I’ve been asked to do it many times, and I am happy to announce that the Rookie’s Guide to Options, 2nd edition is available in eBook format.
The new eBook and the paperback version were updated (minor changes) Sept 11, 2014.
I’ve been asked to do it many times, and I am happy to announce that the Rookie’s Guide to Options, 2nd edition is available in eBook format.
The new eBook and the paperback version were updated (minor changes) Sept 11, 2014.
You mention in your response to Aldo that you would recommend “credit spreads” as a top suggestion for new traders (assuming they are comfortable). Do you have a kind of progression through strategies you would suggest?
I’ve traded covered calls, naked puts and bought calls/puts based on a course (similar situation to Aldo) and I’m looking to expand my trading strategies into spreads.
I do have a recommended progression. However, it is not because the trader moves from one strategy to something that is “better.” I recommend beginning with covered call writing (CCW) because it involves stock trading and many option newbies have stock-trading experience. That makes it easier to begin using options.
I also recommend writing covered calls because it is a hedged, reduced risk strategy – when compared with stock ownership. One more important point: CCW positions earn profits more often than straight stock ownership, although profits are limited. I want traders to make money with options, and CCW produces far better results than simply buying/selling options (the method taught in the course you took). In fact, I hate the idea of brand-new option traders trying to make money by buying options. There is far more involved than predicting when a stock price will change. One must have a good idea of whether the options are reasonably priced (that requires an, understanding of implied volatility) and which options to buy (avoid OTM options). And the brand new trader knows nothing about any of that.
Next I encourage the sale of naked puts because it is equivalent to CCW. By switching strategies, the trader must learn about equivalent positions. That knowledge is very important to an option trader.
I then encourage traders to understand a collar position (a covered call plus the purchase of a put option) because it demonstrates how options can be used to limit losses. I’d love to get the new trader interested in learning to limit risk from day one, but it is important not to overwhelm a trader with too much new information at one time. Thus, I begin with a risk-reducing (and not a risk-limiting) strategy.
I consider those three strategies to represent the “Three Basic Conservative Option Strategies.”
Next I encourage the use of credit/debit spreads as a method of taking on far less risk.
The call debit spread can be looked at as something similar to a covered call, but instead of owning stock, one buys a call option. This is where the trader learns the difference between buying calls and buying stocks — each combined with the sale of a call option (essentially the ‘covered’ call).
The credit spread is a high-probability, limited profit strategy and is ideal for most traders. Sure there are other strategies that accomplish specific needs, but for the trader who has a small bullish or bearish bias, these plays are far superior to buying options.
Continuing with the discussion of equivalent positions, the trader should next learn why credit and debit spreads are equivalent strategies. To be more specific: Selling a call spread is equivalent to buying a put spread when the strike prices and expiration are identical. That must be mentioned repeatedly, otherwise some people may believe than selling any call spread is equivalent to buying any put spread. Thus, I’m careful to mention that essential requirement as often as necessary to be certain that it is well understood.
Basically that’s it. Once a trader has those strategies in his/her arsenal, more advanced strategies come from combining one or more credit/debit spreads into something that appears to be more complex. The other more advanced concept is understanding implied volatility and the importance it plays in selecting option strategies:
NOTE: A vertical spread involves two calls or two puts on the same underlying with the same expiration date. Both credit and debit spreads are vertical spreads.
Bottom line: I do not suggest learning the next strategy is done because it is a “better” strategy. What I urge traders to do is understand something basic and then move on to something that requires a bit more knowledge. We learn strategies to learn more about how options work – and not specifically as a way to make money. Whenever a trader discovers a strategy that suits his/needs and is comfortable to trade, I suggest pausing and getting some good experience using that strategy before moving on.
Patrick, there is one more concept that is crucial (in my opinion): We all want to adopt strategies that have a good probability of meeting our requirements. In other words, strategies that we understand how to use and which make money. However, it is the trader’s ability to maintain discipline and manage risk that is far more important in determining a trader’s success/failure rate. Choosing “a good” strategy for ourselves plays a role, but it is dwarfed by the need to skillfully manage risk.
Hello Mark, and thank you for your kind help.
I would be grateful if you could answer a few follow-up questions.
1a. I am intrigued by the concept of bull put spreads – thank you for bringing them to my attention. Since you seem to prefer them over bull call spreads, could you briefly explain why? Is it just because in the case of the former time decay works in one’s favor and that profits can be retained even if the stock stays steady, or is there something more to them?
I do not prefer selling put spreads to buying call spreads BECAUSE they are equivalent. It makes no difference which you trade. Each spread has the same time decay. The spreads are essentially identical, even though they appear to be different. When you are ready, take this lesson: Equivalent positions.
Understand that some traders are more comfortable collecting cash when entering into the trade and then they can (when it works) watch the spread value decline towards zero. Others are more comfortable buying spread because they know the cash [paid represents the maximum possible loss and they will never have to pay an money to get out of the position. NOTE: The maximum possible loss when selling the put spread is identical, but some are more comfortable when the cash has been paid upfront. It is all psychological and truly makes no difference.
If you are a new option trader (as your questions suggest), then choose the trade that you want to make. If looking at the trade from the buyer’s perspective makes you more comfortable, then buy the spread. As you gain experience, you will come to recognize that it really does not matter whether you buy a call spread or sell a put spread as long as one thing is true: The options must have the same strike prices and expiration date. That is iron clad. Change anything and the positions are no longer identical.
1b. Would you say that the optimal way of specifying the strike prices of the relevant puts is to make the strike price of the short one correspond to the level we believe the stock can reach and the strike price of the long one to a point somewhat below the nearest major support level?
No. Let’s be honest: Neither you nor I know where the stock price is headed. More importantly, your goal is to make money — it is not to be exactly correct on your predictions.
If a stock is priced at $100, you may want to buy the $100/105 or $100/110 call spread [or SELL the $100/105 or $100/110 put spread]. These should earn a profit when the stock rallies, but will lose money if the stock price does not budge, or when it rallies by ~$1. That’s not good enough for me. I want to make money even when I am not as correct as i expected to be.
Therefore, I’d prefer to buy the $95 calls and sell the $100 calls (or buy the $95 puts and sell the $100 puts). Noe I make money even when the stock does not rally. That’s good – but there must be a downside to making this trade — and there is. If the stock price tumbles, the $95/100 trade will lose more money than the $100/105 trade [If you do not know why, then I recommend starting your option education at the beginning and not try to jump in at this level.] Sure, you want to avoid the larger loss, but if you have any confidence that the stock price will increase, then you ought to have even more confidence that the stock price will not move lower.
Choosing the specific spread to trade is important — but please: it has nothing to do with your predictions unless you have a wonderful track record of successful predictions. One trade risks losing more, but comes with a higher probability of success. The other comes with the chance to earn more money, but with a lower probability of success. Choose whichever spread appeals to you more. You are the mast of your own risk-tolerance universe.
1c. Would you say that it is worthwhile to close out a bull spread (be it call or put) as soon as the predicted upper price level is reached, regardless of how far away one is from expiration?
I think you know the answer. If the stock rallies and reaches your target price, then you clearly do not expect it to move higher. So, why would you want to own a bull spread when you do not expect the stock to move higher? Yes, exit. Expiration has nothing to do with this decision.
I note that you said “upper price level” and not your target price.
If your question is really this: “I buy call spreads. Should I exit as soon as the stock hits the upper strike price?”
Then my answer is: “NO.” If you make a trade and have a profit target for your spread in mind (rather than a price target for the stock), then exit when you earn the profit. It does not matter what the stock price is. You will not want to choose the strike prices such that you expect “the upper level” to be reached. You should pick spreads than you believe will make money. That is the primary goal for a trader. You must remember that if you expect the stock to rise from 75 to 85, do not buy the $80/85 call spread. If the stock rallies, but only gets to 79 or 80, you must own a spread that earns a profit.
1d. Am I right in thinking that the margin requirements for any given bull spread (be it call or put) essentially correspond to the amount of cash one has to put up when assigned, so, for instance, if one sold 2 contracts with the strike price of 40, then the required margin is $8000?
NO. When you buy a spread, there is zero margin. You just pay for the spread. When you sell a credit spread, the margin represents the maximum possible value for the spread, but you can use the cash collected to meet some of that margin requirement. If you sell a naked put option, that is where the Reg T margin requirement is essentially the cash required of assigned an exercise notice. But it is reduced by other considerations, including how far OTM the strike price is.
2. You said “If you are only going to buy options (or option spreads), then 10% of your portfolio is far too much in my opinion. But that is because I do not like the idea of predicting the market by buying options.” Am I right in thinking that what you mean is that you are happy with committing more of your portfolio to option positions provided that they are tied up with non-directional strategies?
Yes. When my positions are much less risky than owning calls, and when they are hedged, I am willing to place more money into option positions. But please note: That is my personal comfort zone and it is NOT a recommendation for anyone else.
3. And, finally, one very different question – are you aware of any free software/website that displays not only unusual options activity, but also shows the list of biggest daily transactions and indicates whether the options involved were bought at the ask or sold at the bid? I know that thinkorswim offers this function, but apparently you need a TDAmeritrade account to use their software, and since I’m not US-based, I don’t think that I can access it.
No, I do not. Nor do I like the idea of using that information. It is 100% useless to you. Yes, 100% useless. So what if you know that someone buys 10,000 calls for a given stock? What does that tell you? It does not tell you whether this is a new position of if the buyer is covering a short position. It does not even tell you whether the trader is making a bullish play because there may be another part of the transaction that you cannot see. For example, if he buys 10,000 ATM calls and sells short 500,000 shares, then he owns a market-neutral position equivalent to owning 500,000 straddles. And if he sells short 1,000,000 shares, then he essentially bought 10,000 puts but to the casual observer it loos as if he bought 10,0000 calls.
One more point, even if you do know whether this big buyer is bullish or bearish, or neutral, what do you know about his track record as a call buyer? Nothing. Acting on this type of information is foolish.
Once again, thank you for your time – I really learn a lot from you and greatly appreciate your expert help.
I posted a list of my recommended ideas when it comes to trading. You can find them here.
These are ideas that I’ve developed over a lifetime as a trader (1975 thru today).
This is an excerpt from the Introduction to The Rookie’s Guide to Options.
You are about to enter the exciting world of stock options. These versatile investment tools possess properties not found elsewhere in the investment universe: limited lifetimes with explicit expiration dates. Options were invented as hedging, or risk-reducing tools, allowing specific risks (described by the Greeks) associated with owning any position to be identified. Thus, each risk factor can be controlled to suit your needs.
Options allow investors to use leverage to take control of far more valuable stock positions with less cash at risk.
Options are versatile and can be used in a variety of strategies, ranging from ultra conservative to outright gambles. I encourage readers to adopt strategies between the extremes.
It is possible to use advanced mathematics when discussing options, but in keeping with the goal of making this an enjoyable learning experience, this book uses nothing more complicated than elementary algebra. Let’s leave the advanced math to the academics.
Equity options are related to stocks. The term used to describe that relationship is derivative. The value of an option is derived from the value of an individual stock or group of stocks (an index). If this sounds complicated, it is not. Computers and calculators do the math for us, and our job is to understand how to use the numbers — just as we learn to use any tool.
This book delivers the background information needed to understand why options do what they do. Note that key word: ‘understand.’ I’m not going to define a term without explaining how it relates to trading options. I’m not going to tell you how to open a trade and then leave you stranded. You will learn to open, manage and exit positions. I do not provide rules to follow. Instead, you get detailed explanations and suggestions that enable you to make your own decisions.
Many trade choices are personal, and I cannot know your specific circumstances. However, I’ll help you find trades and make trade plans that suit your tolerance for risk and financial goals. In other words, we will work within your comfort zone.
The book contains a great deal of background information (Part I), lessons on three basic strategies (Part II), as well as explanations of how to adopt more advanced strategies (Part III).
These lessons are designed to help you use options effectively. That means trading with less risk, increasing the frequency of winning trades, and earning more money (when compared with trading without options). There is one important point: both the basic concepts and basic strategies are easy to understand. As with any other endeavor, the more sophisticated you become, the more you can do. Consider this book to be your college level course—perhaps even an elective course. However, it is not graduate school. Option trading can get very sophisticated and today’s top experts are quants with a PhD in math or physics. The good news is that you do not have to compete directly with them. Option trading is so widespread that there is ample opportunity for everyone.
If you want to become an expert trader, this book will not get you there. However, it is an excellent starting point. And if your objective is to enhance your income by generating earnings with less chance of suffering large losses, then you have come to the right place. You do not have to compete with the professionals. Most of us can succeed by adopting the most basic strategies —if we have the discipline to manage risk. While I appreciate advanced strategies, I use only the methods discussed in this book when trading my personal money.
This guide takes you from the novice stage through the intermediate trader stage. Although intended for option rookies, there is enough meat in The Rookie’s Guide to Options for the investor who already trades options. Re-reading these pages as you gain experience will provide insights you may have missed the first time.
My objective is for you, the reader, to gain a solid understanding of options and learn to use them to improve your investment results. You will not learn everything there is to know about options, but, you will be prepared to trade profitably. If we each do our jobs well, you will come away with a clear understanding of options—how they work and how you can make money by incorporating option strategies into your investing methods.
Be prepared for discussions on risk, including definitions (how much money can be lost vs. the probability of losing), setting risk limits (position size), using calculators to discover the odds that something specific will go wrong (stock doesn’t move your way), etc. Included are ideas on how to handle risky situations. Is it better to get out of the trade or use an ‘adjustment’ trade that reduces risk to an acceptable level (compared with the potential reward)? These are all part of risk management, and included are my thoughts on why survival should be any trader’s top priority. Earning money is important—in fact it is our reason for trading—but it ranks behind risk management, unless you plan to have a very short trading career.
In the sports world, a rookie is someone in his/her first year of professional play. The term also refers to someone who is new to a profession. This book was written for newcomers to the world of options—not necessarily investment rookies, but option rookies. The strategies detailed are not the only ones available, but they were chosen because they can be understood and put into practice by traders who have patience and discipline. I stress discipline throughout the book because without it you have almost no chance of becoming a successful trader. Most investors who enter this realm are familiar with stock investing from the standpoint of owning individual stocks (mutual fund ownership does not count, but ETF trading does). If that is your experience, it should be a smooth transition when you add options to your arsenal of investment tools.
If you are brand new to investing, then you have more to learn. However, the good news is that you can get started without having formed any difficult-to-break bad habits.
One of the basic problems for traders everywhere is the notion that any time that you lose money, you must have made a mistake. If you make a trade that should be profitable 90% of the time, then it must be true that the same trade will be unprofitable 10% of the time. Yet, when one of those occasional losses occurs, the trader is sure that he/she did something wrong.
We trade in a statistical world. The odds-on favorite wins most of the time. But not every time. Thus, if you cannot discover a true mistake — if you cannot find something that the evidence told you not to do but you did it anyway — then the chances are good that you were unlucky this time, and that you made no mistakes.
Here is a bit of my trade philosophy that I believe would benefit any trader who adopts it:
In Rookies Stuff 01 I pointed out how difficult it is to buy options and then hope the underlying stock price moves (far enough) in the correct direction (up for calls and down for puts) quickly enough (before the options expire) to earn a profit.
Knowing that buying options is the favorite strategy for the vast majority of new option traders, I don’t want to leave anyone without an alternative strategy. For traders who do want to base trades on their ability to predict the future of stock market prices, there is the vertical spread strategy.
Consider the two ideas below as something that the very new option trader should learn. It is far better than the strategy of buying puts or calls. However, this is just the entry point for using vertical spreads, These spreads can be used far more effectively by adding a bit of sophistication. Lessons on just how to do that follow in this series. For today, the key takeaway is that spread trading reduces risk (yes, it also reduces potential profits).
Note: A ‘spread’ is a hedged (reduced risk) position. There are many examples, but for our purposes today, the two strategies under consideration are
When we ‘buy’ a spread, we own the more expensive option and sell the less expensive. As a result, we pay cash to own the position.
One possible bullish play is to buy a call spread:
The options expire after the close of business on Feb 21, 2014.
The option strike prices are $75 and $80 respectively. In other words, those are the prices that the option owner has the right to pay for 100 shares – if and when that person decides to exercise those rights.
Buying the 75 call gives you the right to buy 100 shares of XYZ at $75 per share.
Selling the 80 call gives you an obligation. You may (or may not, depending on the price of XYZ when expiration arrives) be required to sell 100 shares of XYZ at $80 per share.
Important: There is no reason to fear the obligation to sell shares, even if you entered into this trade without owning any shares. Why? If the stock is above $80 per share and you are forced to sell those 100 shares at $80 per share, then the stock will (obviously) also be above $75 per share so that you can exercise your rights as the option owner to buy those shares at $75. When the smoke clears, you will have bought 100 share at $75 and sold 100 shares at $80, locking in a profit. You would have no remaining position.
This is a bullish position because the spread you bought gains value as the price of the underlying stock rallies.
An example of a bearish trade is to buy a put spread.
It the stock moves below $75 per share, then both options gain value. However, the put with the higher strike price gains value more quickly. That means that the spread increases in value and you earn money if the stock declines, as hoped.
If the price is below $70 when expiration arrives, both options are ITM and the spread reaches its maximum value ($500). This is a bearish position because it earns a profit as the stock price falls.
Buying the 75 put gives you the right to sell 100 shares of XYZ at $75 per share.
Selling the 70 put may obligate you to buy 100 shares of XYZ at $70 per share. This obligation will go away if XYZ is higher than $70 when expiration arrives.
There is a lot more to learn about trading spreads. We barely touched the surface. Stay tuned.
It is easy for anyone who teaches others about how to use options to overlook the most beginnerish topics. It is difficult to recall just what each of us knew way back then, when we began to learn about options.
Some traders have good experience with markets in general because they have been buying and selling stock for years. Others are looking into options as their entrance into the investment world. To me it is obvious that teachers cannot give the same lessons to each group. Previous trading experience makes the learning curve easier to handle.
The following is a brief idea for anyone who wants to begin trading options, and who truly does not know where to begin:
You chose a broker and opened an account. Excellent.
If making your first trade excites you, please slow down. Here is an important lesson in just a few sentences:
–First, stocks do not always rally when you expect them to do so.–
–Second, choosing an appropriate option to buy is a matter of skill. You cannot choose some cheap option at random and expect to make money.–
–Third, no matter how well your friend did of the one trade idea that he shared with you, the chances are high that he did not share his many losing trades.–
–Bottom line: It is very difficult to make money when buying options unless you have a proven track record — in writing — of just how skilled you are.
Options for Rookies advice: Learn first; trade later.
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