Best Thread T2W Guide to Trading: Options

RogerM

Established member
752 6
T2W Guide to Trading: Options
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Edited by RogerM - Last Updated: 17th Oct 04

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Editor's Message:
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Welcome to the options trading guide. We hope that this new initiative will over the next few months develop into a valuable resource for both new and experienced traders alike. This is YOUR guide - I am just your humble editor. There will inevitably be plenty of gaps that need to be filled and I look forward to receiving your suggestions for added or amended content which can be included into the guide. Please add them to this thread, and I’ll include ideas as appropriate into the guide. After acknowledging your contribution your posting will then be deleted to keep this thread short and confined to that of being a guide only.

RogerM
5th Feb 04

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How does it work?
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  • Please contribute to the guide in any way you can. The editor will integrate your suggestions, feedback and text into the guide - whereupon your post will be removed.
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Options Trading Guide Contents
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1. The Guide
2. FAQs
3. Recommended Forum Topics
4. Glossary
5. Further Resources
a) Related Links
b) Recommended Reading
c) Useful Software
d) Brokers


1. The Guide
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1.1 Introduction

Trading options is often seen as a high risk activity, which immediately conjures up a vision of Nick Leason and the ruination of Barings Bank. In practice, trading options can be anything between exceptionally high risk and very low risk, lower in fact than trading shares or indices directly. The aim of this guide is NOT to be an options trading course, but to provide some direction to enable you to learn about this fascinating and frequently misunderstood area of trading for yourself. You will need to do lots of your own research , lots of background reading, and be prepared to work at it in the same way as you would any other form of trading venture.

1.2 Index Options

A good place to start is trading Index Options, the FTSE100 perhaps, or the S&P 500 or DOW. Index options have a number of advantages over share options, which can be summarised as follows :-

1. Does not require constant screen watching.
2. Indices tend to move more smoothly than individual shares.
3. Tend not to “spike” up or down, and if they do, normally return to the mean.
4. No take-overs or profit warnings.
5. Spikes down tend to recover, whilst shares can carry on falling to zero.
6. Monthly contracts available.
7. Tighter spreads than share options.
8. Highly liquid.

1.3 Share Options

Share options tend to offer “more bang for the buck” than index options, and also enable you to spread risk across a number of trades. Volatility will be greater than for index options, which can be a benefit if used correctly.


2. FAQs
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  • Q1, Aren’t options very high risk?
  • Q2, Do I have to learn all that “greeks” stuff?
  • Q3, So how do I get started?
Aren’t options very high risk?

They certainly can be for those who do not take the time and trouble to learn to trade them with discipline and knowledge. But used correctly, the risks involved can be reduced until they are lower than if you were to trade the underlying index or share directly.

Do I have to learn all that “greeks” stuff?

A working knowledge of the main factors that affect options pricing will come with time and practice, and will definitely enhance your trading results.

So how do I get started?

1. Read a good options primer. There are many good ones out there. By choice, I would choose “Options Plain and Simple” by Lenny Jordan. Then follow that up with "Option Volatility and Pricing" by Sheldon Natenberg.

2. Use the resources of this site and the internet. There is an excellent free on-line training course run by 21st Century Education

3. Learn how to construct and interpret profit/loss pay-off diagrams. Use appropriate software. There is an excellent free plug-in to Excel97 and higher, Options Strategy Evaluation Model available from Peter Hoadley.

4. Paper-trade using free 20 min delayed data from Liffe for UK share and index options, or CBOE which is the equivalent site for share options in the US.


3. Recommended Forum Topics
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Options Trading Thread
Started by Morris
One of the first options threads on T2W. Contains an explanation of ratio call spread, and how to turn it into a butterfly.

Option Strategy
Started by Neutron Bomb
Discusses pros and cons of Straddles, Butterflies and Short Strangles.

Selling Put Options
Started by Osho67
Lively discussion on merits (or otherwise) of selling puts.

Trading Options
Started by aacharya
Discussion on the use of buying long puts versus synthetics and ratio backspreads.

Trading Marker direction with options
Started by RogerM
Showing how direction can be traded with protection and space if it goes pearshaped.


4. Glossary
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American Style Option
An option contract that can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style.

Arbitrage
The simultaneous purchase and sale of identical financial instruments or commodity futures in order to make a profit where the selling price is higher than the buying price.

At-the-Money (ATM)
An option with it’s strike price closest to the price of the underlying security.

Automatic Excercise
The automatic exercise of an in-the-money option at expiration by the clearing firm

Back Months
The futures or options on futures months being traded that are furthest from expiration.

Backspread
A spread in which more options are purchased than sold and where all options have the same underlying and expiration date. Backspreads are usually delta neutral.

Bear Call Spread
A strategy in which a trader sells a lower strike call and buys a higher strike call to create a trade with limited profit and limited risk. A fall in the price of the underlying increases the value of the spread. Net credit transaction; Maximum loss = difference between the strike prices less credit; Maximum gain = credit; requires margin.

Bear Put Spread
A strategy in which a trader sells a lower strike put and buys a higher strike put to create a trade with limited profit and limited risk. A fall in the price of the underlying increases the value of the spread. Net debit transaction; Maximum loss = d ifference between strike prices less the debit; no margin.

Break-even
The point at which gains equal losses.
The market price that a stock or future must reach for an option to avoid loss if exercised.
For a call, the break-even equals the strike price plus the premium paid.
For a put, the break-even equals the strike price minus the premium paid.

Bull Call Spread
A strategy in which a trader buys a lower strike call and sells a higher strike call to create a trade with limited profit and limited risk. A rise in the price of the underlying increases the value of the spread. Net debit transaction; Maximum loss = debit; Maximum gain = difference between strike prices less the debit; no margin.

Bull Put Spread
A strategy in which a trader sells a higher strike put and buys a lower strike put to create a trade with limited profit and limited risk. A rise in the price of the underlying increases the value of the spread. Net credit transaction; Maximum loss = difference between strike prices less credit; Maximum gain = credit; requires margin.

Butterfly Spread
The sale (purchase) of two identical options, together with the purchase (sale) of one option with an immediately higher strike, and one option with an immediately lower strike. All options must be the same type, have the same underlying and have the same expiration date.

Calendar Spread
A spread consisting of one long and one short option of the same type with the same exercise price, but which expire in different months.

Call Option
An option contract which gives the holder the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time in exchange for a paying a premium.

Call Premium
The amount a call option costs.

Chicago Board options Exchange (CBOE)
The largest options exchange in the United States.

Condor
The sale or purchase of 2 options with consecutive exercise prices, together with the sale or purchase of 1 option with an immediately lower exercise price and 1 option with an immediately higher exercise price.

Covered Call
A short call option position against a long position in an underlying stock or futures.

Covered Put
A short put option position against a short position in an underlying stock or futures.

Credit Spread
The difference in value between 2 options, where the value of the short position exceeds the value of the long position.

Debit Spread
The difference in value between 2 options, where the value of the long position exceeds the value of the short position.

Deep-in-the-Money
A deep-in-the-money call option has a strike price well below the current price of the underlying instrument. A deep-in-the-money put option has a strike price well above the current price of the underlying instrument. Both primarily consist of intrinsic value.

Delta
The amount by which the price of an option changes for every point move in the underlying instrument.

Delta Hedged
An options strategy protecting an option against price changes in the option's underlying instrument by balancing the overall position delta to zero.

Delta Neutral
A position arranged by selecting a calculated ratio of short and long positions that balance out to an overall position delta of zero.

European Style Option
An option contract that can only be exercised on the expiration date.

Exercise Price
A price at which the stock or commodity underlying a call or put option can be purchased (call) or sold (put).

Expiry
The date and time after which an option may no longer be exercised

Extrinsic Value
The price of an option less its intrinsic value. An out-of-the money option's worth consists of nothing but extrinsic or time value. Also known as Time Value.

Fill
An executed order.

Front Month.
The first expiration month in a series of months.

Gamma
The degree by which the delta changes with respect to changes in the underlying instrument's price.

Guts
A strangle where the call and the put are in-the-money.

Hedge
Reducing the risk of loss by taking a position through options or futures opposite to the current position they hold in the market.

Historic Volatility
A measurement of how much a contract's price has fluctuated over a period of time in the past; usually calculated by taking a stand`ard deviation of price changes over a time period.

Implied Volatility (IV)
The volatility of an Option implied by the price, taking into account supply and demand, anticipated future price movement of the underlying security, and time left to expiry. Also known as statistical Volatility (SV).

Index Options
Call options and put options on indexes of stocks are designed to reflect and fluctuate with market conditions. Index options allow investors to trade in a specific industry group or market without having to buy all the stocks individually.

In-the-Money Option
A "call" option is in-the-money if the strike price is less than the market price of the underlying security. A "put" option is in-the-money if the strike price is greater than the market price of the underlying security

Intrinsic Value
The amount by which a market is in-the-money. Out-of-the-money options have no intrinsic value. Calls = underlying -strike price. Puts = strike price - underlying.

Iron Butterfly
The combination of a long (short) straddle and a short (long) strangle. All options must have the same underlying and have the same expiration.

LEAPS
Long-term stock or index options which are available with expiration dates up to three years in the future.

Leg
One side of a Spread

Long
The term used to describe the buying of a security, contract, commodity, or option.

Margin Requirements
The amount of cash an uncovered (naked) option writer is required to deposit and maintain to cover his daily position price changes

Naked Option
An option written (sold) without an underlying hedge position.

Near-the-Money
An option with a strike price close to the current price of the underlying tradable.

Option
A security that represents the right, but not the obligation, to buy or sell a specified amount of an underlying security (stock, bond, futures contract, etc.) at a specified price within a specified time.

Option Writer
The seller of either a call or put option.

Out-of-the-Money Option (OTM)
A call option is out-of-the-money if its exercise or strike price is above the current market price of the underlying security. A put option is out-of-the-money if its exercise or strike price is below the current market price of the underlying security.

Put-Call Parity
The relationship between the price of a put and the price of a call on the same underlying with the same expiration date.

Put Option
An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. The put option buyer hopes the price of the shares will drop by a specific date w hile the put option seller (or writer) hopes that the price of the shares will rise, remain stable, or drop by an amount less than their profit on the premium by the specified date.

Ratio Backspread
A delta neutral spread where an uneven amount of contracts are bought and sold with a ratio less than 2 to 3. Optimally no net credit or net debit occurs.

Ratio Call Backspread
A bearish or stable strategy in which a trader buys 2 higher strike calls and sell1 lower strike call. This strategy offers limited risk and unlimited profit potential.

Ratio Put Backspread
A bullish or stable strategy ion which a trader buys 1 higher strike put and sells two lower strike puts. This strategy offers limited risk and unlimited profit potential.

Short
The selling of a security, contract or commodity not owned by the seller.

Spread
A trading strategy in which a trader offsets the purchase of one option by selling another against it.

Straddle
A position consisting of a long (short) call and a long (short) put, where both options have the same strike price and expiration date.

Strangle
A position consisting of a long (short) call and a long (short) put where both options have the same underlying, the same expiration date, but different strike prices. Most strangles involve OTM options.

Strike Price (Exercise Price)
A price at which the stock or commodity underlying a call or put option can be purchased (call) or sold (put) over the specified period.

Synthetic
The sale and purchase of a call or put at the same strike price to emulate the characteristics of a straight purchase or sale of the underlying security.

Theta
The Greek measurement of the time decay of an option

Time Decay
The amount of time premium movement within a certain time frame on an option due to the passage of time in relation to the expiration of the option itself.

Time Value (Extrinsic Value)
The amount that the current market price of a right, warrant or option exceeds its intrinsic value.

Triple Witching Day
The third Friday in March, June, September and December when U.S. options, index options and futures contracts all expire simultaneously often resulting in massive trades.

Underlying Instrument
A trading instrument subject to purchase upon exercise.

Vega
The amount by which the price of an option changes when the volatility changes. Also referred to as volatility.

Volatility
A measure of the amount by which an underlying is expected to fluctuate in a given period of time. Volatility is a primary determinant in the valuation of options premiums and time value. There are two basic kinds of volatility, implied and historical (statistical). Implied volatility is calculated by using an option pricing model (Black-Scholes for stocks and indices and Black for futures). Historical volatility is calculated by using the standard deviation of underlying asset price changes from clos e to close trading going back 21 to 23 days.

Volatility Skew
The theory that options that are deeply out-of-the-money tend to have higher implied volatility levels than at-the-money options. Volatility skew measures and accounts for the limitation found in most options pricing models and uses it to give the trader an edge in estimating an option's worth. May also be applied to account for different implied volatilities between options at the same strike price in different months


5. Further Resources
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a) RELATED LINKS
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Screening Sites

IVolatility offers a range of analysis tools and strategy finders, some of which are free and some of which are subscription only.

Optionetics offer a range of courses and web based screening services. The Optionetics Platinum options Analysis site offers a web based service that enables the subscriber to screen for trades and opportunities that meet pre-set criteria. Aimed at US stock option traders.


General Options education Sites

21st Century Education provides an excellent free options training course.

Bob’s Options Corner provides a useful list of opportunities meeting defined criteria.

Investorprofit is a UK based site run by Val Harrison, a retired vet and FT columnist, who runs a number of ghost portfolios in realtime, “warts ‘n all”.

LIFFE Equity Options The London International Financial Futures Exchange (LIFFE) – Loads of useful stuff on UK Index and Equity Options.

Chicago Board Options Exchange CBOE is the largest US options exchange and the US equivalent of LIFFE in the UK. Loads of useful stuff on US Index and Equity Options.

Yahoo Finance Fast and user friendly source of delayed prices for shares and option chains.

Mr.Stock Excellent site for explanation of various strategies.

"Think or Swim" online seminar transcripts. An extremely imformative series of transcripts of online tutorials from this highly regarded US Options brokerage. Well worth working your way through the lot and keeping as a resource library.


Further Options Sites

www.oioonline.com

www.futuresknowledge.com

www.onechicago.com

www.bettertrades.com

www.optionstrategist.com

www.schaeffersresearch.com

www.pcquote.com

www.amex.com



b) FURTHER READING
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Options Plain and Simple
By Lenny Jordan
RRP: £14.74

Option Volatility and Pricing
By Sheldon Natenberg
RRP: £29.45

Options as a Strategic Investment
By Laurence McMillan
RRP: £36.84

Coulda Woulda Shoulda
By Charles Cottle. An excellent FREE (yes - FREE) options book by the founder of "ThinkorSwim" the US Options Brokerage. Well worth downloading and keeping. Not an easy read, but very worthwhile.


c) SOFTWARE LIST
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Hoadley Options Strategy Evaluation Model is an excellent free plug-in to excel that will model payoff diagrams and the greeks. There is also a superb additional module that can be added for a modest fee.

OptionVue systems is a highly regarded (but expensive) stand alone screening system to identify trades, trading opportunities and many other things besides. Their website is full of useful information and educational articles.

The Institute for Options Research Inc has a useful free Options Calculator that will fill in the blanks based on known data.

d) BROKERS
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Options Brokers

ODL Securities

Interactive Brokers

Options Express For those who want to test out spread strategies in options, you can open an account in Options Express, and without funding it, you can try out different spreads and combo strategies. Most other paper trading sites won't let you paper trade these more complicated positions.

thinkorswim highly regarded options brokerage with very informative website.
 
Last edited:

75again

Newbie
6 0
Hi there RogerM

Great stuff, and timely too – I enjoyed your presentation at Helen’s Traders’ Day, enough to go and buy the Lenny Jordan book (I’m up to reading about positive and negative gamma – i.e. very much the basics).

How do you envisage this forum working – will you be answering specific questions, walking through different live ‘paper’ trades, or a la FTSE Beater’s First Steps thread in which he used to (still does?) set ‘homework’ every week or so as the weeks/months passed?

All the above would get my vote.

Cheers

75
 

osho67

Well-known member
407 3
Dear Roger

Great presentation, congtratulations.

I think options are least risky. At the most you lose premium paid to buy a call or a put.

I also think us options are great. One contract only covers 100 shares as compared to 1000 in uk. The commission with IB is only $1 per contract as compared to about £25 from uk brokers. And no stamp duty for purchases of shares.

Your site will give me plenty to learn. Thanks.
 

MikeW

Junior member
29 0
Roger,

A great deal of useful info collated for all to see/learn from - thx.

The 21st century education free course I joined 4 wksago when I first saw a mention of it from you on another thread & I'd recommend it to anyone here - it explains things well & gives plenty of diagrams & a weekly test (&answers) to check understanding.
Rgds.
Mike
 

RogerM

Established member
752 6
Thanks for the positive comments guys.

75again - don't you just love it when people find you work to do ! :D Always happy to try and answer questions. Not certain that I will be able to emulate FTSEBeaters "First Steps" thread, but I hope to be able to continue posting interesting charts and pay-off diagrams when the opportunity arises.
 

zambuck

Experienced member
1,608 101
Right from Indexia board to this Site, Roger's contribution has been exemplary and educational.......the information in the editorial piece is very informative....As I am moving on to Options this board will be god sent...

Keep it up Roger...

regards
 

saad

Newbie
3 0
Congratulations Roger on the outstanding and professional work. It is enlightening and worthy of the highest praise. Keep it up my dear friend.

Tahir
 

euroderivatives

Junior member
45 0
Dear Roger,

I just wanted to say that for those who want to test out spread strategies in options, they can open an account in optionsxpress, and without funding it, they can try out different spreads and combo strategies. Other paper trading sites won't let you paper trade such complicated positions.

Cheers!