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EX D E

2N
PA D
THE

N ITI
DE ON
D
TM

Featuring 40 strategies for bulls, bears, rookies, all-stars and everyone in between

Brian Overby
TradeKing Senior Options Analyst
WITH R. BURT MEMBER FINRA/SIPC
TABLE OF CONTENTS:
THE OPTIONS WELCOME TO THE GAME
PLAYBOOK™ 01 « Introduction
THE LONG AND SHORT OF THINGS
07 « Taking Stock of the Situation
Contents of this book © 2009 by TradeKing.
Member FINRA/SIPC. All rights reserved. 08 « What’s an Option?

Options involve risk and are not suitable for all investors.
10 « The Two Flavors of Options
This book is distributed with the booklet titled “Characteristics
12 « Definitely-not-boring Definitions
and Risks of Standardized Options,” published by the Options
Clearing Corporation (OCC). You must read this publication 14 « What Is Volatility?
before investing in options. To obtain additional copies of this
booklet please go to: www.tradeking.com/ODD or call 18 « Meet the Greeks
(877) 495-KING.
23 « Cashing Out Your Options
The content of this publication is provided for educational
and informational purposes only and does not constitute a 24 « Keeping Tabs on “Open Interest”
recommendation to enter in any of the securities transactions
or to engage in any of the investment strategies presented in
ROOKIES’ CORNER
such content. TradeKing provides self-directed investors with 28 « Getting Your Feet Wet
discount brokerage services, and does not make recommenda-
tions or offer investment advice. You alone are responsible for 30 « Writing Covered Calls
evaluating the merits and risks associated with the use of our
systems, services or products. All investments involve risk, losses 32 « Buying LEAPS® Calls as a
may exceed the principal invested, and the past performance of
Stock Substitute
a security, industry, sector, market, or financial product does not
guarantee future results or returns. 34 « Selling Cash-Secured Puts
LEAPS® is a registered trademark of CBOE. THE PLAYS
38 « Where to Find Your Favorite Plays
FINAL THOUGHTS
132 « The Players in the Game
134 « How We Roll
138 « Keeping an Eye on Position Delta
140 « What Is Early Exercise and Assignment
and Why Does it Happen?
142 « Five Mistakes to Avoid When
Trading Options
145 « So What’s an Index Option, Anyhow?
147 « A Brief History of Options
APPENDICES
152 « Appendix A: Margin Requirements
154 « Appendix B: Glossary
WELCOME TO
THE GAME
INTRODUCTION OPTION TRADING is a way for savvy investors I’m not going to derive the Black-Scholes option
to leverage assets and control some of the risks pricing model in this book. As a matter of fact,
associated with playing the market. Pretty much this is one of the only times I even mention the
BY BRIAN “THE OPTIONS GUY” OVERBY
every investor is familiar with the saying, “Buy Black-Scholes model. It’s nice to know that sort of
TradeKing Senior Options Analyst
low and sell high.” But with options, it’s possible thing, but the goal here is to provide the essential
to profit whether stocks are going up, down, knowledge needed to trade a specific strategy, not
or sideways. You can use options to cut losses, to completely bore the pants off of you.
protect gains, and control large chunks of stock
Throughout this playbook, you’ll also find
with a relatively small cash outlay.
“Options Guy’s Tips,” which clarify essential
On the other hand, options can be complicated concepts or give you extra advice on how to run
and risky. Not only might you lose your entire a particular play. As an indicator of these tips’
investment, some strategies may expose you to importance, I put a little picture of my head next
theoretically unlimited losses. to them like the one you see at left. So be sure to
pay extra attention whenever you see my melon.
So before you trade options, it’s important to
think about the effects that variables like implied I certainly hope you enjoy reading
volatility and time decay will have on your The Options Playbook.
strategy. This playbook will help you answer
those tough questions. No need to ponder,
just turn to the play.

WELCOME TO THE GAME » 1


WHAT’S AN
OPTION?
OPTIONS ARE CONTRACTS giving the owner the
right to buy or sell an asset at a fixed price (called
the “strike price”) for a specific period of time.
That period of time could be as short as a day or
as long as a couple of years, depending on the
option. The seller of the option contract has the
obligation to take the opposite side of the trade if
and when the owner exercises the right to buy or
sell the asset.
Here’s an example of a standard quote
on an option.

8 « THE OPTIONS PLAYBOOK ™ .COM


XYZ JANUARY 70 CALL AT $3.10

on the
next pages.

THE LONG AND SHORT OF THINGS » 9


THE TWO CALL OPTIONS
When you buy a call, it gives you the right (but

FLAVORS not the obligation) to buy a specific stock at a


specific price per share within a specific time

OF OPTIONS:
frame. A good way to remember this is: you have
the right to “call” the stock away from somebody.
If you sell a call, you have the obligation to sell

CALLS the stock at a specific price per share within a


specific time frame if the call buyer decides to

& PUTS
invoke the right to buy the stock at that price.

Call options
give you the right to
call stock away from someone

10 « THE OPTIONS PLAYBOOK ™ .COM


PUT OPTIONS USING CALLS AND PUTS IN MORE
COMPLEX STRATEGIES
When you buy a put, it gives you the right (but
not the obligation) to sell a specific stock at a Much of the time, individual calls and puts are
specific price per share within a specific time not used as a standalone strategy. They can be
frame. A good way to remember this is: you combined with stock positions, and/or other calls
have the right to “put” stock to somebody. and puts based on the same stock.

If you sell a put, you have the obligation to buy When this is the case, the strategies are called
the stock at a specific price per share within a “complex.” This term does not imply they are
specific time frame if the put buyer decides to hard to understand. It just means these plays
invoke the right to sell the stock at that price. are built from multiple options, and may at times
also include a stock position.
You’ll find out about the various uses of calls
and puts when we examine specific plays later
in the book.

Put options
give you the right to
put stock to someone

THE LONG AND SHORT OF THINGS » 11


WHAT IS
HISTORICAL VOLATILITY is defined in text- Even if a $100 stock winds up at exactly $100
books as “the annualized standard deviation of one year from now, it still could have a great
past stock price movements.” But since this isn’t deal of historical volatility. After all, it’s certainly

VOLATILITY? your average textbook and I don’t want to bore


you silly, I’ll just say it’s how much the stock price
fluctuated on a day-to-day basis over a one-
conceivable that the stock could have traded
as high as $175 or as low as $25 at some
point. And if there were wide daily price ranges
OR WHY YOUR OPTION PRICES CAN BE LESS year period. throughout the year, it would indeed be consid-
STABLE THAN A ONE-LEGGED DUCK ered a historically volatile stock.

Some traders mistakenly believe that volatility


is based on a directional trend in the stock FIGURE 1: HISTORICAL VOLATILITY OF TWO DIFFERENT STOCKS
price. Not so. By definition, volatility is simply
the amount the stock price fluctuates, without
regard for direction.

As an individual trader, you really only need


to concern yourself with two forms of volatility:
historical volatility and implied volatility. (Unless
your temper gets particularly volatile when
a trade goes against you, in which case you
should probably worry about that, too.)
STOCK PRICE

$100

J F M A M J J A S O N D

This chart shows the historical pricing of two different stocks over 12 months. They both start at $100 and end at
$100. However, the blue line shows a great deal of historical volatility while the black line does not.

14 « THE OPTIONS PLAYBOOK ™ .COM


MEET THE
go up. Here’s an example. If a call has a delta of
DELTA .50 and the stock goes up $1, in theory, the price
of the call will go up about $.50. If the stock goes

GREEKS
Beginning option traders sometimes assume that
when a stock moves $1, the price of options based down $1, in theory, the price of the call will go down
on that stock will move more than $1. That’s a little about $.50.
silly when you really think about it. The option costs Puts have a negative delta, between 0 and -1. That
7JB;7IJJ>;<EKHCEIJ much less than the stock. Why should you be able to means if the stock goes up and no other pricing
IMPORTANT ONES) reap even more benefit than if you owned the stock? variables change, the price of the option will go
Before you read the plays, it’s a good idea to It’s important to have realistic expectations about the down. For example, if a put has a delta of -.50 and
get to know these characters because they’ll price behavior of the options you trade. So the real the stock goes up $1, in theory, the price of the put
affect the price of every option you trade. Keep question is, how much will the price of an option will go down $.50. If the stock goes down $1, in
in mind as you’re getting acquainted, the move if the stock moves $1? That’s where “delta” theory, the price of the put will go up $.50.
examples I use are “ideal world” examples. comes in. As a general rule, in-the-money options will move
And as Plato would certainly tell you, in the real more than out-of-the-money options, and short-term
Delta is the amount an option price is expected to
world things tend not to work quite as perfectly options will react more than longer-term options to
move based on a $1 change in the underlying stock.
as they do in an ideal one. the same price change in the stock.
Calls have positive delta, between 0 and 1. That
means if the stock price goes up and no other As expiration nears, the delta for in-the-money
pricing variables change, the price for the call will calls will approach 1, reflecting a one-to-one reac-
tion to price changes in the stock. Delta for out-of
the-money calls will approach 0 and won’t react
at all to price changes in the stock. That’s because
if they are held until expiration, calls will either be
exercised and “become stock” or they will expire
worthless and become nothing at all.
As expiration approaches, the delta for in-the-money
puts will approach -1 and delta for out-of-the-money
puts will approach 0. That’s because if puts are held
until expiration, the owner will either exercise the
options and sell stock or the put will expire worthless.

NOTE: The Greeks represent the consensus of the marketplace


as to how the option will react to changes in certain variables
associated with the pricing of an option contract. There is no
guarantee that these forecasts will be correct.

18 « THE OPTIONS PLAYBOOK ™ .COM


CASHING
The fact that option contracts can be opened
or closed at any given point prior to expiration
leads us to the mysterious and oft-misunderstood

OUT YOUR concept called “open interest.”

OPTIONS OPTION OUTCOMES:


CALENDAR YEAR 2008
Source: Options Clearing Corporation
So, you’ve bought or sold an option to open a
“long” or “short” position. What now?

19%
Some beginning option traders think that any
time you buy or sell options, you eventually have
to trade the underlying stock. That’s simply not
true. There are actually three things that can
happen.
11.6% Expired
Exercised
1) You can buy or sell to “close” the position
prior to expiration.
worthless
2) The options expire out-of-the-money and
worthless, so you do nothing.
3) The options expire in-the-money, usually
resulting in a trade of the underlying stock
if the option is exercised.
There’s a common misconception that #2 is the
most frequent outcome. Not so. Outcome #1 is
69.4%
actually the most frequent. Bought or sold to
close position
If you have a trade that’s working in your favor,
you can cash in by closing your position in the
marketplace before the option expires. On the
other hand, if you have a trade that’s going
against you, it’s OK to cut and run. You don’t
necessarily have to wait until expiration to
see what happens.

THE LONG AND SHORT OF THINGS » 23


AND NOW, FOR A QUICK DISCLAIMER

It’s very important to account for commissions,


taxes, margin rates and other fees whenever
you trade options because they can impact your
bottom line. However, to make this book easier to
read, I don’t talk about them very much.
At any rate, TradeKing’s commissions and fees
are among the lowest in the business. So don’t
worry. We won’t nickel and dime you. If we
wanted to engage in chiseling, we would have
become sculptors instead of brokers.
Just remember to factor all of the costs of each
trade into your profit and loss calculations and
consult your tax advisor whenever possible.

THE LONG AND SHORT OF THINGS » 25


ROOKIES’
CORNER
B E G I N N I N G P L AY A HERE’S HOW YOU CAN OPTIONS GUY’S TIP:
WRITE YOUR FIRST COVERED CALL

WRITING
Try using the covered call chain on TradeKing.com
to determine your optimal strike price and expiration
First, choose a stock in your portfolio that has
date for the calls you plan to sell.
already performed fairly well, and which you

COVERED
are willing to sell if the call option is assigned. There are three possible outcomes for this play:
Avoid choosing a stock that you’re very bullish
on in the long-term. That way you won’t feel too SCENARIO 1: THE STOCK

CALLS
heartbroken if you do have to part with the stock GOES DOWN
and wind up missing out on further gains.
If the stock price is down at the time the option
Now pick a strike price at which you’d be
expires, the good news is the call will expire
comfortable selling the stock. Normally, the strike
worthless, and you’ll keep the entire premium
price you choose should be out-of-the-money.
received for selling it. Obviously, the bad news
That’s because the goal is for the stock to rise
Writing a covered call means you’re selling is that the value of the stock is down. That’s the
further in price before you’ll have to part with it.
someone else the right to purchase a stock that nature of a covered call. The risk comes from
you already own, at a specific price, within a Next, pick an expiration date for the option owning the stock. However, the profit from the
specified time frame. Because one option contract contract. Consider 30–45 days in the future as a sale of the call can help offset the loss on the
usually represents 100 shares, to run this play, starting point, but use your judgment. You want stock somewhat.
you must own at least 100 shares for every call to look for a date that provides an acceptable
If the stock takes a dive prior to the expiration
contract you plan to sell. premium for selling the call option at your
date of the call, don’t panic. You’re not locked into
chosen strike price.
As a result of selling (“writing”) the call, you’ll your position. Although losses will be accruing
pocket the premium right off the bat. The fact As a general rule of thumb, some investors think on the stock, the call option you sold will go
that you already own the stock means you’re about 2% of the stock value is an acceptable down in value as well. That’s a good thing
covered if the stock price rises past the strike premium to look for. Remember, with options, time because it will be possible to buy the call back
price and the call options are assigned. You’ll is money. The further you go out in time, the more for less money than you received to sell it. If
simply deliver stock you already own, reaping the an option will be worth. However, the further you your opinion on the stock has changed, you can
additional benefit of the uptick on the stock. go into the future, the harder it is to predict simply close your position by buying back the
what might happen. call contract, and then dump the stock.

On the other hand, beware of receiving too much


time value. If the premium seems abnormally high,
there’s usually a reason for it. Check for news in
the marketplace that may affect the price of the
stock, and remember if something seems too good
to be true, it usually is.

30 « THE OPTIONS PLAYBOOK ™ .COM


SCENARIO 2: THE STOCK STAYS THE THE RECAP ON THE LOGIC
SAME OR GOES UP A LITTLE, BUT
DOESN’T REACH THE STRIKE PRICE Many investors use a covered call as a first foray
into option trading. There are some risks, but the
There’s really no bad news in this scenario. risk comes primarily from owning the stock – not
The call option you sold will expire worthless, from selling the call. The sale of the option only
so you pocket the entire premium from selling it. limits opportunity on the upside.
Perhaps you’ve seen some gains on the under-
When running a covered call, you’re taking
lying stock, which you will still own. You can’t
advantage of time decay on the options you sold.
complain about that.
Every day the stock doesn’t move, the call you
sold will decline in value, which benefits
SCENARIO 3: THE STOCK you as the seller. (Time decay is an important
RISES ABOVE THE STRIKE PRICE concept. So as a beginner, it’s good for you
If the stock is above the strike price at expiration, to see it in action.)
the call option will be assigned and you’ll have to As long as the stock price doesn’t reach the strike
sell 100 shares of the stock. price, your stock won’t get called away. So in
If the stock skyrockets after you sell the shares, theory, you can repeat this strategy indefinitely on
you might consider kicking yourself for missing the same chunk of stock. And with every
out on any additional gains, but don’t. You covered call you run, you’ll become more
made a conscious decision that you were familiar with the workings of the option market.
willing to part with the stock at the strike price, You may also appear smarter to yourself when
and you achieved the maximum profit potential you look in the mirror. But I’m not making any
from the play. promises about that.
Pat yourself on the back. Or if you’re not very
flexible, have somebody else pat your back for
you. You’ve done well.

ROOKIE'S CORNER » 31
THE
PLAYS
WHERE ONE-LEG PLAYS

PLAY ONE
TWO-LEG PLAYS

PLAY NINE

TO FIND
LONG CALL » P40 FIG LEAF » P56
PLAY TWO PLAY TEN

YOUR
LONG PUT » P42 LONG CALL SPREAD » P60
PLAY THREE PLAY ELEVEN

FAVORITE
SHORT CALL » P44 LONG PUT SPREAD » P62
PLAY FO UR PLAY TWELVE

SHORT PUT » P46 SHORT CALL SPREAD » P64

PLAYS PLAY FIVE

CASH-SECURED PUT » P48


PLAY THIRTEE N

SHORT PUT SPREAD » P66


PLAY FO URTE E N
PLAYS INVOLVING A STOCK POSITION
LONG STRADDLE » P68
KEY TO INTERPRETING SYMBOLS PLAY SIX

» BULLISH COVERED CALL » P50 PLAY FIFTEEN

SHORT STRADDLE » P70


» BEARISH PLAY SEVEN

PROTECTIVE PUT » P52 PLAY SIXTEEN


» NEUTRAL LONG STRANGLE » P72
» NOT SURE - You think the stock is PLAY EIGHT

going someplace, but you don’t know COLLAR » P54 PLAY SEVENT E E N

which direction. SHORT STRANGLE » P74


PLAY EIGHTE E N

LONG COMBINATION » P76


PLAY NINETE E N

SHORT COMBINATION » P78

38 « THE OPTIONS PLAYBOOK ™ .COM


P L AY T WENTY THREE-LEG PLAYS FOUR-LEG PLAYS
FRONT SPREAD PLAY TWENTY-EIGHT P L AY T H I RT Y- S E V E N
W/ CALLS » P80 LONG BUTTERFLY SPREAD LONG CONDOR SPREAD
P L AY T WENTY-ONE
W/ CALLS » P102 W/ CALLS » P122
FRONT SPREAD PLAY TWENTY-NINE P L AY T H I RT Y- E I G H T
W/ PUTS » P82 LONG BUTTERFLY SPREAD LONG CONDOR SPREAD
P L AY T WENTY-TWO
W/ PUTS » P104 W/ PUTS » P124
BACK SPREAD W/ CALLS » P84 PLAY THIRTY P L AY T H I RT Y- N I N E

P L AY T WENTY-THREE
IRON BUTTERFLY » P106 IRON CONDOR » P126
BACK SPREAD W/ PUTS » P87 PLAY THIRTY-ONE P L AY F O RT Y

P L AY T WENTY-FO UR
SKIP STRIKE BUTTERFLY DOUBLE DIAGONAL » P128
LONG CALENDAR SPREAD W/ CALLS » P108
W/ CALLS » P90 PLAY THIRTY-TWO
Keep in mind that multi-leg strategies are subject to
additional risks and multiple commissions and may be
P L AY T WENTY-FIVE
SKIP STRIKE BUTTERFLY subject to particular tax consequences. Please consult with
your tax advisor prior to engaging in these strategies.
LONG CALENDAR SPREAD W/ PUTS » P110
W/ PUTS » P93 PLAY THIRTY-THREE

P L AY T WENTY-SIX
INVERSE SKIP STRIKE
DIAGONAL SPREAD BUTTERFLY W/ CALLS » P112
W/ CALLS » P96 PLAY THIRTY-FO UR

P L AY T WENTY-SEVEN
INVERSE SKIP STRIKE
DIAGONAL SPREAD BUTTERFLY W/ PUTS » P115
W/ PUTS » P99 PLAY THIRTY-FIVE

CHRISTMAS TREE BUTTERFLY


W/ CALLS » P118
PLAY THIRTY-SIX

CHRISTMAS TREE BUTTERFLY


W/ PUTS » P120

THE PLAYS » 39
P L AY O N E

LONG
CALL PRO FIT

THE SETUP
UÊ ÕÞÊ>ÊV>]ÊÃÌÀˆŽiÊ«ÀˆViÊ
UÊi˜iÀ>Þ]Ê̅iÊÃ̜VŽÊ«ÀˆViÊ܈ÊLiÊ>ÌʜÀÊ
above strike A
STOCK
PRICE
WHO SHOULD RUN IT AT EXP.
Veterans and higher
NOTE: Many rookies begin trading options by purchasing
out-of-the-money short-term calls. That’s because they
tend to be cheap, and you can buy a lot of them.
However, they’re probably not the best way to get
your feet wet. See the “Rookies’ Corner” section of this
book for other plays to consider.

WHEN TO RUN IT
You’re bullish as LO SS
a matador.

40 « THE OPTIONS PLAYBOOK ™ .COM


THE STRATEGY OPTIONS GUY’S TIPS: MARGIN REQUIREMENT

A long put gives you the right to sell the


Don’t go overboard with the leverage you can get After the trade is paid for, no additional
when buying puts. A general rule of thumb is this: If margin is required.
underlying stock at strike price A.
you’re used to selling 100 shares of stock short per
If there were no such thing as puts, the only trade, buy one put contract (1 contract = 100 shares). AS TIME GOES BY
way to benefit from a downward movement If you’re comfortable selling 200 shares short, buy two
in the market would be to sell stock short. The put contracts, and so on. For this play, time decay is the enemy. It
problem with shorting stock is you’re exposed to You may wish to consider buying an in-the-money will negatively affect the value of the option
theoretically unlimited risk if the stock price rises. put, since it’s likely to have a greater delta (that is, you bought.
changes in the option’s value will correspond more
But when you use puts as an alternative to short closely with any change in the stock price). Try looking IMPLIED VOLATILITY
stock, your risk is limited to the cost of the option for a delta of -.80 or greater if possible. In-the-money
contracts. If the stock goes up (the worst-case options are more expensive because they have intrinsic After the play is established, you want implied
scenario) you don’t have to deliver shares as you value, but you get what you pay for. volatility to increase. It will increase the value
would with short stock. You simply allow your of the option you bought, and also reflects an
puts to expire worthless or sell them to close your BREAK-EVEN AT EXPIRATION increased possibility of a price swing without
position (if they’re still worth anything). regard for direction (but you’ll hope the direction
Strike A minus the cost of the put. is down).
But be careful, especially with short-term
out-of-the-money puts. If you buy too many option THE SWEET SPOT CHECK YOUR PLAY WITH TRADEKING TOOLS
contracts, you are actually increasing your risk.
Options may expire worthless and you can lose The stock goes right in the tank. UÊ1ÃiÊ̅iÊProfit + Loss Calculator to establish
your entire investment. break-even points, evaluate how your strategy
MAXIMUM POTENTIAL PROFIT might change as expiration approaches, and
Puts can also be used to help protect the value
analyze the Greeks.
of stocks you already own. These are called There’s a substantial profit potential. If the stock
“protective puts.” See Play Seven. goes to zero you make the entire strike price UÊ,i“i“LiÀ\ʈvʜÕ̇œv‡Ì…i‡“œ˜iÞʜ«Ìˆœ˜ÃÊ>ÀiÊ
minus the cost of the put contract. Keep in mind, cheap, they’re usually cheap for a reason. Use
however, stocks usually don’t go to zero. So be the Probability Calculator to help you form an
realistic, and don’t plan on buying an Italian opinion on your option’s chances of expiring
sports car after just one trade. in-the-money.
UÊ1ÃiÊ̅iÊTechnical Analysis Tool to look for
MAXIMUM POTENTIAL LOSS
bearish indicators.
Risk is limited to the premium paid for the put.

THE PLAYS » 43
P L AY S E V E N

PROTECTIVE
PUT PRO FIT

THE SETUP
UÊ9œÕʜܘÊ̅iÊÃ̜VŽÊ
UÊ ÕÞÊ>Ê«ÕÌ]ÊÃÌÀˆŽiÊ«ÀˆViÊ
UÊi˜iÀ>Þ]Ê̅iÊÃ̜VŽÊ«ÀˆViÊ܈ÊLiÊ
above strike A STOCK
PRICE
AT EXP.
WHO SHOULD RUN IT
Rookies and higher

WHEN TO RUN IT
You’re bullish but
nervous.

LO SS

NOTE: This graph indicates profit and loss at expiration, respective to the stock value
when you bought the put.

52 « THE OPTIONS PLAYBOOK ™ .COM


THE STRATEGY OPTIONS GUY’S TIP: IMPLIED VOLATILITY

Purchasing a protective put gives you the right to


Many investors will buy a protective put when After the play is established, you want implied
they’ve seen a nice run-up on the stock price, and they volatility to increase. That will increase the price of
sell stock you already own at strike price A.
want to protect their unrealized profits against a the option you bought.
Protective puts are handy when your outlook is downturn. It’s sometimes easier to part with the money
bullish but you want to protect the value of stocks to pay for the put when you’ve already seen decent
CHECK YOUR PLAY WITH TRADEKING TOOLS
in your portfolio in the event of a downturn. They gains on the stock.
can also help you cut back on your antacid intake UÊ1ÃiÊ̅iÊProfit + Loss Calculator to establish
BREAK-EVEN AT EXPIRATION break-even points, evaluate how your strategy
in times of market uncertainty.
might change as expiration approaches, and
Protective puts are often used as an alternative to From the point the protective put is established, the
analyze the Greeks.
stop orders. The problem with stop orders is they break-even point is the current stock price plus the
sometimes work when you don’t want them to premium paid for the put.
work, and when you really need them they don’t
work at all. For example, if a stock’s price is THE SWEET SPOT
fluctuating but not really tanking, a stop order You want the stock to go to infinity and the put to
might get you out prematurely. If that happens, expire worthless.
you probably won’t be too happy if the stock
bounces back. Or, if a major news event happens MAXIMUM POTENTIAL PROFIT
overnight and the stock gaps down significantly on
the open, you might not get out at your stop price. Potential profit is theoretically unlimited, because
Instead, you’ll get out at the next available market you’ll still own the stock and you have not
price, which could be much lower. capped the upside.

If you buy a protective put, you have complete MAXIMUM POTENTIAL LOSS
control over when you exercise your option, and
the price you’re going to receive for your stock is Risk is limited to the “deductible” (current stock
predetermined. However, these benefits do come price minus the strike price) plus the premium paid
at a cost. Whereas a stop order is free, you’ll for the put.
have to pay to buy a put. So it would be nice
if the stock goes up at least enough to cover the MARGIN REQUIREMENT
premium paid for the put.
After the trade is paid for, no additional
If you buy stock and a protective put at the margin is required.
same time, this is commonly referred to as a
“married put.” For added enjoyment, feel free AS TIME GOES BY
to play a wedding march and throw rice
For this play, time decay is the enemy. It will nega-
while making this trade.
tively affect the value of the option you bought.

THE PLAYS » 53
P L AY T H I RT Y- N I N E

IRON
CONDOR PRO FIT

THE SETUP
UÊ ÕÞÊ>Ê«ÕÌ]ÊÃÌÀˆŽiÊprice A
UÊ-iÊ>Ê«ÕÌ]ÊÃÌÀˆŽiÊprice B
UÊ-iÊ>ÊV>]ÊÃÌÀˆŽiÊprice C
UÊ ÕÞÊ>ÊV>]ÊÃÌÀˆŽiÊprice D STOCK
PRICE
UÊi˜iÀ>Þ]Ê̅iÊÃ̜VŽÊ܈ÊLiÊLiÌÜii˜Ê
AT EXP.
strike price B and strike price C
NOTE: All options have the same expiration month.

WHO SHOULD RUN IT


Veterans and higher

WHEN TO RUN IT
You’re anticipating minimal movement on
the stock within a specific time frame. LO SS

126 « THE OPTIONS PLAYBOOK ™ .COM


As a general rule of thumb, you may wish to
THE STRATEGY consider running this play approximately 30–45 days
AS TIME GOES BY
from expiration to take advantage of accelerating time For this play, time decay is your friend. You want
You can think of this play as simultaneously decay as expiration approaches. Of course, this
running an out-of-the-money short put spread (play all four options to expire worthless.
depends on the underlying stock and market conditions
thirteen) and an out-of-the-money short call spread such as implied volatility.
IMPLIED VOLATILITY
(play twelve). Some investors consider this to be
Some investors may wish to run this play using
a more attractive strategy than a long condor After the play is established, the effect of implied
index options rather than options on individual stocks.
spread with calls or puts because you receive a volatility depends on where the stock is relative to
That’s because historically, indexes have not been as
net credit into your account right off the bat. volatile as individual stocks. Fluctuations in an index’s your strike prices.
Typically, the stock will be halfway between strike component stock prices tend to cancel one another out,
If the stock is near or between strikes B and C,
B and strike C when you construct your spread. If lessening the volatility of the index as a whole.
you want volatility to decrease. This will decrease
the stock is not in the center at initiation, the play the value of all of the options, and ideally, you’d
will be either bullish or bearish. BREAK-EVEN AT EXPIRATION
like the iron condor to expire worthless. In addi-
The distance between strikes A and B is usually There are two break-even points: tion, you want the stock price to remain stable,
the same as the distance between strikes C and and a decrease in implied volatility suggests that
UÊ-ÌÀˆŽiÊ Ê“ˆ˜ÕÃÊ̅iʘiÌÊVÀi`ˆÌÊÀiViˆÛi` may be the case.
D. However, the distance between strikes B and C
may vary to give you a wider sweet spot UÊ-ÌÀˆŽiÊ
Ê«ÕÃÊ̅iʘiÌÊVÀi`ˆÌÊÀiViˆÛi` If the stock price is approaching or outside strike
(see Options Guy’s Tip). A or D, in general you want volatility to increase.
THE SWEET SPOT
You want the stock price to end up somewhere An increase in volatility will increase the value of
between strike B and strike C at expiration. An You achieve maximum profit if the stock price is the option you own at the near-the-money strike,
iron condor spread has a wider sweet spot than between strike B and strike C at expiration. while having less effect on the short options at
an iron butterfly. But (as always) there’s a tradeoff. strikes B and C. So the overall value of the iron
In this case, your potential profit is lower. MAXIMUM POTENTIAL PROFIT condor will decrease, making it less expensive to
close your position.
Profit is limited to the net credit received.
OPTIONS GUY’S TIPS: CHECK YOUR PLAY WITH TRADEKING TOOLS
One advantage of this strategy is that you want
MAXIMUM POTENTIAL LOSS
UÊ1ÃiÊ̅iÊProfit + Loss Calculator to establish
all of the options to expire worthless. If that happens, Risk is limited to strike B minus strike A, minus the
you won’t have to pay any commissions to get out of
break-even points, evaluate how your strategy
net credit received. might change as expiration approaches, and
your position.
analyze the Greeks.
You may wish to consider ensuring that strike B and MARGIN REQUIREMENT
strike C are around one standard deviation or more away UÊ1ÃiÊ̅iÊProbability Calculator to verify that
from the stock price at initiation. That will increase your See Appendix A for margin requirement. strikes B and strike C are about one standard
probability of success. However, the further these strike deviation away from the stock price.
prices are from the current stock price, the lower the
potential profit will be from this play.

THE PLAYS » 127


FINAL
THOUGHTS
FINAL THOUGHTS » 131
THE
retail investors will be trading on a smaller scale a market maker, that loose change can really
than the other players in the game. add up. In practice, the picture is a little more
complex. But for now, the above scenario is all
INSTITUTIONAL TRADERS are professionals

PLAYERS IN
you really need to know.
trading for large entities like mutual funds, hedge
funds, etc. Oftentimes they will trade options to EXCHANGES exist to maintain a fair and orderly

THE GAME
hedge their positions, but they may also trade marketplace and to provide timely dissemination
options as pure speculation. of price information. Any time you place an
BROKER-DEALERS are in the game to facilitate option order, it is routed to an exchange, where
trades. These are firms like TradeKing, that buyers are matched with sellers. Exchanges
Many option traders don’t understand who might accept orders on behalf of clients and then can be either a physical “open outcry” location
be buying or selling the options on the other end ensure they are executed in the open market at where traders meet to conduct transactions or an
of their transaction. Fortunately, after reading this the best available price. This is done in exchange electronic platform.
section, you won’t be one of them. for commissions on the trade. In addition to
facilitating trades, a dealer may also choose to SO WHO’S ON THE OTHER SIDE OF MY
Buying or selling an option is a process quite
similar to buying or selling stock. It’s not some
buy or sell options for its own benefit, whereas OPTION TRADE?
a regular broker won’t. So the combined term
mystical process just because it’s a different type When you enter an option order with TradeKing,
“broker-dealer” encompasses all of the players
of security. In fact, it trades pretty much like any we look in the marketplace for the national best
that serve these particular functions.
other security. bid or offer price for your trade. Your transaction
MARKET MAKERS are the 800 lb. gorilla in is then matched with the entity providing that
In the option market, you’re dealing with four
the game. They’re obligated to make bids and bid or offer.
different entities: retail investors like you,
offers on the options traded on specific securities.
institutional traders, broker-dealers and “market Much of the time you will be trading with a
Thus, market makers provide liquidity in the
makers.” The generic term “trader” is often used market maker. However, you may instead wind
options marketplace.
interchangeably for any of these players. up trading with an institutional trader, a dealer,
In other words, market makers stand ready to or another retail client. It really makes no differ-
Orders generated by each player are routed
take the opposite side of a trade if and when ence who you’re trading with, as long as your
to entities called “exchanges.” You probably
one of the other players wants to buy or sell an order is executed at a favorable price.
already know how exchanges work. But figuring
option. Market makers provide a firm bid and
out just how options change hands can be a ask (offer) price in order to facilitate trading Ultimately, what this all means is that there will
little confusing. So let’s take a look at just who on that option. always be a market for any exchange-traded
each player is, then we’ll look at how your option option you would like to buy or sell. You may
orders get executed. In theory, market makers earn their profits from
not always like the market for a given option,
the difference between the bid and ask price of
RETAIL INVESTORS are individuals like you but rest assured it will always be there for you
options. They try to continually buy at the bid
who are buying and selling options with their to participate in should you choose to do so.
price and sell at a higher ask price, so they’ll
own money for personal profit. Their objective
make a few nickels or dimes on each transaction.
is usually to make a significant percentage gain
And when you’re making as many trades as
on their initial investments. Normally, individual

132 « THE OPTIONS PLAYBOOK ™ .COM


FINAL THOUGHTS » 133
SO WHAT’S DIFFERENCE 1:
MULTIPLE UNDERLYING STOCKS VS.
A SINGLE UNDERLYING STOCK
DIFFERENCE 3: SETTLEMENT STYLE
As of this writing, all stock options have American-

AN INDEX Whereas stock options are based on a single


company’s stock, index options are based on a
style exercise, meaning they can be exercised at
any point before expiration. Most index options,
on the other hand, have European-style exercise.

OPTION,
basket of stocks representing either a broad or
So they can’t be exercised until expiration.
a narrow band of the overall market.
But that doesn’t mean that if you buy an index

ANYHOW?
Narrow-based indexes are based on specific
option, you’re stuck with it until expiration. As
sectors like semiconductors or the financial
with any other option, you can buy or sell to
industry, and tend to be composed of relatively
close your position at any time throughout the life
few stocks. Broad-based indexes have many
of the contract.
Like stock options, index option prices rise or fall different industries represented by their compo-
based on several factors, like the value of the nent companies. But that doesn’t necessarily
underlying security, strike price, volatility, time until mean there are a ton of stocks that make up a DIFFERENCE 4: SETTLEMENT DATE
expiration, interest rates and dividends. But there particular broad index.
The last day to trade stock options is the third
are five important ways index options differ from For instance, the Dow Jones Industrial Average Friday of the month, and settlement is determined
stock options, and it’s important to understand is a broad-based index that’s only composed of on Saturday. The last day to trade index options
these differences before you can start trading 30 stocks, but it still represents a broad range is usually the Thursday before the third Friday
index options. of sectors. As you would expect, however, other of the month, followed by determination of the
Let’s have a look at these differences, shall we? broad-based indexes are indeed made up of settlement value on Friday. The settlement value
many different stocks. The S&P 500 is a good is then compared to the strike price of the option
example of that. to see how much, if any, cash will change hands
between the option buyer and seller.

DIFFERENCE 2: SETTLEMENT METHOD


DIFFERENCE 5: TRADING HOURS
When stock options are exercised, the under-
lying stock is required to change hands. But Stock options and narrow-based index options
index options are cash-settled instead. stop trading at 4:00 ET, whereas broad-based
indexes stop trading at 4:15 ET. If a piece of
If you exercise a call option based on the S&P
news came out immediately after the stock
500, you don’t have to buy all 500 stocks in
market close, it might have a significant impact
the index. That would be ridiculous. The index
on the value of stock options and narrow-based
value is just a gauge to determine how much the
index options. However, since there are so many
option is worth at any given time.
different sectors in broad-based indexes, this is
not so much of a concern.

FINAL THOUGHTS » 145


A BRIEF
HISTORY OF
OPTIONS
There are plenty of good option traders who
don’t know anything about the following historical
facts. But I’ve included this section of the book
for those inquisitive souls with the drive to learn
everything possible about whatever subject they
choose to study.
If you fall into that category, I salute you. Join me
in the trusty Way-back Machine and let’s examine
the evolution of the modern-day options market.

FINAL THOUGHTS » 147


CONGRATULATIONS ON MAKING
IT ALL THE WAY TO THE END OF
ACKNOWLEDGEMENTS
THE OPTIONS PLAYBOOK.™ Special thanks to the crew at Stick and Move
in Philadelphia for all their hard work from
By now, your head must be so full of option-
day one. They helped with the conception of
related knowledge you probably need a bigger
The Options Playbook, did the layout and
hat. Hopefully, you’re also well on your way to
production and pretty much supported me
making smarter trades.
every step of the way.
If your mental hard drive isn’t quite full, check
I would also like to show appreciation to my
out my blog in the TradeKing Trader Network.
friend and mentor Jim Bittman, just for being
I’m constantly updating it with information that
Jim Bittman. He did not have a hands-on
you’ll find useful when placing your trades. And
involvement in this book, but contributed
don’t forget to refer back to this playbook while
immensely with his willingness to share his
considering which strategy to run.
vast options knowledge throughout our many
Now, in parting, I’d like to leave you with years of friendship.
one simple wish:
Thanks also go – in alphabetical order – to
Jude Stewart (TradeKing Director of Online
May all the options you buy expire Content) and Nicole Wachs (TradeKing
in-the-money, and all the ones you sell Director of Education) for their editorial
expire out-of-the-money. assistance. You were a huge help.
A thousand truckloads of thanks to every-
Happy Trading, body else on the TradeKing team who
helped make this book possible. You know
Brian Overby
who you are, and you rock.

158 « THE OPTIONS PLAYBOOK ™ .COM


• Setups, risks, rewards and optimal • How the Greeks measure variables
market conditions for 40 different that affect options pricing
option plays
• How time decay and changes in
• Option terms and concepts without implied volatility can affect your plays
any mumbo jumbo
• Common mistakes to avoid
• Strategies for rookies to get their feet
• Lots of other valuable stuff that would
wet in options trading
make this a really long list
• How implied volatility can be used to
anticipate future stock movement

P R A I S E FO R T H E O P T I O N S P L AY B O O K ™

The Options Playbook is a valuable reference for option The sure sign of a good option teacher is an ability I think The Options Playbook is outstanding. The structure
traders of all levels. Not only does it explain complex to teach the basics. I’ve taught alongside Brian at the is logical and informative, and the text is quite amusing.
subjects like implied volatility and the Greeks in a manner Chicago Board Options Exchange many times, and he Of course, since Brian is a former colleague, we at
that is easy to understand, it does so with appealing wit. excels at making complex concepts easily understood CBOE take some of the credit for his creative genius.
It’s the kind of resource you will reach for every time you by retail traders.
make an option trade. Edward L. Provost
Dan Sheridan
Executive Vice President
James B. Bittman Chicago Board Options Exchange
President / Founder
Senior Staff Instructor Sheridan Options Mentoring Corporation
The Options Institute at CBOE Former CBOE Market Maker
Author of Options for the Stock Investor
and Trading Options as a Professional

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