Table of Contents

Title Page

Copyright Page

Acknowledgements

Element Key

Introduction

Chapter 1 - Calls and Puts: Defining the Field of Play

The Call Option

The Put Option

Option Valuation

Chapter 2 - Opening, Closing, Tracking: How It All Works

A Note on the Expiration Cycle

Using the Daily Options Listings

Understanding Option Abbreviations

Chapter 3 - Buying Calls: Maximizing the Rosy View

Understanding the Limited Life of the Call

Judging the Call

Call Buying Strategies

Defining Profit Zones

Chapter 4 - Buying Puts: The Positive Side of Pessimism

The Limited Life of the Put

Judging the Put

Put Buying Strategies

Chapter 5 - Selling Calls: Conservative and Profitable

Selling Uncovered Calls

Selling Covered Calls

Calculating Rate of Return

Timing the Decision

Avoiding Exercise

Chapter 6 - Selling Puts: The Overlooked Strategy

Analyzing Stock Values

Evaluating Risks

Put Strategies

Chapter 7 - Choosing Stocks: Finding the Right Ingredients

Developing an Action Plan

Selecting Stocks for Call Writing

Averaging Your Cost

Analyzing Stocks

Applying Analysis to Calls—the “Greeks”

Acting on Good Information

Chapter 8 - Strategies in Volatile Markets: Uncertainty as an Advantage

Avoiding 10 Common Mistakes

Modifying Your Risk Tolerance

The Nature of Market Volatility

Market Volatility Risk

Options in the Volatile Environment

Chapter 9 - Combined Techniques: Creative Risk Management

Overview of Advanced Strategies

Vertical Spread Strategies

Horizontal and Diagonal Spread Strategies

Altering Spread Patterns

Hedge Strategies

Straddle Strategies

Theory and Practice of Combined Techniques

Chapter 10 - Paper Trading: A Test Run of the Theory

The Case for Paper Trading

Two Sites Worth Checking

Proceeding with a Paper-Trading Plan

Chapter 11 - Options for Specialized Trading: Leveraging the Technical Approach

Swing-Trading Basics

The Setup Signal

Testing the Theory

A Strategic View of Options for Swing Trading

Options Used for Other Trading Strategies

Swing- and Day-Trading Advanced Strategies

Chapter 12 - Leveraging Your Leverage

Important Distinctions

Regulatory Differences

Chapter 13 - Trading Index Options: Playing the Broader Market

Advantages to Trading Index Options

Exercise and Expiration Rules

Index Option Strategies

Structured Index Options

Chapter 14 - Risk and Taxes: Rules of the Game

Identifying the Range of Risk

Tax Consequence Risk

Evaluating Your Risk Tolerance

Tax Ramifications in Trading Options

Qualified Covered Calls—Special Rules

Looking to the Future

Chapter 15 - Calculating the Return: A Complex Aspect to Options

Finding a Realistic Method

Annualizing Models and Guidelines

An Overview of Basic Calculation for Calls

Anticipating the Likely Return

—Glossary—

—Recommended Reading—

Index

Copyright © 2010 by Michael C. Thomsett. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 646-8600, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Thomsett, Michael C.

Getting started in options / Michael C. Thomsett. - 8th ed. p. cm. - (Getting started in-)

Includes index.

eISBN : 978-0-470-55383-1

1. Stock options. 2. Options (Finance) I. Title.

HG6042.T46 2010

332.63’2283-dc22

2009033767

Acknowledgments

Thanks to those many readers who wrote to offer their suggestions and insights to previous editions of this book, including constructive criticism and clarifying questions. Their letters have helped to improve the ever-changing sets of explanations and examples, definitions, and other materials used in this book.

A very special thanks goes to Debra Englander, my editor for many years at John Wiley & Sons, whose encouragement through many editions of this and other books has been greatly appreciated.

Also, thanks go to Candlestickchart.com for their generous permission to use their charts to illustrate many points in this book; and to the RediNews Network, which provided the market data used in those charts.

Finally, I am grateful to my wife, Linda Rose Thomsett, for her insights, support, and enthusiasm for this project.

Element Key

Examples: Numerous examples illustrate points raised in the discussion surrounding them, and are designed to express those ideas in practical applications of the principles.

Definitions: This symbol is found in boxed notations providing specific definitions of options terms. These occur at the point of discussion within the book, making definitions applicable to the section being read. (All definitions are also summarized for you in the glossary.)

Smart Investor Tips: These are useful observations, rules of thumb, resources, and other added points every options trader can use.

Introduction to the 8th Edition

The options market has had a remarkable history since its inception in 1973. Every year, new records are set that vastly pass up previous record levels. This trend is going to continue into the future, because option trading makes sense on so many levels and for so many reasons.

In 1989, the year the first edition of Getting Started in Options was published, only 227 million options contracts traded during the entire year. In 2008, for the first time, total trading volume exceeded three billion contracts. That is considerable growth in only 20 years.

In the first year that listed options were traded (1973), only 1.1 million contracts traded. In those days of pre-Internet, pre-electronic trading, that was a lot of volume. However, the Internet has made the entire options market faster and more efficient and, most important, accessible to anyone with a computer.

In 2000, the Options Clearing Corporation (OCC) reduced its clearing fees by a record 41 percent, making options trading practical at bargain levels for the first time. Trading since then has grown at an amazing rate. In 1999, volume passed one-half billion contracts for the first time. Volume then moved over one billion in 2004 and over two billion in 2006. Even with the volatile and fast-changing market of 2008, the popularity—and for many, the necessity—of options continued to grow. In 2008, volume of contracts traded passed the three billion mark for the first time.

Why are options so popular and why is this popularity expanding? The answer involves several aspects:

1. The Internet has made options accessible to everyone. In the past, you had to telephone or visit a stockbroker, who had to then place a call to an exchange to get a quote and place an order. This cumbersome process meant that anyone who was not physically on the exchange floor missed many fleeting opportunities.

2. Costs have been vastly reduced. Since 2000, when clearing fees were reduced 41 percent, the cost of trading options is quite low. If you use an online discount broker, you can buy or sell contracts for about $10. That is a real bargain.

3. The use of options goes far beyond speculation. Many people think of options as high-risk and purely speculative instruments in which it is easier to lose than to win. However, many strategies are undertaken to hedge stock positions, insure paper profits, and take profits without having to sell stock. The many uses of options make them not only a valuable tool, but an essential tool in the modern portfolio. The flexibility of options is increasingly making them a vital strategy for portfolio management and risk reduction.

4. Expanded products have made options useful in many ways beyond options on shares of stock. Today, you can buy long-term options or options on futures, exchange-traded funds, indices, and even futures contracts. Options trading is also available internationally today, and many foreign exchanges and fully automated exchanges provide options trading. In other words, the universe of options trading has become quite mainstream.

5. Education has expanded along with ease of access through the Internet. The Chicago Board Options Exchange (CBOE) offers many online and live educational seminars on options trading; seminars, online courses and tutorials, articles, and books are easily found; and more and more stock investors are beginning to recognize the value of options as part of their portfolios.

Even with all of the improved access, lowered costs, and widespread availability, there remains a great deal of confusion about the market. Anyone new to options trading is easily confused and lost in the jargon and technical explanations of how options trading works. Many strategies have more than one name, making it even more difficult to master the complexities of advanced strategies. Many books on the topic are overly technical and do not carefully explain and define the field of information. In this book, the learning curve is made easier with the use of several tools. These include:

• Definitions in context. The complex terminology of the options market makes comprehension difficult and often overwhelming. In this book, as each important term is first introduced, it is defined in a shaded box on the applicable page. (Definitions are also summarized in the glossary at the end of the book.)

• Smart investor tips. These set-asides give you observations, resources, web links, or important points to bring home a main point. In fact, one of the most practical ways to use this book is to skim through it and read only the smart investor tips. Then, when you find an area of discussion especially interesting or relevant to your portfolio and trading strategy, you can focus on that section of the book.

• Examples. This book employs dozens of examples to show how a particular strategy works. These are straightforward and to the point, but detailed enough to clarify the discussion.

• Checklists. A lot of discussion in this book includes organization in a checklist or outline format. This makes it easier to absorb information logically.

• Illustrations. Much of what we learn is visual in nature, and all learning is easier when new ideas are presented graphically. Options trading can be complex, mathematical, and difficult to envision, so the use of ample visual aids makes the task much easier.

• Tables. Besides illustrations, tables are very useful in summarizing a lot of information, especially when a lot of dollar values are involved. This is most true for options strategies involving two or more offsetting positions. Tables make it possible to explain a strategy in text and demonstrate its potential in rows and columns of numbers.

As you go through this book, don’t expect yourself to grasp and master everything right away, or even with a first read. The nature of options is that it takes time to think about the strategies and to come to conclusions. This is why trying out strategies with paper trading (a technique of hypothetical trading) is valuable. It enables you to learn about how a specific trade works using real contracts and stocks, but without risking actual money.

Set a goal for yourself to learn how to best use this growing, exciting, but complex field, in four stages:

1. Master the terminology of the options field. Of course, you cannot simply memorize definitions without a context, which is why all of the terms you need are defined as they are introduced.

2. Be constantly aware of risk as you read this book. Options strategies are best defined and compared by their risk levels, so this is most important. You will also discover that options strategies cover the entire risk spectrum, from speculative through very conservative.

3. Watch the market and check trends in option values as well as stocks. Become familiar with how option values changes in relation to price movement in stocks, noting that these values do not always mirror the changes in stocks. This occurs for many reasons, and it is valuable to be aware of the variations between stock and option price levels.

4. Identify your personal risk tolerance level and decide how options are most appropriate for you. Everyone has a different set of goals, financial resources, and ability to tolerate loss, and this all defines how you can and should employ options as part of your portfolio. Try various strategies with paper trading before putting real money at risk (see Chapter 10). Only when you have a clear appreciation of the range of outcomes for any specific strategy will you be ready to proceed with confidence.

The John Wiley & Sons Getting Started in series is designed to provide people like you with a solid basis and understanding in a particular market or strategy. The use of many learning tools and carefully designed book layout make this series popular and successful in its many investment titles. Options and many other markets are highly technical, but one important premise to this series is the underlying belief that anyone can master a new idea. If information is provided and explained in a user-friendly format, you can acquire all of the skills you need to master a new field of investing. This ultimately improves your chances for success in the market.

Chapter 1

Calls and Puts: Defining the Field of Play

Nine-tenths of wisdom is being wise in time.

—Theodore Roosevelt, speech, June 14, 1917

Options are amazing tools that can help you expand your control over your portfolio, protect positions, reduce market risk, and enhance current income. Some strategies are very high risk, but others are extremely conservative. This is what makes the options market so interesting. The variety of creative uses of options makes it possible to tie in profits in the most uncertain of conditions, or to pursue income opportunities without being exposed to even the most volatile markets.

Because the option is an intangible device, its cost is only a fraction of stock prices. This makes it possible to control shares of stock without assuming the market risks. Each option controls 100 shares, so for approximately 10 percent of the cost of buying shares in a company, you can use options to create the same profit stream. This makes your capital go farther while keeping risks very low.

This idea—using intangible contracts to duplicate the returns you expect from well-picked stocks—is revolutionary to anyone who has never explored options trading. Most people are aware of the two best-known ways to invest money: equity and debt. An equity investment is the purchase of a share of stock or many shares of stock, which represents a partial interest in the company itself. Shares are sold through stock exchanges or over the counter (trades made on companies not listed on an exchange). For example, if a company has one million shares outstanding and you buy 100 shares, you own 100/1,000,000ths, or .0001 percent of the company.

equity investment

an investment in the form of part ownership, such as the purchase of shares of stock in a corporation.

share

a unit of ownership in the capital of a corporation.

When you buy 100 shares of stock, you are in complete control over that investment. You decide how long to hold the shares and when to sell. Stocks provide you with tangible value, because they represent part ownership in the company. Owning stock entitles you to dividends if they are declared, and gives you the right to vote in elections offered to stockholders. (Some special nonvoting stock lacks this right.) If the stock rises in value, you will gain a profit. If you wish, you can keep the stock for many years, even for your whole life. Stocks, because they have tangible value, can be traded over public exchanges, or they can be used as collateral to borrow money.

Example

Equity for Cash: You purchase 100 shares at $27 per share, and place $2,700 plus trading fees into your account. You receive notice that the purchase has been completed. This is an equity investment, and you are a stockholder in the corporation.

Example

Partway There: You buy an automobile for $10,000. You put down $3,000 and finance the difference of $7,000. Your equity is limited to your down payment of $3,000. You are the licensed owner, but the financed balance of $7,000 is not part of your equity.

debt investment

an investment in the form of a loan made to earn interest, such as the purchase of a bond.

The second broadly understood form is a debt investment, also called a debt instrument. This is a loan made by the investor to the company, government, or government agency, which promises to repay the loan plus interest, as a contractual obligation. The best-known form of debt instrument is the bond. Corporations, cities and states, the federal government, agencies, and subdivisions finance their operations and projects through bond issues, and investors in bonds are lenders, not stockholders.

When you own a bond, you also own a tangible value, not in stock but in a contractual right with the lender. The bond issuer promises to pay you interest and to repay the amount loaned by a specific date. Like stocks, bonds can be used as collateral to borrow money. They also rise and fall in value based on the interest rate a bond pays compared to current rates in today’s market. In the event an issuer goes broke, bondholders are usually repaid before stockholders as part of their contract, so bonds have that advantage over stocks.

Example

Lending Your Money: You purchase a bond currently valued at $9,700 from the U.S. government. Although you invest your funds in the same manner as a stockholder, you have become a bondholder; this does not provide any equity interest to you. You are a lender and you own a debt instrument.

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!

Lesen Sie weiter in der vollständigen Ausgabe!