matter which way the market moves. However in practice, the income is rarely enough to offset the commissions. If you look at the Boeing Co. Butterfly diagram again, you will see that opening the trade in reverse would result in a maximum profit of just over $50. That hardly justifies the risk of a maximum loss of nearly $200, even before commissions are considered. To turn a profit, the number of contracts used would need to be large enough to offset the commissions and fees.

Stock Trader: That diagram really helps. If I trade a Butterfly on Boeing Co., I have a chance to make a $200 profit using just four option contracts, so that would cover the cost of the commissions; but if I trade a Reverse Butterfly, the $50 profit could be entirely lost to commissions unless I increased the total number of contracts.

Optionz Traderz: You’ve got it. It is very important to consider your position size when trading Reverse Butterflies in order to ensure that commissions do not steal all of your possible profits. Just as with regular Butterflies, Reverse Butterflies can be created three ways. They can be opened with all Calls; a Short Call Butterfly, all Puts; a Short Put Butterfly, or a Long Straddle surrounded by a Short Strangle; a Reverse Iron Butterfly.

Stock Trader: That makes sense. So my choice of which strategy to use would depend on whether I thought the stock price was more likely to go up or down. A Short Call Butterfly could have all of the options expire worthless if the stock price dropped, a Short Put Butterfly could have all of the options expire worthless if the stock price climbed, and a Reverse Iron Butterfly would guarantee that no more than two of the options would require a trade to close them at expiration.

Optionz Traderz: It’s as simple as that. All three strategies have similar behaviors, so it is the difference in commissions that sets them apart. The same is true of Reverse Condors. The Short Call Condor requires no closing trades when the underlying shares fall below the lowest Call strike, the Short Put Condor expires with all options worthless when the underling price rises above the highest Put strike, and the Reverse Iron Condor always expires with at least one option, but no more than two requiring a closing trade.

Stock Trader: You were right; those six strategies are not that difficult to understand.

Optionz Traderz: I’m glad I could help. Reverse Butterflies and Condors can be particularly useful when there is pending news surrounding a company, such as an upcoming earnings report. Unlike a Long Straddle, which can capture a strong move that results after earnings are released, a Reverse Butterfly or Condor will not change in value significantly due to the collapse in volatility that often occurs. Implied Volatility has an effect on both the long options and short options in a Butterfly Spread, so even when volatility does decrease after an earnings report, it usually has little overall effect.

Stock Trader: That’s a great idea, using a Reverse Butterfly to capture a move caused by an earnings report without the volatility risks involved in a Long Straddle.

Optionz Traderz: Another nice aspect about all Spreads, especially Butterflies and Condors, including the Reverse varieties, is that they normally react very slowly to changes in the underlying price. But that’s a topic for another day. I want to get out and enjoy this nice weather.

Stock Trader: Got it. Thanks for that last piece of the puzzle concerning option strategies.

Optionz Traderz: O.K., now it is time for a run on the beach. I will see if I can beat my best time.

Optionz Traderz is now offline……

Optionz’s generosity never stopped amazing Stock Trader. He smiled at the thought of Optionz’ beach run; he himself would soon get to be ocean side on his upcoming, much-deserved vacation. He was really looking forward to enjoying some hot weather and meeting up with his old college roommate, just as he had done most every autumn since graduation. But until that day came, it would be back in traffic tomorrow morning.

“Good grief!” The very thought of the 9-5 grind made his spirit fall.

Chapter 14

DEALING WITH THE BEHAVIORAL PROBLEMS OF IMMATURE OPTIONS

“71 degrees Fahrenheit in Sunny San Diego, California” is what his smart phone said. A smile came across his face.

“Nice.”

With a week to go before he took off, he began his annual daydreaming about how great his vacation would be.

No more traffic, bosses, fellow employees, or monotonous work for two weeks of bliss by the ocean.

But for now he had to focus.

Stock Trader was casually looking through some option chains that baffled him.

He noticed for the first time how all the volume, open interest, and action started with the nearest date at-the-money options in both Calls and Puts, and the farther away and out-of-the-money he looked, the more chaotic they became.

When he looked up option chains and compared options with strike prices that were $90 or more out-of-the-money, the options all had about the same premium even though they had different strike prices and the same month of expiration. He figured the chances that they would all expire worthless probably played a big role in the price not being an issue. They were just random bets with close to zero odds of ever having any real intrinsic value.

He was amazed to see thousands of open interest contracts in strikes $200 out-of-the-money in the upcoming month, no doubt bought by mega bulls long ago that were now trapped in purgatory with no way of getting out. Two cents bid with 600 contracts of open interest was like trying to squeeze a camel through the eye of a needle with only 100 contracts a day in volume.

It was interesting to see that options deep out-of-the-money lost all relation to Delta and Theta movements and became simply priced based on demand from gamblers. Apple options deep out-of-the-money more resembled penny stocks for their lack of volume and random valuations based on a few random buyers than stock options of one of the world’s premier corporations.

It appeared to Stock Trader that the at-the-money front month Calls were like the big city with specific laws that were enforced and the farther away you went from this city the more you got into the lawless wild west of gamblers and gun slingers.

You could buy options a month out that had strike prices within $90 of the underlying price and get no move in your option for a $50 or more move in the stock.

He wondered what Optionz had to say about the weird movements in options when you do not get what you expected.

Bingo, as usual Optionz was online.

“He must live at his computer,” thought Stock Trader.

Stock Trader: When we left off the other day, you were talking about Butterflies and Condors being very slow to react to changes in the underlying price.

Optionz Traderz: That is true. One of the most common complaints I hear from option traders is that their options did not behave as they expected. Unlike stock trading, it is possible for the underlying price to move in a direction that is favorable to an option position and still lose money. There are also times when the share price can move against an option position and result in a profit.

Stock Trader: Yes, I think I remember you mentioning that when you were explaining Ratio Spreads. It seems a little counterintuitive that options sometimes behave opposite to the way one might expect.

Optionz Traderz: It can be frustrating, and it may be one of the main reasons that traders abandon option trading. However if you understand the behavioral problems of immature options, it will not only give you the confidence to stick to your proven system, but there may be times that you can take advantage of those behaviors.

Stock Trader: I’m not sure I understand. How is it possible to predict when an option won’t behave as expected?

Optionz Traderz: Well, it is not possible to predict how an option strategy will behave under all circumstances, but there are some general guidelines that can be used to make an educated guess.

Stock Trader: O.K., I’m with you so far.

Optionz Traderz: First, as you know, options have much less liquidity than stocks. There are almost always fewer option contracts traded than shares of the underlying stock. The result of the lower liquidity is that the bid/ask spread is normally much wider on options than it is on stocks, even on those that are heavily traded.

Stock Trader: I have looked up some option chains and I have to admit I was surprised to see that some of the bid/ask spreads were in excess of $1.00.

Optionz Traderz: Even on a heavily traded stock such as Apple, where the bid/ask spread on the shares is sometimes 5 cents or less, the spread on at-the-money options can be 25 cents or more. Generally, the further out you go in the expiration date of an option, the greater the spread. Also, depending on the particular stock, some expiration dates may be more popular than others. For example, there may be high volume on options expiring in one year and those expiring in one month, but almost no volume on those expiring in three months. In that scenario, it is likely that the bid/ask spread could be significant on the three-month-out options.

Stock Trader: You have mentioned many times that it is very important to consider liquidity when trading options, not only in terms of volume, but also the amount of open interest at a specific strike price.

Optionz Traderz: I’m glad you were paying attention because liquidity can drive an option trader insane if it is ignored. So now we can add a second behavioral problem to the mix: option premiums change much slower than the underlying share price.

Stock Trader: O.K. That I understand, thanks to your explanation of Delta. If I buy a Call option with a Delta of 0.5, the premium should initially change about half as fast as the underlying price.

Optionz Traderz: Correct. So here is where a lot of option traders lose confidence. When you buy a stock and the price immediately goes up, the trade will usually show up as an unrealized gain. Many discount brokers also offer very low cost commissions on stock trades, and some also offer free stock trades if certain conditions are met. A stock trade involving a very low commission might only need to experience a price increase of a few pennies to show a profit.

With options, most brokers charge higher commissions, and there are often fees that add to those amounts. The result is that every option trade will initially appear as an unrealized loss, first due to the wider bid/ask spread, and second due to the higher commission. Because the option premium changes slower than the underlying share price, it takes much more of a move to offset the initial loss.

Stock Trader: So every option trade will look like a loss when I first open it, and that loss will take longer to erase than it would on a stock trade?

Optionz Traderz: Exactly, and as we have discussed in the past, changes in the underlying share price can affect Implied Volatility, which can cause unexpected changes in option premiums. This is especially true of immature options; those with the longest amount of time to expiration are generally more vulnerable to changes in volatility than those nearing expiration day.

A Call option may not gain as much value as expected, when the underlying price rises, if the market perceives the increase in price in a way that causes fear of falling prices to diminish. The decrease in Implied Volatility is reflected in a smaller increase in the value of a Call due to the effect of Vega. Likewise, a Call may lose less value than anticipated if a decrease in the underlying price creates fear and uncertainty for traders.

The opposite is true of Put options, which normally gain value more quickly in a downtrend while also losing value more quickly in an uptrend.

Stock Trader: So Puts are more sensitive to changes in the underlying price than Calls?

Optionz Traderz: As a general rule they are more sensitive, but there are times when volatility does not match the direction of the price movement. It is possible for the underlying price to rise while Implied Volatility is increasing and decrease when volatility is falling. I believe one of the easiest ways to understand this is by studying options on an inverse ETF, such as a bear ETF that mimics the opposite behavior of the general market. When the market makes a strong downturn, Implied Volatility will usually increase, but a bear ETF will see its share price rise in spite of the Increased Volatility. The effect of volatility spreads across the market like a virus, infecting bull ETFs and bear ETFs alike. The result is that the options on bear ETFs may behave the opposite of what one might expect, as far as changes in general market volatility.

Stock Trader: I think I see where you are going now. A stock or ETF that tends to move in the opposite direction as the rest of the market might have Call options that are more sensitive than Puts.

Optionz Traderz: The effect is not often a huge one, but it is something to keep in mind. Inverse ETFs, precious metals, and commodities such as oil can all have price movements that contradict the rest of the market, and that can have an effect of the behavior of the associated options.

Stock Trader: You mentioned that the effect of volatility is greatest on immature options, so I’m assuming that it disappears as the option approaches expiration.

Optionz Traderz: Correct again. As options mature, they begin to act their age. When they reach the final days leading up to expiration, there are few surprises when it comes to changes in premiums. Also, volume tends to increase in the final days of trading, especially on expiration day itself, as traders roll out, exercise, or close their positions. The increased liquidity can sometimes narrow the bid/ask spread, which also makes the option premiums more predictable.

Stock Trader: So that would explain the increasing popularity of weekly options.

Optionz Traderz: That and the increased rate of time decay makes selling weekly options attractive. At the same time, the lower premiums on weekly options make them desirable for buyers who are attempting to limit their loss exposure. The combination of liquidity and the relatively small effect of changes in volatility cause the premiums of weekly options to be fairly predictable.

Stock Trader: Any other thoughts?

Optionz Traderz: Another behavior problem of all options, especially the immature ones, is that they like to sleep late.

Stock Trader: LOL, I’m not sure I understand.

Optionz Traderz: I’m sure you have noticed that stocks tend to have very high trading volume right after the opening bell. Normally volume drops off as the morning progresses and a final increase in volume then precedes the closing bell. Many stocks are also traded in the pre-market hours as well as after-market. Not so with options; they never start early or stay late.

But even with shorter hours than stocks, options aren’t content with a trading day that is confined to regular market hours, so they tend to sleep late. Most options have very little trading volume at the open, and the effect is usually more pronounced with those that have longer times to expiration. When a new chain of options is first introduced, it can sometimes be an hour or more after the open before a single trade occurs. The bid/ask spread, even on heavily traded options, can be significant in the first hour of each day’s trading.

Stock Trader: I would not have thought of that, but I believe you are correct. If an option chain normally experiences its highest volume at a particular time of the trading day, opening or closing a trade at that time could help ensure the minimum amount of loss due to the bid/ask spread.

Optionz Traderz: Yes, it’s just another way of decreasing liquidity risk. As we already discussed, immature options tend to have lower liquidity than those nearer to expiration.

Stock Trader:  O.K., if I understand what you have said so far. Immature options don’t always behave as expected. Trading volume is usually lower when an option has a lot of time remaining until expiration, which causes the bid/ask spread to widen. In addition, changes in volatility can cause immature Puts to be more sensitive to moves in the underlying price than Calls.

Optionz Traderz: You’ve got it. So let’s move on to immature combinations.

Stock Trader: As in Straddles and Strangles?

Optionz Traderz: Exactly. In a Straddle or Strangle, volatility tends to lower the sensitivity of the Call and increase the sensitivity of the Put. The result is that a Straddle may not behave as expected in an uptrend. The lower volatility may sometimes decrease the time value of both options enough to offset the increase in intrinsic value gained by the Call. The opposite is true in a downtrend, where volatility may cause a Straddle to increase in value faster than anticipated.

Stock Trader: That makes sense. So a Long Straddle is actually a slightly bearish strategy and a Short Straddle is a little bit bullish?

Optionz Traderz: Straddles and Strangles are often described as neutral strategies, but when the options are immature their behavior gives them a bias that makes them perform better in certain markets than in others.

Stock Trader: What about combinations of Calls and Puts in Synthetic Stock positions? Do they experience the same effects?

Optionz Traderz: Yes and no. They are exposed to the same forces as Straddles and Strangles, but the effect on one option is offset by the effect on the other. For example, in a Synthetic Long Stock position created with a Long Call and Short Put, the Call’s performance will tend to lag in an uptrend, but the decrease in volatility will increase the performance of the Short Put; they cancel each other out. Synthetic Stock positions are essentially immune to all of the behavior problems of options, except liquidity.

Stock Trader: So with Synthetic Stock, I am selling Theta to buy Theta, selling exposure to Vega and buying exposure to Vega, and selling negative Delta and buying positive Delta.

Optionz Traderz: I’ve never seen it worded quite that way, but you are correct. Everything cancels out except that selling negative Delta is equivalent to buying positive Delta, so you are essentially buying Delta, twice. Disregarding the loss on the bid/ask spread, the position should behave the same as the stock, dollar for dollar, no matter how much time remains until expiration.

Stock Trader: Any other behavior problems I should know about?

Optionz Traderz: Let’s see… We talked about Spreads. Spreads are not entirely immune to changes in volatility, but the effect is reduced considerably. In a Vertical Bull Call Spread, if the underlying price rises, any decrease in Implied Volatility that lowered the time value of the Long Call would also tend to decrease the value of the Short Call. The effect of volatility is not exactly the same at two different strike prices, but it is usually close enough that it does fall into the ‘bad behavior’ category. By far, the biggest behavioral problem with immature Spreads is that they are lazy. However, as I mentioned a few days ago, you can use that behavior to your advantage, cutting losses when trades move unfavorably and holding winners until they mature enough to show their true value. I’m sending you a chart to show what I mean.

Stock Trader: LOL, thanks for sending this. I can really see what you are implying when you say immature options are lazy. The Vertical Spread using monthly options was very slow to react, even when the share price was up and down as much as $25. The weekly options were much faster at picking up the full value of the Spread.

Optionz Traderz: The weekly Spread can also lose value much faster if the trend goes against you, so those options aren’t necessarily a better choice. It all comes down to your trading style and personality. Some traders would prefer holding the monthly Spread for an extra two weeks, given that the Long Calls ended the week more than $25 deep in-the-money. Other traders would rather take on the additional risk of the weekly Spread quickly becoming worthless in a downtrend, in return for the faster price discovery in an uptrend.

Stock Trader: So it’s ‘slow and steady,’ or ‘fast and furious.’

Optionz Traderz: That’s one way of looking at it. The effect becomes even more evident when multiple Spreads are used, such as with Butterflies or Condors.

Stock Trader: So a Butterfly Spread will have an even slower price discovery than a single Vertical Spread?

Optionz Traderz: Normally that is the case. Unless there is a very strong trend in one direction or the other, a Butterfly will usually experience little change in value until the week of expiration. Even then, most of the change occurs during the last few days. There are times when the underlying price can move to a point that would result in the maximum profit for a Butterfly, and that profit might not fully reveal itself until the very last day of the contracts.

Stock Trader: That seems reasonable. If I open a Long Call Butterfly Spread, and Delta is 0.6 on the lowest strike, 0.5 on the middle strike and 0.4 on the highest strike, small changes in the underlying price will have little effect. The two Long Calls would gain 60 cents and 40 cents respectively, for every dollar increase in the stock price, and the two Short Calls would lose 50 cents each.

Optionz Traderz: A Butterfly can be nearly Delta neutral when it is initially opened. The profit from a Butterfly is a result of slightly faster time decay on the Short options compared to the long ones. Because the difference in Theta is usually quite small, it takes a lot of time for a Butterfly to realize a profit. Even when a Butterfly trade works perfectly, if one-month-out options are used, it can take about three weeks to see the first half of the profit. The final half of the time decay usually occurs in the final seven days.

Stock Trader: I see, so the same should also be true of Reverse Butterflies and Condors; if the trade is in a position to experience its maximum loss that loss might not appear until the final days of trading.

Optionz Traderz: Exactly. That makes it very easy to trim losses. However, as we discussed earlier, Butterflies and Condors have an additional behavioral problem: they eat too much.

Stock Trader: Now that analogy I get! With as many as eight trades required to open and close a Butterfly or Condor, those trades can really eat up a lot of commissions.

Optionz Traderz: I think that about covers most of the unexpected behaviors you might experience with the different option strategies. There are a few additional problems that can cause all options to act in ways that can catch you off guard if you aren’t prepared for them, regardless of the strategy.

Stock Trader: O.K., I’m ready.

Optionz Traderz: I think we have talked about this before, but it bears repeating. Dividends can cause options to perform strangely. Option premiums are based on the expected price of the underlying stock at expiration. If an ex-dividend date occurs prior to expiration, those premiums will have the expected dividend-induced decline in the share price baked-in. Puts become slightly more expensive and Calls a little cheaper.

Stock Trader: I do remember you mentioning ex-dividend dates in the past.

Optionz Traderz: Assuming all other market forces remain unchanged, the passing of the ex-dividend date will result in the price of the underlying shares falling by an amount which is normally a percentage of the dividend itself. However, the premium on the options expiring after that date will not usually change much. For example, if you sold a Covered Call and the stock went ex-dividend, the share price would likely decline but the Call premium probably would not, although you would be entitled to receive the dividend when it became payable.

Stock Trader: Got it! Any other ideas?

Optionz Traderz: I hope you’re not timing me, because I am about to mention the Holy Grail again.

Stock Trader: It doesn’t surprise me to see Rookie bring it up, but you?

Optionz Traderz: I don’t intend to disappoint you, but Rookie’s infamous no-loss trade can be helpful in understanding the effect of dividends.

Stock Trader: So we are back to selling a Covered Call and buying a Put at the same strike price.

Optionz Traderz: Exactly. The only difference now is that instead of being guaranteed not to lose money on the stock, you would be entitled to the dividend. In theory, the Call should be ‘underpriced’ and the Put “overpriced’ so that opening such a trade would result in a guaranteed loss equal to the expected gain from the dividend.

Stock Trader: In theory?

Optionz Traderz: I say ‘in theory’ because option pricing is more of an art than an exact science. There may be times when such a trade could result in a loss that would be less than the profit from the dividend, what might be called an arbitrage opportunity. However, it has been my experience that few stocks have options with enough liquidity to make such a trade profitable enough to account for the loss due to the bid/ask spread.

Stock Trader: You’ll have to tease Rookie with that one sometime. I’m sure he’d like to find out that the Holy Grail actually exists. It just doesn’t work in real life.

Optionz Traderz: That’s funny. But seriously, the true Holy Grail of option trading is risk management. Understanding how options behave and learning how that behavior can change as options mature is one of the keys to successfully managing your trades.

Stock Trader: So are there any other behavioral problems to consider?

Optionz Traderz: In the past, we have discussed news events and their effect on options. Immature options are more likely to be influenced by changes in volatility than those nearing expiration.

Stock Trader: So the collapse of volatility after the release of an earnings report would have a greater influence on longer term options?

Optionz Traderz: That is often the case. However it might depend on how often that particular company reported its earnings. If another report was expected prior to expiration of a long term option, Implied Volatility might remain elevated on that option while simultaneously evaporating on a near term option.

Stock Trader: I have always found it strange that Implied Volatility can be different depending on the amount of time to expiration, but that makes sense. If there was increased uncertainty due to a future earnings release, Implied Volatility might be higher on long term options than those with shorter terms.

Optionz Traderz: Immature options also have one additional behavior issue. They are at a higher risk of being affected by a stock split or reverse split.

Stock Trader: When a stock split occurs, aren’t the options adjusted to reflect the change?

Optionz Traderz: Yes, they are. However, it often takes time for the adjustment to be completed. During that time, options are normally unavailable for trading, and you could get stuck with a bad trade if the blackout on trading happens to coincide with some unforeseen event in the market.

Stock Trader: That’s a lot to think about, so I’ll let you go, in case you want to take another run on the beach. Thanks for all the help again.

Optionz Traderz: As always, you’re welcome. I would go for a run, but my legs are still tired from yesterday. I may go for a swim though; the weather this week has been unusually hot, even by Southern California standards.

Stock Trader: That is funny. I will be in San Diego in a week on vacation. Too bad California is such a huge state. Where do you live, if you don’t mind me asking?

Optionz Traderz: Long Beach.

Stock Trader: Oh, where is that?

Optionz Traderz: Well, you can get from San Diego to Long Beach in two hours with no traffic. Of course we have plenty of traffic in California, LOL.

Stock Trader: Really? What do you say about us meeting for a few beers while I am there?

Optionz Traderz: How about I get a martini or margarita? I really hate beer. Yuck!

Stock Trader: O.K., as long as you let me talk options and trading you can drink whatever you want.

Optionz Traderz: That sounds like a deal.

Stock Trader: Oh, and it will be my treat for all your teaching about options.

Optionz Traderz: Now that sounds like a good deal.

Stock Trader: Have a great swim, my friend.

Stock Trader was very excited about the prospect of meeting Optionz face to face in California. It would be great to break his normal monotony of reading books on the beach and relaxing as a lone wolf for the majority of the time with some quality time with his college buddy mixed in.

So few people really understood him and his goals and he felt like Optionz was already living his dream. Maybe he could be a mentor?

Stock Trader thought that a man who didn’t like beer was just odd, and he personally would never get caught drinking a martini in public.

He also had the funny thought that maybe Optionz could introduce him to some lady friends and they could double date, but how good could he be at the dating game while drinking girly drinks?

This would no doubt be a trip to remember.

Chapter 15

A TRADER’S CHOICES: INSURANCE, STOP LOSSES, OR RUIN

Stock Trader awoke staring at the ceiling.

What a wonderful morning for him. No alarm, no traffic, no work day. He drifted back into a blissful sleep.

An hour later he awoke with the wonderful feeling that one gets on the first morning of a long vacation. He wanted this feeling to last.

He had to get going, though, as his plane left in three hours. He had to leave plenty of time to be frisked, x-rayed, and groped by security before boarding the plane, or so he had heard.

“What to take?”

He pulled three new trading books out of his bookcase that he was currently enjoying reading. All of them were about options, the world of Collars, Married Puts, Spreads, Synthetics, etc. He really was beginning to feel more confident about trading options with each book he read and each online chat with Optionz.

“Clothes, check, belt, check…”

“Wait, I need some trading magazines for the plane; here are some good ones,” he thought, as he shoved them in his bag.

“I also need beach stuff, swimming trunks.”

“I am scared to take anything that will not be allowed on the plane, I think liquids are pretty much banned. I guess I will just have to buy those when I get there,” he thought.

He went to his computer and tweeted out on his 2nd favorite social network site:

On his main social networking site he posted as his status:

Stock Trader: I am flying out to San Diego today, planning on having a blast with my friend John. I am also planning to meet the legendary trader and teacher, Optionz Traderz, in person for the first time.

He was finishing up his packing when a comment hit his post a few minutes later.

Optionz Traderz: I am looking forward to it.

Stock Trader: Me too.

It was time to be off to the airport.

The security was not nearly as bad as he had dreaded and he was soon on the plane.

He had a copy of the day’s financial newspaper and read on the front page that the airline company handling his flight had filed for bankruptcy that very morning.

“Wow,” he thought. “That’s just my luck.”

The flight went on and on. With no computer and not even a smart phone to play with, Stock Trader tried to focus on his magazines and books, but he really missed the markets and the interaction online with other traders. He truly had a passion for the markets. He loved nothing more than catching that big trend and letting it run and run; for him that was happiness. However, he had to deal with the times he was wrong also.

With each loss he would think to himself and sometimes say out loud,

“The market giveth and the market taketh away; if I manage my risk I will live to trade another day.”

While it didn’t remove the pain of losses, it helped refocus his mind on the next trade.

Finally, he could see the ocean out of his window. He was in San Diego and the plane prepared to land.

He felt a little wobbly leaving the plane after sitting still for so long. A four-hour flight was a long time for him to try to sit and entertain himself.

He carried off his bag and finally made his way to the lobby after weaving his way through an endless crowd of people.

Stock Trader made his way to the car rental place and got his wheels, a red Mustang.

“Nice,” he thought.

With his handy smart phone he updated his status.

Stock Trader: Mission accomplished, the eagle has landed.

He made his way to the hotel and checked in. He went to his room and immediately loved the view: water for as far as the eye could see. It was a different world from the land locked state he was used to.

“Freedom!” he said out loud.

“Now where do I begin? Should I call good old John or the legend of Optionz? Hmm… college stories or option and trading talk? ”

As much as he wanted to meet his Facebook trading friend in person, he knew his old college buddy would be awaiting his call. Sure, he was married now, but John was always up for some fun and Stock Trader really enjoyed relaxing over a few beers and reminiscing about some of the crazy times in what now seemed like the distant past. Besides, he would be here for two whole weeks, plenty of time to share college stories and also learn about options.

A cold beer sounded like a nice way to unwind after that long flight. Unfortunately, his phone call to John went to voicemail.

He looked out of his hotel window at the paradise below; the late afternoon December sun shining over the seemingly endless beaches, dotted by the occasional surfer or body-boarder.

He changed out of his winter clothes into some shorts, unpacked a trading book and smart phone, and was off to the front desk.

After renting a beach chair and obtaining the hotel’s Wi-Fi password, he was soon sitting with his feet in the warm sand, listening to the sound of the waves.

“This is the life,” he said to himself.

But still, he felt the need to connect with Optionz.

He took out his phone and sent Optionz a direct message through the site.

Stock Trader: I am in your neck of the woods; any thoughts on when we can meet?

About five minutes later he received his response.

Optionz Traderz: How about a nice Sunday brunch in Long Beach? I will send you the address in a message. How about noon?

Stock Trader: That sounds great. I guess I need to adjust to Pacific Time from Central, so it will be like my 10 a.m.

Optionz Traderz: My real name is Terry and I will be wearing all green, money green to be exact.

Stock Trader: My off-screen name is Jack. I look forward to it, see you then.

“Wow, very eccentric. All green?” he thought. “This should be very interesting.” He had pictured them meeting up to leisurely discuss options over some steaks at dinnertime, but brunch would be O.K. too. It was probably just as well. With his stomach still set to a different time zone, a heavy meal might not be such a good idea. Still, there was something about meeting a man for brunch that made him feel uneasy.

A while later John returned Stock Trader’s call, and they spoke for over an hour about life, goals, and the future, catching up on old times and dreaming about the future. After an hour, John got a business call from an important client, so they agreed to pick up their conversation in person later. John was free after work on Tuesday, and that fit nicely into Stock Trader’s plans. Stock Trader ended up sitting on the balcony of his room and drinking a beer with lime and watching the sun set over the ocean. It was a great first day.

The next morning he woke up early without the assistance of an alarm clock. He felt excited and invigorated.

“Was it his job that was sucking the life out of him?” he wondered.

Then guilt rushed in; he should be thankful to have a job in this day and age of recession.

He checked his GPS to see that the restaurant was about two hours away. Soon he and Optionz would meet; they would be transformed into Jack and Terry. It was like being unplugged from the Matrix.

The drive was simply beautiful. Jack, the stock trader, dreamed of retiring from his job and moving here into a nice condo by the beach. That would be the life that Optionz was living now.

He got to the freeway exit and felt the butterflies in his stomach. He was hoping he could hang with Terry the options trader in real life, talking without the pauses of thinking and typing.

He pulled into the restaurant parking lot and there, in real life, was parked the pink Cadillac he had looked at online for so long. He got out of his car and walked beside it – perfect condition.

But he couldn’t help thinking, “What man in the world drives around in a pink Cadillac, wearing all green?”

As he walked into the restaurant he saw a portly man wearing a green football jersey and blue jeans waiting to be seated. His spirits fell.

“Terry?” he said while holding his hand out to shake.

“No buddy, my name is Billy,” he responded.

“Oops, sorry, I am waiting for someone,” he said, embarrassed.

“Can I help you?” Jack was asked by the smiling and friendly hostess.

“Yes, I am waiting on a friend,” he replied.

“Is your name Jack?”

“Yes.”

“Right this way.”

The hostess led him to a table by the window where a very attractive lady was seated.

Jack was disappointed again.

“I guess Optionz brought his girlfriend to brunch, and she is also wearing all green. Good grief! He never mentioned he was bringing his girlfriend!” he thought.

He hid his disappointment and introduced himself.

“Hello, I am Jack, known as Stock Trader online,” he said, as he held out his hand to shake.

“I am Terry, better known as Optionz Traderz with two ‘Zs,’” she responded.

Stock trader Jack had that strange moment of vertigo, when a person is so surprised they feel as if up is down and down is up. He sat down at the table unable to hide his surprised look from Terry.

“What is wrong? You look surprised,” said Terry.

“I uh, just… uh, pictured you looking differently,” said Jack.

“What does an option trader look like?” she asked.

Not wanting to offend, he tried to choose his words carefully and tactfully, but he was not quick enough.

She looked at him sternly and asked.

“What, you don’t think girls can trade options?”

Jack was stunned and speechless, but Terry let him off the hook by breaking out in laughter. He was relieved that she was not offended. Suddenly a bunch of things made sense: the margaritas, the pink Cadillac, the pet tortoise, the endless patience with other traders; it seemed obvious in hindsight.

“It is so great to get to meet you in person. I feel like you are my option trading mentor,” Jack said.

“I have also enjoyed our online chats,” Terry said.

“I realized on the drive up here that I wanted to be just like you when I grow up,” Jack said with a playful grin.

“It is a great life, if you can handle the heat in trading and on the beach,” Terry said jokingly.

“Well, I am not scared of the beach, so I guess I better just manage the heat in my trading,” responded Jack confidently.

“So, how was the drive from San Diego?” asked Terry.

“Not what I expected,” answered Jack. “There was very little traffic, and the countryside is so green; it hardly looks like the middle of a desert.”

“Yes, December is a beautiful time of year here in southern California,” Terry replied. “And the traffic isn’t always as bad as its reputation, especially on a Sunday morning. That’s why I suggested meeting for brunch. Late afternoon Sunday traffic can be a nightmare.”

The waitress came and took their orders and they soon drifted off into option talk, even faster than Jack had expected, having just met face to face.

“I am only able to trade for a living because I manage all my positions carefully, first with the correct position sizing, then stop losses, and at times insurance when needed,” said Terry.

“You have touched on these before. I am all ears, and this is much easier without you having to type each response.” Jack relaxed in his chair and got comfortable.

“I never risk my lifestyle or net worth on any one trade. A good risk is 1% to 2% of trading capital on any given trade, for most systems. Also, I do not expose my accounts to more than 6% of total capital loss at any one time based on multiple trades. Of course market gaps, like the ones we have seen recently, can take more than you planned; but 6% is a good basis point. That is why it is important to have adequate capital to trade with for a living. If a 2% gain in total account capital in your account can pay for your living expenses, then you are in business. A $200,000 account with a monthly return of $4,000 is definitely doable with a robust strategy. If you are risking a total of $2,000 per trade, you only have to be right a few more times than you are wrong to win for any given month. Or if you are right much bigger than wrong, you can do very well,” explained Terry.

“So if I risked, say, 1% of total capital per trade in a month, and had three stop out with losses for a total of $3,000 and five wins that made $5,000, because they were all equal, then I would have a 2% gain that month?” asked Jack.

“Exactly, that is how you trade risk. Of course, in real life we would hope the winners were much bigger than the losers, just as you would expect with stocks, based on your trend trading style. Trend trading, using stop losses or trailing stops, is very similar to many high-probability option strategies.”

“In options you also have the benefit of using insurance as opposed to stop losses. In a Butterfly and Condor the Long Calls or ‘wings’ are insurance for the Short ‘body’ of the option strategy against a wild trend. In a Married Put or Collar, the Long Put is insurance for the stock. Investors at times may buy Puts to protect gains in their holdings which for whatever reason they do not want to sell. This alternative does not exist with stocks; there you just have to use stop losses and trailing stops,” finished Terry.

“I think I understand all of that except the Collar. I don’t recall you mentioning that strategy before,” said Jack.

Terry quickly apologized. “I’m sorry if I left that one out during our online chats. A Collar is simply the selling of an out-of-the-money Call in order to offset some of the cost of the premium of a Married Put. I personally don’t use Collars very often because they can be simplified using synthetics.”

Jack pulled out a small notebook he had tucked into his shirt pocket and began to flip through the pages.

“I see you’ve been taking notes,” Terry chuckled, “I’m impressed.”

“I like to keep a journal of my trading ideas. I find it helps me to avoid repeating mistakes I have made.” Jack quickly flipped through a few more pages. “Here it is; I wrote down the formulas you gave me for synthetic option positions. Let’s see… A Married Put is the same as a Long Call. If I add that to a Short Call, it makes a Collar the same as a Vertical Bull Call Spread?”

Terry smiled and then replied: “You are correct. I probably should have talked about Collars earlier because they can be useful in protecting gains on a stock you already own. The Put acts as insurance against the stock price losing value, and selling the Call helps offset some or all of the cost of that insurance.”

Their brunch arrived. French toast, pancakes, bacon, eggs, and hash browns; it all looked great to a hungry pair of traders.

“If you want to trade options you have to think of risk first and profits second. You have to understand all elements of risk in each trade. The Theta that will evaporate on your Long options, the directional trend risk on your Short options, the expiration date when they will become worthless, the percentage of your capital that is at risk in each option play. With options there is the risk that you will have volume dry up as you win, with your position ending up so deep in-the-money that you might have to take a big loss to close your winner. If you just wait for it to be exercised at expiration, then you run the risk of the trade going against you. So an exit strategy should be planned to avoid this situation, among many others,” explained Terry in her calm, confident voice.

“So I take it that risk is by far your number one theme that you think about before anything else while planning an option trade?” asked Jack.

“You would be correct. The question is not how much can I make if I am right, but how much can I lose if I am wrong? What is my possible upside and what is my possible downside? If my possible upside is small and my possible downside is huge, then no trade is warranted. I want a good reward/risk scenario to make it worth my trouble,” she said.

“That is the same principle I use for trading stocks,” Jack added.

“I do trade options with the same ideology, but as you know, there are many more moving parts and possible outcomes with option strategies. An option trader should carry much more of a cash position than a stock trader. You can very easily get 30:1 leverage with options, but you really only need 1:1 leverage with a large account. So you can keep 90%-95% of your capital safely in cash and focus your attention on just the very best trades. It is very dangerous to get carried away with options and have dollar signs in your eyes and just go for what you think is a can’t miss trade – which is all fun and games until you blow up your account with just one bad ‘can’t miss’ trade that puts you out of the game,” cautioned Terry.

“I know what you mean. I have to keep catching myself not fully grasping the leverage of trading 10 contracts because it may only cost me $3,000. But unlike stocks where the worst move may be 7% or 8%, options can go down 50% in a few days due to an adverse move in the underlying. I have to get used to much smaller trades and much bigger percentage moves,” said Jack.

“I believe options have a tendency to amplify emotions as they amplify leverage; it is more difficult to trade with Theta ticking away each day on your Longs and violent moves against your position taking away big percentages while liquidity is drying up and the bid and ask spread is expanding against you. It can become intense, and if you add trading too big of a position to the balls you are already trying to juggle, you may not be able to think rationally with all the heat,” cautioned Terry.

“I have been warned,” Jack assured her.

“Define your risk before any trade. What percentage of your account can you risk? How many losses can you handle in a row? If you are using options as insurance, place them as a hedge at a point that controls your total risk in your position to less than 1% or 2% of your total capital. You have to get your risk down to an amount that eliminates your risk of ruin, the risk that you will eventually blow your account up completely by risking too much per trade. It all starts with a percentage at risk then a proper position size,” she cautioned again.

“I am familiar with the risk of ruin; I agree with you. If you divide your capital into equal increments and then risk 1% of your capital per trade, then after 10 losses in a row you are down 10%; risk 10% of your capital per trade and after 10 straight losses you are ruined. That is risk of ruin in a nutshell,” Jack assured her.

“Anyone who has been trading for a while has had ten straight losses in a row. Some hedge funds mismanage their risk so badly that all it takes is one big loss and they are done,” said Terry.

“That is sad, but amazingly true,” agreed Jack.

Terry continued, “It is sort of like the traffic here in southern California. Anyone who has driven here long enough has been caught in multiple traffic jams. Anyone who ignores that eventuality is risking the consequences of being horribly late arriving at their destination. A hedge fund that mismanages risk is the equivalent of a job applicant taking the freeway to get to a job interview. Any unforeseen event could cause him to miss the interview, and he might never get a second chance.”

“Your analogies are as good in person as they are over the Internet,” Jack responded.

With empty plates and Jack thoroughly warned about the dangers of risk and the importance of stop losses and insurance, they had finished their first hour together. Jack was far more pleased than he had even imagined with this face to face meeting. Not what he was expecting, but he was very pleasantly surprised with Optionz Traderz turning out to be the lovely, friendly, and outgoing Terry.

Jack hoped this would be the first of many face-to-face meetings with Terry over the next two weeks.

“Could I get a doggie bag for these strawberries?” Terry asked the hostess.

“She is taking a handful of strawberries home; how odd,” thought Jack.

Seeing the perplexed look on Jack’s face, Terry explained: “They’ll make a nice dinner for my tortoise.”

As they left the restaurant, he opened the door for her and then they chatted for a minute as she got into her legendary pink Cadillac.

As she got into her car, Terry quickly said: “Oh, I almost forgot. I have worked out the odds for many different option strategies and I printed out a copy for you.”

“Thanks,” Jack replied, as he leafed through, scanning the many tables and graphs she had prepared. “I’m sure these will be as helpful as the rest of your advice.”

As she sat in her convertible with the top down, he asked her a question, somewhat nervously.

“What do you say about me taking you to dinner tomorrow night?”

“What are your intentions for this dinner?” she asked cynically.

He paused, then looked right in her eyes and said: “I just want to know more about what my options really are.”

There was an awkward pause. Jack thought surely he had missed the opportunity.

Maybe he was too nervous.

“Did she think I was nervous?”

“Maybe I didn’t appear confident enough.”

“Maybe I sounded too confident.”

He had taken a risk. But was the risk justified?

Then, with a giggle and a smile, Terry broke the silence. “I’d be happy to. Just send me a message on Facebook when you decide where you’d like to go.”

It was now early afternoon and Jack was feeling on top of the world. He had a date, not with any ordinary girl, but with his mentor. He felt they had a real connection, not just as traders but as people. During brunch they had shared not only option strategies, but also dreams and goals. It all seemed to be progressing so quickly, perhaps due to the amount of time they had spent together previously, chatting online over the past several months.

He programmed a few landmarks into his GPS and was soon cruising the streets of Los Angeles in his red Mustang – his idea of a dream car.

Los Angeles was certainly a deviation from the dull landscape of his hometown. He stopped for a break at the La Brea Tar Pits and then continued on past Universal Studios, the Kodak Theater, and the Hollywood Walk of Fame.

He continued to stop occasionally to snap photos on his phone as vacation souvenirs.

As he drove deeper into the Hollywood Hills, he finally found his ultimate destination, a spot with an unobstructed view of the Hollywood Sign. As luck would have it, some other tourists had also chosen the same spot and they gladly offered to capture a photo of him on his phone with the Sign looming in the background, high on the hills above. It would make a perfect profile picture for his social networking sites.

It was such a nice December afternoon, with people outside in T-shirts and shorts. This really was the good life.

As he programmed the GPS for the trip back to his hotel, his mind went back to something Terry had said at brunch. On a $200,000 account, $4,000 of income per month was not out of the question when trading options.

He had never seriously considered leaving his hometown before. But what was keeping him there? Was it his nine-to-five job? If he could earn more trading options than he could while working full time, there really was no reason to be tied down. He could trade options from anywhere. Besides, his friend John had offered to recommend him for a position with his employer in San Diego if he ever decided to relocate. He had never taken John up on the offer because it would have meant taking a pay cut from his current position. But what if he added the income from option trading to the mix?

He was quickly jarred from his daydream by a flashing sign on the side of the freeway. It read “SIGALERT.”

“Sigalert, what the heck is that?” he said to himself out loud.

It quickly became apparent that it meant he would not be getting back to his hotel anytime soon; traffic had slowed to a crawl, and the backup extended as far into the distance as he could see.

An hour later, the traffic began to thin out a little. In the meantime, he had managed to keep himself busy looking at the landscape, the mansions perched on the edge of hills as if they were on stilts, and homeless people washing the windshields of cars as they slowly made their way down the freeway off ramps. Some cars were full of girls in bikinis, probably on their way home from a day at the beach, and others had skis strapped to the roof. Things were certainly different here than what he was used to.

Three and a half hours later, he arrived at his hotel. Terry’s warning about the late afternoon traffic had proven to be accurate, just like all of her warnings about option trading.

The sun was still warm and there was a gentle breeze, so he went out onto the balcony with his phone and the charts Terry had given him. They truly told a story; every strategy had different risks and different potential rewards. It was one thing to talk about a strategy like a Vertical Spread, but to see the charts showing the odds really made it all so much easier to comprehend.

His curiosity was nagging him. Did Terry only accept his dinner invitation to be polite? Maybe she had posted something on Facebook that would give him a clue to her true feelings.

He logged on.

No new messages, no new posts.

He decided to see if she was in the Winning Traders group, as she always seemed to be.

Sure enough, there she was, engaged in a conversation with Rookie. He didn’t want make it appear as though he was obsessed with her, so he sat back and watched without interrupting.

Rookie Trader: I opened a Vertical Spread thinking it would be less risky than a Covered Call, but I lost $1,000 when it expired; that was almost half of my account.

Optionz Traderz: How many contracts did you use?

Rookie Trader: I sold 10 Calls and then bought 10 Calls two strikes higher.

Optionz Traderz: There’s your problem; you were risking too much capital on a single trade. Sure, it probably looked great on paper. You would have made a hefty profit if everything expired worthless.

Rookie Trader: But shouldn’t my broker have stopped me from opening the trade if it was too risky?

Optionz Traderz: That might be true if you were using a full-service broker, where you pay for advice as to whether your trade is in line with your goals. However, when you trade in a self-directed account, it is up to you to manage your risk. The broker’s responsibility is not to guard your account from loss, only to protect its own funds from loss due to the risks you are taking.

Rookie Trader: So what should I have done differently? I only have about $1,000 left in my account, and I don’t want to lose that too.

Optionz Traderz: In order to profit in the world of options, you need to follow the rules.

Rookie Trader: The rules? Do you mean your rules?

Optionz Traderz: Yes and no. There are rules to trading options for income, but I did not create them; they form a sort of ‘natural law’ that is based upon the properties of the options themselves. Just as there are rules to language, there are rules for successful trading. Some rules are obvious and some are more obscure.

For example, you need to learn words in order to communicate. However, it is not enough to simply learn the vocabulary; there are rules governing the usage of every word. Just as society determines the rules for sentence structure and grammar, the market determines the rules for options.

Learning options is a lot like learning a foreign language; it is not sufficient to learn the vocabulary of options. In order to succeed with options, you need to learn the correct usage. Still, even after learning the vocabulary and proper usage, being able to write and understand the new language on paper does not guarantee that you will be successful using it to interact with others in real time. In order to excel in the world of options, you need to speak the language fluently.

Rookie Trader: So what rule didn’t I follow correctly?

Optionz Traderz: I wouldn’t say it was any one rule; there are many. I would suggest that you read through all of the previous threads from this group where I have discussed many of the rules with other traders. You can’t pick and choose which rules to follow. To be successful as an option trader, you need to follow them all.

Rookie Trader: I will definitely read through the previous posts, but what is the biggest thing you would say I did wrong? I don’t want to repeat my mistake and lose the remaining $1,000 in my account.

Optionz Traderz: Well, the easiest way to avoid losing it is to stop trading altogether. $1,000 isn’t really a sufficient amount of capital to trade options anyway.

But if you are intent on continuing to trade, you must reduce your position size. You followed one of the major rules; you used insurance when you bought an option to protect yourself from ruin if your short position moved against you. However, you ignored another rule; you risked more of your capital than your account was prepared to handle. Then you ignored a third rule when you failed to either use a stop loss or close out of the trade when it moved against you.

Rookie Trader: So I should only be trading five contracts instead of 10?

Optionz Traderz: Actually, you should be trading less than that. On the Vertical Spread you mentioned, even one Short Call combined with one Long Call at a strike $2 higher would expose you to a loss of $200. Even if you collected $100 in net premiums when you opened the trade, you would still have a possible net loss of $100; that’s 10% of your account.

Risking 10% of your account on one trade is asking for trouble. In fact, a friend and I were just discussing this very issue at brunch today. It is usually a good idea to limit your risk on any single trade to 1% to 2% of your total capital. Unfortunately, your account has been drawn down to a level that does not permit that, but risking 10% is still much safer than risking 100%.

Rookie Trader: I guess I see what you’re saying. If I risk $100 on each trade, it would take 10 trades to completely wipe out my account.

Optionz Traderz: Exactly. It could happen, but it is unlikely you will have ten losing trades in a row. Even if that does occur, if it’s any consolation, I lost my entire account the first year I began trading options. That’s why I now risk no more than 2% on a single trade.

Rookie Trader: So you are saying that I should not be risking more than 2% of my money on one trade. 2% of $1,000 is $20. It doesn’t seem like I’ll ever get rich doing that.

Optionz Traderz: Probably not, unless you increase the size of your account, but you won’t blow your account up either. Let me ask you, when you opened your last trade, could you feel your heart beating faster as you pressed the ‘trade’ button?

Rookie Trader: Actually, yes. Does that happen to you too?

Optionz Traderz: No, not anymore. In fact, that can be one of the best warning signs you will get that you are breaking the rules. If your heart starts racing or you start to sweat, it means you don’t have faith in your trade or you feel you are doing something risky. Let me ask you this: Would you have felt the same way pressing the trade button if the most you could have lost was $20?

Rookie Trader: Well, of course not. Twenty dollars is no big deal.

Optionz Traderz: And yet $20 is 2% of your account. Now try to think of it this way: A trader with a $100,000 account who risks $2,000 on a single trade should feel the same way you do risking $20 –nearly emotionless. Both trades would result in a 2% maximum loss. Don’t let the dollar gains and losses of other traders concern you. It is the percentages that are important.

Rookie Trader: But if I am only getting small profits, I will never get anywhere. Why trade options at all?

Optionz Traderz: As I said earlier, I lost everything my first year. Then I read books, researched options online, and tested some strategies on paper. After starting over with an account about the size of yours, I was able to grow my capital over time. As my account grew, I was able to gradually increase my position size, which got me to where I am today. But as I was rebuilding my account after it collapsed, at no time did I intentionally break the rules. When you break the rules, the market will almost always find a way to punish you.

Rookie Trader: So the rule is 2% risk on each trade?

Optionz Traderz: 1% to 2% per trade is what worked for me, and I rarely risk more than 6% on all my trades combined. But when my account was small, there were times when it was not possible to meet those guidelines, so I got as close as I could. Like I mentioned earlier, 10% of capital at risk is not ideal, but it is much better than 100%.

Rookie Trader: So you’ve been where I am now. I guess I should have asked for your advice before I opened the trade, instead of after. Well, thanks for all the help. I’ll be searching through your previous posts to learn the rest of the rules.

Optionz Traderz: You are welcome.

Seeing that the conversation was over, Jack logged out of the group. He planned to send Terry a message later, after he had picked out a nice restaurant where he could take her for dinner. Maybe his friend John would have some dining suggestions; after all, he was always entertaining clients with fancy meals.

One part of Terry’s conversation with Rookie stuck in Jack’s mind. She said she had brunch with a friend. She considered Jack to be her friend. He felt good about that; he considered her to be a friend too, in spite of the fact that they had only met once in real life. They seemed to share so many similar ideas about trading, as well as life itself. Whether their friendship would continue was unknown, but he thought the probability was good.

This was really turning out to be a nice vacation.

Chapter 16

YOUR METHOD, YOUR RULES, YOUR EDGE

Jack opened his eyes. It was safe to get out of bed in a relaxed state. He was safely tucked away in a hotel and not about to battle the traffic for the reward of working in his cubicle cage.

He liked this feeling and wanted to keep it. How would he accomplish this?

His cell phone had a message from his social networking app.

Optionz Traderz: I had a great time yesterday. You are great company.

Jack felt a warm happiness in his heart which spread throughout his body. He was having a flood of mixed-up emotions. His mind was trying to combine ‘Terry’ that he met yesterday with ‘Optionz Traderz’ from the Winning Traders group.

His phone rang.

“Hey buddy, what you are up to tonight?” asked John on the other end.

“Well, I may be taking my online buddy to dinner in Long Beach,” replied Jack.

“Is he as sharp and as cool as you had imagined?” John questioned.

“Well… she is amazing,” Jack responded in a strange voice.

“She? Your option buddy is a woman? Isn’t that a little odd that she never mentioned that?” John shot back very surprised.

“Not really, I just assumed too much. I should have realized it. I was focusing on option strategies, not her gender,” Jack said a little embarrassed.

“Well, I guess it really does not matter. A trader is a trader, right?” John responded.

“The funny thing is, I do not think the world’s best dating site could have found me a better match,” Jack said.

“Good grief, I bet you have little heart symbols in your eyes. Buddy, you need to focus on options strategies before you mess that whole thing up. Your trading group is not a dating service,” John counseled.

“You are probably right. She is probably out of my league anyway. I will call you back once I make plans for tonight,” Jack replied.

As he hung up he pondered what his next move would be. He went to the balcony without his usual early morning energy drink. He felt invigorated just thinking of Terry and how great she was. He flipped through the option notes that she had handed him. It was very thoughtful of her to take the time to prepare them for him.

It fascinated him to see these odds on options being winners or losers. He was sure there would be a way to generate cash flow using these notes. He had to sell options with little odds of winning and buy options with great odds of making money based on his current systems. He had to take on little risk and put the risk on the other side of the option seller or buyer. If he was wrong he had to get out of the trade; if he was right he had to get out at the most profitable time. He had to be the casino and let the other traders be the gamblers. Things were starting to make sense.

He was ready to make his move. He searched steak houses online in Long Beach.

Stock Trader: How about I treat you to a steak dinner tonight?

His heart raced in anticipation of sending the message. He no longer felt like a serious trader going to dinner with his mentor. Instead he felt like a teenage boy asking a girl out on a first date – truly a different relationship than they had just a day ago.

Something occurred to him as he paused. It was something Terry had said to Rookie Trader the previous day. She had asked Rookie if his heart started beating faster when he pressed the trade button. She then advised him that his racing heart was warning him that he was taking on a disproportionate amount of risk compared to the faith in his trading system.

Jack thought back to his own days as a rookie trader, back when trading made his heart race like it was currently. He had been a risk taker and the adrenaline rush was poor compensation for his mounting losses that nearly wiped out his entire account. Nowadays he felt no emotion when he traded, other than the satisfaction that came from watching his trading system slowly grow his account over time.

Today was different. He was taking a risk, but not with his capital. He felt like a rookie trader again, getting ready to press the trade button for the first time, without any faith in the outcome. However, unlike trading, he had nothing to lose. The worst case scenario would be a rejection of his dinner offer. “This is the proper place for emotions; relationships with people, not money,” he thought.

He sent the message. A few moments later there was a reply.

Optionz Traderz: Sounds lovely.

Stock Trader: I will send you the address. Is 7 p.m. late enough to miss traffic?

Optionz Traderz: Yes, that is a great idea. You are a quick learner in other areas besides options.

Stock Trader: I am a good student.

Optionz Traderz: I will see you then.

The weather was a little cooler than it had been the previous day, but it was still sunny. The cool temperatures and lack of lifeguards did not seem to keep people out of the water though. As he looked out over the beach from his balcony, he noticed a group of boys with boogie boards attempting to ride the waves.

The three appeared to be brothers and it looked like they were having fun – well, two of them, anyway. The youngest looked as if he was trying to catch every wave that washed in. Most of the time, the waves were too small and no matter how fast he paddled, he got nowhere. After a few minutes he threw the board onto the sand and stomped up the beach to the blanket where his parents sat watching.

The middle brother was having better luck; he was more selective in the waves he chose to ride. He stood with his back to the ocean, looking over his right shoulder at the waves approaching from behind. He ignored the waves that were too small, but when a bigger one came he would jump at the chance. A few times he managed to catch a good one and ride it as far as he could, but other times the wave would crash over his head, sending the boogie board flying as far as the tether on his arm would allow it to go.

The oldest brother appeared to be the most experienced. He also ignored the small waves, but he also let some of the bigger ones pass by him too. Jack was no expert, but from what he saw, the key to boogie boarding looked as if it was catching a wave at the precise moment when it began to break. It was interesting to watch, and a few times the oldest brother's strategy paid off, taking him 50 yards or more. Once, he caught such a good wave that it propelled him all the way to shore. Other times his timing was wrong, but rather than let the wave crash over him, he simply stood up and let it harmlessly pass him by.

Maybe it was all of the analogies that Terry had shared with him, but Jack began to think of boogie boarding in terms of option trading. She truly was having an effect on his mind.

The youngest brother was like an inexperienced option trader, taking a shot at riding every wave he saw, regardless of the probability of the outcome. As many new option traders and stock traders for that matter soon realize, attempting to trade without regard for the probability of the outcome can quickly lead to frustration.

The middle brother had an edge. He avoided the frustration that caused his little brother to quit by timing his entry, just as an option trader increases the probability of success by using a strategy with a high likelihood of profiting under the current conditions of the market. He didn’t win all of the time, but he did well enough that the few times he wiped out were not enough to take away his enthusiasm and energy.

The oldest brother was like an experienced option trader; he timed both his entry and exit. When he realized he had miscalculated the probability of success of any single wave, he admitted his error and got out early. Other times, when it was clear that his analysis was correct, he rode the wave until expiration.

Unfortunately, a patrol officer on an all-terrain vehicle put an end to the boogie boarding as he summoned them out of the water and proceeded to instruct the family that swimming was not permitted when lifeguards were not on duty. Of course, Jack couldn’t hear the conversation, but the body language made it fairly easy to decipher.

Jack returned to his room and relaxed for a few hours, all the while thinking about options and his upcoming dinner with Terry. He was on vacation, his trading accounts safely protected in cash positions, and yet he was unable to stop thinking about options. “Is it options that have taken over my mind,” he thought, “or is it Terry?”

Later in the afternoon, after a quick call to John to tell him about his plans for that night, he went downstairs. Jack started up his Mustang. He loved the way it sounded and handled on the road. He had spent a casual day looking through the notes that Terry had given him. He anticipated a very thought-provoking evening.

He pulled up to the restaurant a few minutes earlier than 7 p.m. He parked right next to the Cadillac. He walked confidently into the restaurant with his notes in hand. Terry, dressed in all pink, waved him over to her table. As he sat down she had a glass of wine in front of her and had managed to find a pink outfit – a pink blouse and a pink skirt. Surprisingly, she looked sharp and elegant. She seemed to be even more attractive than he remembered from the day before.

“I guess your favorite color is pink?” Jack said as he smiled.

“How did you guess?” Terry shot back with a grin.

“Even your wine is pink,” Jack said.

“Well, I am a girl, you know,” Terry responded with a playful look.

“Well, my favorite color was the one you wore yesterday, green, money green to be exact,” Jack said.

“I couldn’t care less about money itself. It is only a tool to get me what I really want: freedom, time, and more choices,” Terry said.

“I agree. How is it you are able to make consistent returns with options?” Jack inquired.

The waiter approached the table.

“I would like a light beer with lime,” Jack requested.

“Well, I have specific rules that I follow that I believe give me an edge over other traders. I manage my risk on every trade no matter how confident I am that I will be right. I always want the odds in my favor and the possible reward to be worth the risk,” Terry explained.

“Would you give me an example?” Jack asked.

She whipped out her computer tablet and pulled up the chart for Apple.

Charts courtesy of FreeStockCharts.com

“For example, currently Apple is trading at $405 a share, its 200-day moving average is at $368. In 11 of the past 12 months the 200-day moving average has been support for this market leader. 50% of the time the 50-day will hold as support. I can sell 1 contract for a $270 January Put for $200, the bid/ask spread is only 3 cents and there are 25,000 contracts currently open to bolster liquidity.

You can also see how the 200-day is sloping upwards due to the overall long term uptrend in this stock, so the odds are also if the 200-day is breached in the next few weeks then it will be much higher than my Put strike price. The Put buyer is betting that this market leader will lose its support line in the next 30 days. I am betting that even if it does it will be higher when it happens and the Put will still expire worthless. That is the key to selling Puts in an up trending stock, even when it retraces to the 200-day, it is much higher than a few weeks ago when the Put was sold. The Delta of -.12 reflects exactly the odds of the buyer being right. It is a bad bet for the buyer a good bet for me, and a great way to pay my utility bills.

Now here is the funny part. I have almost no stress in this trade because I am bullish on Apple and want to own it at the 200-day moving average. If it goes a few dollars in-the-money I will allow it to be put on me. Of course, I will buy back the Put if I start being down more than 1% of my account equity,” Terry explained before sipping her wine.

“I think you have talked about this before, sell Puts on the hottest up trending stocks, under support levels,” Jack replied.

“Yes, but only when the leaders are holding up far above their 50-day and safely in an uptrend. Also, only one month out at a time maximum; be stingy with giving option buyers enough time to be right,” Terry explained as the waiter approached.

Terry ordered the filet mignon and Jack ordered the porterhouse. Then they got back to business.

“Puts can generate some good steady income from market leaders until they are no longer leaders; then you buy Puts,” Terry said as she pulled up a new chart.

Charts courtesy of FreeStockCharts.com

“This chart of NetFlix really shows how quickly a stock can crater with the wrong news. As you can see though from the chart, I had time to get out from where I sold the Put in July, when the stock was healthy, until the breach of the 200-day in August. While I lost on this trade, I won for a long time before it collapsed, selling my Puts over and over again at the 200-day for premiums. Before the collapse it starting feeling like the Delta should have been zero on the Puts for this monster stock. I also felt confident buying Call options as the price bounced off or regained and went through the 50-day moving average over and over risking the Call premium to make a 5% move in price. That was a great system until the collapse. Even then, I only lost my Call premium, while investors trading the stock itself lost their shirts and pants too. It is possible to buy Puts on a top stock that loses the 50-day multiple times and cover at the 200-day.” Terry grinned as she took the last sip from her wine glass.

The beer that Jack ordered sat untouched as he was completely absorbed with everything Terry said. His mind wondered back and forth between options and how truly amazing Terry was.

“I think one thing that really helps me win in option trading is the fact that I only watch five of the very best stocks and a few leveraged ETFs. I try to become an expert in support and resistance levels and how their options trade based on market volatility. I make trades based on historical odds, not guesses or hopes or gambles. If something already traded a certain way the last ten times, I bet that it will trade that way again. Sometimes I think about what the dumbest thing an option trader could do right now would be. Then I do the opposite,” Terry said, then laughed out loud.

“So you are truly an option trader that trades option probabilities? You are not really a trend trader, swing trader, day trader, or position trader?” Jack asked.

“You are correct. I would say I am a probability trader. I trade what I think the odds are in favor of. I will trade anything that I think will be profitable with options. I attempt to trade what the market is saying to me, not what I think will happen. I do not predict; I figure probabilities,” Terry explained with a look of authority.

“Are you a chameleon trader? Selling options above support and resistance when you see a range bound market? Selling Short Straddles in quiet markets while buying Strangles when you see things possibly getting very volatile? Buying Calls on hot stocks at key supports and selling Puts on momentum stocks at the last place of support? Using Synthetic Longs or Shorts to take positions you are very confident in with little to no capital outlay? And you do all this while keeping your mind and emotions clear, studying charts, and making calculated controlled risks on each trade? Is that all there is to it?” Jack asked exasperated.

“Yes, piece of cake, huh?

“I take my trading very seriously. Tortoise’s have to eat, you know!” giggled Terry.

“Options are far more complex than my simple trend following systems. I am playing checkers and you are playing 3D chess. I need a trend. You just need the odds in your favor over and over again. I am looking for the right set up and entry. You are asking what the market is telling you to do at any given moment. This is fascinating,” Jack said.

Their steaks arrived just as they had ordered. Jack finally realized he had a beer and that there were cold rolls with butter on the table.

Suddenly, Terry became serious for a moment, her face stern. She began to speak in a very serious tone as if to warn and at the same time motivate Jack on his journey with options.

“The markets must be studied just like any other profession or endeavor. That is why very few people will ever attain the highest success in trading, just like very few people ever attain the highest ranks in any other field, be it medicine, sports, music, science, or any other. Emotions should always be restrained and should play no part in trading decisions. Rather, trading decisions should be based on great opportunities as opposed to hopeful situations and dreams. To take advantage of those situations, successful traders need to rely on solid trading rules instead of emotions. Stocks act like human beings; they go through the same stages and phases as people do, including infancy, growth, maturity, and decline.”

She continued, “The key in trading is to be able to recognize which stage the stock and the market is in and to take advantage of that opportunity. Getting a deep understanding of the psychology of the markets is very important. The key place to be for the best profits is in the growth stage because people make prices and behind prices are profits, profits therefore are shaped by people. The actions of people and profits ultimately drive stock prices either up or down.”

“I think I understand. It is not magic. It is work, years of dedication and focus, then profits,” Jack said with understanding and seriousness.

“It is a job like any other, except the reward is freedom and time, along with your own dress code and no commute. Of course, you have to manage any fears you have of not getting a steady paycheck and of having to handle your finances during those months when you do not make any profits or even lose,” Terry cautioned.

“No doubt, I have been warned,” Jack assured her.

“The biggest difference between stock trading and option trading is that options allow you a much wider variety of methods. With stocks, you can only profit by buying and selling at a higher price. There are only two trading methods with stocks: buy and sell higher, or short and buy to cover lower,” explained Terry.

“That is true,” Jack replied. “You have shown me literally dozens of option strategies, but there are only two ways to trade stocks.”

Terry’s tone turned a little sarcastic as she replied, “Actually there is a third ‘method’ for profiting from stocks: buy and hold. In reality it is not trading, though, because the stocks are only bought, not sold.” Then she continued in her normal tone. “But even with three trading methods, stocks are much more limiting than options. I think the single greatest characteristic of options is that they are so flexible. When you trade options, the number of trading methods is virtually limitless.”

Jack nodded in agreement as he took a sip of his beer. Then he inquired, “I like knowing that there are so many different option strategies, but doesn’t that also cause you some stress? I mean, once you open a trade, don’t you start to second guess whether that was the best method, or whether there was another one that might have worked better?”

Terry paused for a moment as she finished a bite of her steak, then responded by asking, “Do you have any regrets about ordering the porterhouse?”

Jack quickly answered, “No, this is one of the best steaks I have ever tasted; much better than what I am used to getting back East. How’s yours?”

“Very tasty. I really like the combination of spices and the texture is perfect. But seeing how much you seem to be enjoying your porterhouse doesn’t make me second guess my choice of filet mignon,” she said with a smile.

Jack laughed a little. “I didn’t realize you were using our entrées as an analogy to options. So I guess what you’re getting at is that there are a lot of different strategies for trading options, but the differences are subtle, like a Straddle being almost the same as a Strangle.”

“That’s what I like about you, you always seem to know what I am saying without me actually saying the words,” she said with an almost affectionate stare. “Whether I’m eating a porterhouse, a hamburger and fries, or filet mignon and baked potato, I’m still getting the same basic meal. When I trade options, all I need to do is choose the strategy that meets my individual taste.”

“And return it for a partial refund if it doesn’t meet your expectations,” Jack added.

“Exactly. The strategy you use is determined by your trading method and your rules. So let’s say you wanted to trade options strictly as a trend trader. Such a method would require only that you pick the strategy that would be most likely to produce a profit if your trend indicator was correct. You can use the charts I gave you as a guide. If you were bullish, you would have your choice of a Long Call, or a Naked Put, Covered Call, Strangle, Straddle, Reverse Butterfly or Condor, to name a few. The decision of which one to use would likely be based on the position you were predicting the stock to reach during the term of the contracts. A prediction of a move to half of a standard deviation would have associated strategies with different probable outcomes than those related to a move of two standard deviations.”

Jack finished the last few bites of his steak. “The charts you gave me were very helpful in visualizing the different strategies. So if my method is to spot trends and use options to profit from those trends, all I need to do is choose the strategy which matches both my prediction and my personal tastes based on risk and reward.”

The waiter returned with a dessert menu. Jack wasn’t hungry after finishing off a 20-ounce steak, but he didn’t want Terry to feel uncomfortable if she wanted desert. He looked through the menu. “The crème brûlée looks good, maybe with a cup of coffee,” he thought to himself. “I’ll have the crème brûlée and a regular coffee,” said Terry. “Same for me”, added Jack. As the waiter took the empty dinner plates from their table, Terry continued talking options.

“There are a few different methods I have used when I trade options. Like you said, it is possible to use technical indicators to look for trends and then use the best strategy to fit the trend. Matching the strategy to what the indicators are telling you will give you an edge. I have traded that way in the past; and I still use that method from time to time on the handful of stocks and ETFs that I follow.”

“So are there other methods?” asked Jack.

“I sometimes place trades on all of the stocks on my watch list, regardless of whether my technical analysis is pointing towards a trend. It is a somewhat different method in that it involves matching an option strategy to every individual stock,” Terry replied.

“So that would be the ‘chameleon’ method,” Jack chuckled. “A range bound strategy on your range-bound stock, a Strangle on your stock that was approaching earnings, et cetera, et cetera.”

“That’s funny. ‘The Chameleon Method’ – that might be a good name for a book on option trading, if I ever decide to write one. There is also another method I use when I either don’t feel like studying the markets or when I don’t have the time. I sometimes use neutral strategies. It’s not like I am living under a rock, but there are times when I have better things to do than watch the financial news networks or read the newspapers. There are many strategies to choose from, but one of my favorites is the Ratio Spread. I often open a Ratio Bull Call Spread and Bear Put Spread, as close as I can get to net even. Then I just manage the trade as it evolves over time. The only way it can lose is if the underlying stock moves by more than one standard deviation, so it’s a fairly solid trade despite the lack of research that goes into it.”

“Is there a name for that trade?” Jack inquired. “I don’t recall you mentioning that one before.”

Terry quickly answered with a grin, “It doesn’t have an official name that I know of, so I like to call it a Bu-Terry-Fly. I already calculated the probabilities on it.” She pulled up a diagram on her tablet and passed it across the table to Jack.

“Now I see what you meant when you said option strategies with names aren’t necessarily superior to those I can create myself,” Jack said with admiration.

“I’m glad you like it. There are probably hundreds of possible strategies that do not have names. But just like any strategy, this one needs to be managed if the underlying begins to approach one of the break even points,” added Terry. She pulled up another chart on her tablet, then continued, “Like all Spreads, this one is very stable as long as the stock price remains between the break even points. It only begins to show a profit when it is close to maturity. My edge on this trade comes not from the entry, but the exit. If the trade starts to go against me, I just exit it early.”

“So if my method involves neutral strategies, I will not see much profit until the trades are very close to expiration, but I will also be able to exit the trades with small losses, or possibly small gains, if I get out while the underlying is in-between the break even points. This is just amazing,” Jack said, with even more admiration in his voice.

They continued talking, even as the waiter brought their desserts to the table, never looking up except to say “Thank you.”

“So there is a trend trading option method in which you study a stock and only open options when your technical analysis shows an upcoming trend is likely. There is a chameleon method, in which you open positions on some or all of the stocks on your watch list, regardless of any trend, but match the option strategies to the market conditions for each individual stock. And then there is the neutral method, in which you don’t make a prediction about the stock price, but open option positions with a wide range of profitability, and then simply cut your losses in the rare event that it becomes necessary?” asked Jack as he looked at Terry intently.

“There are a few more methods that I use,” answered Terry as she poured cream and sweetener into her coffee, “but not as often as the ones you mentioned. Sometimes I just feel like picking the low-hanging fruit, taking the premiums on far out-of-the-money options that have little chance of ever being worth something at expiration, like selling out-of-the-money Calls on NetFlix when the price was falling, Implied Volatility was high, and there was no support in sight.”

“Low-hanging fruit,” said Jack, as he took a sip of his coffee. “I guess after all of the work you put into your other trading methods, you deserve some easy pickings.”

Terry laughed. “I also use a small percentage of my account to speculate. Sometimes there are stocks or sectors that are in the news so much that it is difficult to ignore them. Even though these stocks are not on my watch list, I sometimes do a little bit of research on one and then open an option position to capture what the market consensus seems to indicate. But I never risk very much on these trades because the news reports are rarely impartial.”

“I guess each one of those methods would give me an edge, and as you have said before, with options being a zero sum game, any edge, even a small one, will statistically result in the method being profitable,” said Jack.

Terry finished her coffee and looked right into Jack’s eyes. Again, her voice took on a serious tone. “I’ve really enjoyed the dinner and having someone to talk to about my career in options. It is so comforting to know that there are others out there that think the same way that I do. Some traders that I talk to lose interest, but you are the first person I have met that seems sincerely interested. You have learned so quickly, I’m not sure if there is anything else I can teach you. All you need to do to profit from options is have an edge. You pick the method that suits you best, you make the rules, and you choose the edge that you believe will help you the most. That’s all there is to it.”

“My method, my rules, my edge,” Jack thought to himself. As the waiter began clearing the dessert dishes from the table, they both relaxed and got comfortable in each other’s presence.

“My goal is to trade options like you, for a living,” Jack said.

“It is a worthy goal, no doubt. It takes many hours of study to really understand the flow of the markets, even more hours of live trading and losing to get the experience needed to be able to pull the trigger on live trades. Are you ready to pay that price?” Terry asked.

“I am, and I think you have taken me to a level of understanding where I can begin to trade options for profits. I also have your notes!” Jack said confidently.

“So what are your plans for the next week of your vacation?” Terry inquired.

“I am not sure. I know what I want them to be, and I do have options,” Jack said, flirting and smiling while he looked into her eyes.

“Show me your options,” Terry replied.

“I would like to have the option of spending the next week with you,” Jack replied.

Appendix A

RELATIVE TIME VALUE OF OPTIONS BASED ON THE TIME TO EXPIRATION OF THE CONTRACT

The following tables show the time value of options relative to a contract of exactly one year. The column, Relative Time Value, shows the time value of an option as a multiple of the premium on a one year contract. A Relative Time Value of 0.799 means that contracts expiring in the specified number of days would have a premium approximately 0.799 times as much as a contract expiring in one year. The column, Estimated Premium, shows the approximate time value as a percentage of the annualized Implied Volatility. An Estimated Premium of 40.0% means that options expiring in the specified number of days would likely have a premium equal to about 40.0% of the Implied Volatility of the underlying shares.

The tables are based on at-the-money options only, and the values presented are by no means set in stone. They are offered only as a cursory guide to option premiums, based upon extensive trading experience. Option traders may find the following examples of the use of these tables helpful:

Example 1: A trader buys an option contract exactly 365 days before its expiration date. He wants to know how extensively time decay will affect the value of his contract over the next seven days. Looking at the table, he sees that the Relative Time Value after seven days, with 358 Days to Expiration, is 0.990. So he should expect the value of his contract to have 99.0% of its original value after seven days, so long as the underlying price remains unchanged and there are no changes in volatility or risk-free interest rates.

Example 2: A trader wants to buy a Protective Put, 28 days before expiration and offset the cost of the Put by selling a Call option, seven days before expiration. Looking at the Relative Time Value of options 28 days before expiration, he sees that they should cost about 0.277 times the premium of a one year contract, while the options expiring in seven days are worth 0.138 times the one year premium. He can then estimate that the premium he receives on the Short Call will be about half of the premium he pays for the Long Put.

Example 3: A trader wants to buy a Call option on a stock that is currently trading at $100.00, with an Implied Volatility of 30%, and 127 days until the contract expires. Looking at the table, he determines that the Estimated Premium with 127 Days to Expiration is 23.59% of annualized Implied Volatility. Given that the current Implied Volatility is 30% of $100.00, or $30.00, he can estimate that the premium for an at-the-money Call option would be about 23.59% of $30.00. His calculations lead him to an estimated premium of $7.08. Having found that to be very close to the ask price in an option table, he may feel more confident that he is paying a fair price.

Example 4: A trader owns a stock that is trading at $100 and has seen significant gains, and he wants to delay realizing those gains until the following tax year. Looking at the at-the-money Put options with an expiration date 365 days away, he notices that there is very low trading volume on those options, and the bid-ask spread is over $1.50. So he considers buying options that expire in 183 days and rolling them out another 183 days when they expire. Looking at the table, he sees that options with 183 Days to Expiration cost 0.708 times the premium of those with a one year expiration. Realizing that he would need to purchase two sets of options, each lasting 183 days, to protect his investment for a full year, he calculates the total cost to be 1.416 times the cost of a single one-year contract. Looking at the option tables for the 183 day expiration, he sees that the cost to purchase those options, twice, would be greater than the loss he would experience due to the bid-ask spread on a single contract with a one-year expiration.

Example 5: A trader wants to buy Call options a week before expiration and sell them a day before expiration if they are not in-the-money. He wants to know how much capital he could save by selling early. He looks up the Relative Time Value for both, and finds it to be 0.138 with seven days to expiration, and 0.052 with one day to expiration. His calculations reveal that a weekly at-the-money option would likely lose about 37% of its time value on the final day of trading. This leads him to conclude that he could save significant amounts of capital by closing his losing option trades early.

Relative Time Value is shown as a multiple of the premium of a 1 year contract.

Estimated Premiums are a percentage of annualized Implied Volatility.

All values are for at-the-money options.

Appendix B

ODDS AND EXPECTED PAYOUT OF SELECTED OPTION STRATEGIES

The following analysis depicts the statistical profit and loss potential of option strategies. Each is presented as a ‘lottery ticket.’ Rather than present the possible profit and loss of each strategy, the probable profit and loss is shown. For example, the profit potential of a Long at-the-money Call is very high at two standard deviations, but the odds of the underlying reaching that price are low. The profit potential is multiplied by the odds of that profit being realized, which then determines the values plotted in the graph. For clarity, a traditional ‘possible profit and loss’ plot has been superimposed over each graph.

It should be noted that each graph is only an approximation. Values were determined using a modified form of a log normal distribution. The distribution is based upon historical data, and while it is not guaranteed to be accurate for any particular stock, it is nevertheless useful as a guide.

The odds of winning are presented as profit and loss potential based upon the initial credit or debit to open the trade. For example, a trade consisting of 10 Long at-the-money Calls at $2.50 per share ($2,500 debit) would have a 5% chance of a 200% profit, or $5,000. However, the odds shown only apply to that specific amount of profit. Because there are potential profits in excess of 200%, the odds of a profit of at least $5,000 are actually about 20%.

Note also that the graphs and odds were determined with the assumption that the range of -3 to +3 standard deviations did not include negative values for the underlying price. On volatile stocks, this assumption may be invalid. Because the price of a stock can never go below zero, the weighted distribution would be skewed; hence the odds presented here would not be accurate. Nevertheless, as a general rule, these ‘lottery tickets’ show the predicted behavior of each strategy at expiration.

Lastly, these graphs may provide one additional bit of insight into options. The sections shaded green represent profits, the sections shaded red represent losses, and the areas are nearly equal. Over the long term, given a sufficient number of trades, every strategy has an equal probability of profit or loss.

Appendix C

THE RELATIONSHIP BETWEEN OPTION PREMIUMS, DELTAS, STANDARD DEVIATIONS, AND PROFIT PROBABILITIES

The probability of an option expiring in-the-money can generally be determined by the Delta on that option; e.g. a Call option with a Delta of 0.5 can be roughly estimated to have a 50% chance of expiring in-the-money. However, just because a long option expires with Intrinsic Value does not mean it will result in a profit for the option buyer; Intrinsic Value does not always outweigh value lost to Theta.

The following chart shows not only the probability of an option expiring with Intrinsic Value, but also the probability of a buyer of that option realizing a profit and a seller a loss. For added clarity, the relationship between the Standard Deviation and Delta are also shown for each strike price.

It might not be intuitively obvious to the casual observer that it is possible for option buyers to have similar odds to option sellers. In general, more options expire with a loss in value than in a gain, and a significant percentage of options expire totally worthless. However, the perception of sellers making greater profits than buyers may be rooted in the actions of the market makers.

Market makers, many of whom are engaged in the option selling business, often hedge their short positions. Market makers provide liquidity in the option market; however they do not necessarily profit by selling options that expire worthless or with less Intrinsic Value than their original premium. Rather, market makers profit from the difference in the bid/ask spread; they sell options at the higher ask price and buy them at the lower bid price. As a result there is a common perception among option traders that option sellers, of which a sizeable number are market makers, make money while option buyers lose money.

Note on the following table that every option has a 50% or lower statistical probability of expiring with Intrinsic Value that exceeds the original premium. It can then be inferred that a buyer of an option, any option, Call or Put, will always have less than a 50% chance of making a profit on a single trade. Likewise, a seller will always have better than 50% odds of realizing a gain. While it is true that option buyers have losing trades more often than sellers, over the long term, buyers make more profits on their winning trades. In short, buyers win more, less often; sellers win less, more often. The chart that follows shows how the odds are stacked against the buyer; however, it also shows the manner in which the potential profit to the buyer balances the risk of loss.

The chart has been simplified by disregarding the effects of interest rates, liquidity, kurtosis, skew, and also the volatility smirk that may sometimes occur. It is presented as an aid to understanding option probabilities and is not intended to represent exact pricing for all possible options.

The following is an example of how the chart may be applied:

Example 1: A trader is seeking information on the probabilities of an out-of-the-money Call option. Looking at the option chain for a particular stock, he notes that at-the-money Calls have a premium of $10.00 per share and the Call option he is considering trading has a premium of $2.50.

Looking at the chart, all option premiums are referenced to an at-the-money option costing $1.00. To use this chart effectively, he will need to multiply all premiums by a factor of 10. Call options with a premium of $0.25 on the chart would then have the required $2.50 premium.

Following the columns on the chart, it can then be determined that the Call option with a $2.50 premium has a strike that is located at approximately 1.0 Standard Deviations. Delta on the option would likely be very near 0.2; and he could estimate the odds of the Call expiring in-the-money to be 16%. Continuing across the chart, he can estimate that there are 14% odds of the Intrinsic Value at expiration exceeding the original premium; in other words, a 14% chance of exceeding the break-even point. Given those odds, over the long term, it could be expected that the average Intrinsic Value present in that specific option on the rare occasions when it did expire in-the-money would be $15.60, as shown in the leftmost column.

Statistically, given a sufficiently large number of trades, such as 1,000, there would be $2,500 per share in total premiums paid; 84%, or 840 of the trades would expire worthless and 16%, or 160 of those trades would expire with an average of $15.60 in intrinsic value each, or $2,496 in total gains. Statistically, it’s a total wash.

It may appear confusing that some strikes have higher Probable Intrinsic Values than others when they expire in-the-money. However, the differences are not caused by one option being more profitable than another over the long term; rather this occurs because it is profitable at a different frequency. A far out-of-the-money Long Call might only be profitable in one out of 100 trades, where a large gain erases the previous 99 losses. Its average gain is large, but it is a rare occurrence. Deep in-the-money options expire with Intrinsic Value nearly 100% of the time; statistically, half of the time they will gain value and half of the time they will lose, so the Probable Intrinsic Value at expiration is nearly equal to the premium when the trade was opened.

On a final note, the values shown below were calculated using a slightly different method from that used in Appendix B. As a result, there are slight discrepancies in the probabilities obtained. Those readers intent on reproducing the results of these probability estimates should consider that the following table was formulated using a standard normal distribution applied to current option premiums for open option contracts on an ETF that tracks the S&P 500 index, whereas the probabilities in Appendix B used calculations involving a modified log normal distribution and long-term historical pricing.

One might observe that the statistical probability of a Long at-the-money Call returning a profit was determined to be 34% in Appendix B and 35% here in Appendix C. Again, option pricing is an art, and it is ultimately the decision of the trader to choose which type of statistical model fits his needs or whether a few percentage points one way or the other will have any effect on his trading.

As in Appendix B, Standard Deviations shown in this table are time-weighted. One Standard Deviation refers to the probability of the underlying price reaching a specific strike price upon expiration of the contract. It should not be confused with the annualized Standard Deviation of the underlying share price, which is often stated as annualized Implied Volatility. The only option contracts for which Implied Volatility represents exactly one Standard Deviation are those which expire in exactly one year. A conversion table for option contracts expiring in less than one year may be found in Appendix A.

Appendix D

TIME PROGRESSION PAYOUT POTENTIAL

The following graphs show the differences in possible profit and loss on selected option strategies as a function of time. For each strategy, it is assumed that the trade is opened 30 days prior to expiration. Profits and losses are then plotted based upon an immediate change in the underlying price, with 30 days remaining until expiration. Additional plots show the possible profit or loss with seven days to expiration, and also at the end of expiration day.

There are several characteristics that should become apparent from a study of these plots. First, the profits and losses are most sensitive to time when the underlying price is near zero Standard Deviations. As the price approaches one extreme or the other, the performance of each option strategy is less dependent on the time remaining to expiration. These effects are the result of a combination of Theta and Moneyness. When options are near-the-money, Theta has its most pronounced effect; time value slowly decreases, lowering the value of each option as time progresses. When options become deep in-the-money or far out-of-the-money, the change in Moneyness decreases the time value.

Second, most option strategies have profit and loss potentials which gradually approach the shape of the plot as it would appear on expiration day. As time decay accelerates, a single option will lose about half of its time value during the first three weeks of a 30-day contract, and the remaining half will be lost in the final week leading up to expiration. However, not all strategies are affected equally by time, namely Spreads. A Vertical Spread tends to lose much less of its combined time value during the first three weeks, perhaps only one-third, then accelerates more quickly, losing the remaining two-thirds during the final seven days of trading. With Butterflies and Condors, the effect is even more pronounced; without significant change in the underlying price, these strategies may only experience a combined loss of time value of one-tenth in the first three weeks, with the remaining 90% of time decay occurring in just seven days.

Third, the most striking exception to the time decay characteristics are the Synthetic Long and Synthetic Short Stock, both of which are unaffected by time.

Appendix E

EXPANDED TABLE OF SYNTHETIC POSITIONS

Due to the possibility of option losses exceeding the total value of a trader’s account, most brokers limit the option strategies available to individual traders. However, many strategies can be created synthetically to yield similar performance to the trader without adding risk to the broker.

One of the simplest examples of a position that might be prohibited by a broker would be a Naked Put. A trader seeking the performance of a Naked Put will experience similar profit and loss by opening a Covered Call at the same strike price that would have been used in a Naked Put position. The potential profits are not exactly the same for both positions due to the loss of potential gains on the capital required to open the Covered Call (either through interest income or gains from other potential trades); however, the option trades themselves are nearly identical.

The following table shows the synthetic equivalent for some of the more common option strategies. It should be noted that some of the synthetic positions are not exact equivalents; those that require the use of deep in-the-money options are merely approximations. For example, a Synthetic Long position can be approximated with a deep in-the-money Long Call. Such an option would have little or no time value remaining and would therefore behave nearly identically to an equivalent long position in the underlying shares. However in practice, the option would likely have very low liquidity. Even if it was possible to trade the option, the bid/ask spread could be significant. Even so, there are often options available with sufficient liquidity and Moneyness that their relatively small time value makes them a viable alternative to Synthetic Stock positions.

About Steve Burns

Steve Burns has been an active trader for over 12 years. He is the author of "How I Made Money Using the Nicolas Darvas System," published by BN Publishing (available at all major Internet retailers). He ranks in the top 300 of all reviewers on Amazon.com. He is also one of the site's top reviewers for books about trading. He has been featured as a top Darvas System trader on DarvasTrader.com and interviewed on the Miss Trade YouTube channel. He has also been a contributor to ZenTrader.ca and Business Insider. He lives in Nashville, TN, with his wife, Marianne, and their five children: Nicole, Michael, Janna, Kelli, Joseph. He has one granddaughter, Alyssa.

Steve Burns has not had a losing year actively trading in his main two accounts since 2002. From 2003-2007 he returned an average annual gain of 22.95% and went to a cash position on January 4th, 2008, keeping all of his bull market returns through the Great Financial Panic. His trading beat the S&P 500 for six straight years and had a cumulative 209.5% return over an eight-year period. His returns doubled the market returns, averaging 15.7% versus the S&P returning 7.8% from 2003-2010.

The author trades accounts worth over a quarter of a million dollars.

Connect with Steve:

E-Mail:

stephenburns@bellsouth.net

Web Site/Blog:

www.NewTraderU.com

Facebook Page:

https://www.facebook.com/NewTraderU

Twitter:

@SJosephBurns

About Christopher Ebert

Christopher Ebert has been a real estate investor for over 24 years and an active stock and options trader for over 14 years. His formal education includes undergraduate studies in engineering at the State University of New York and at Rochester Institute of Technology. His option research is featured regularly on Zentrader.ca where he is a contributor. He lives in Rochester, New York, with his wife Anita and their daughter Breeanna.

Christopher Ebert is a contrarian trader and as a result was able to sidestep the majority of the downside of the Bear Market of 2002 and Great Financial Panic of 2008. He has outpaced the S&P in 13 of the past 14 years. Having gone to all cash during the final run of the Bull Market during the spring of 2008, and then gone all-in on February 11, 2009, he missed the market bottom by less than 30 days, leading to a gain of over 50% for the year. His real estate holdings, also being contrarian in nature, were mostly unaffected by the U.S. Housing Bubble and the crisis that followed.

The author trades accounts worth over a quarter of a million dollars.

Connect with Christopher:

E-Mail:

See.Ebert@aol.com

Twitter:

ChristopherEbert@OptionScientist

Contributor to:

Zentrader.ca

References:

www.Dictionary.com (Used with permission)

http://www.optiontradingpedia.com/options_theta.htm

*Quote from chapter 16 by professional trader Jack Mega.

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