Ultimate Options Trading Guide

THE UL ULTIMA TIMATE TE G UIDE TO

TRADING OPTIONS B Y

TRADING ADVANTAGE

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WHAT’S IN THIS GUIDE? Winning. That’s what this guide is all about. We’ll expose the secrets, tips and techniques used by some of the BEST options options traders in the game to help put the odds in your favor and win this zero-sum game.

We’ll reveal: Secret formulas and systems to make quick returns The habits needed to achieve options trading success Major mistakes made by rookie options traders and how to avoid them Some of the most powerful options trading strategies on earth What separates the winners from the losers And much more…

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WHAT’S IN THIS GUIDE? Winning. That’s what this guide is all about. We’ll expose the secrets, tips and techniques used by some of the BEST options options traders in the game to help put the odds in your favor and win this zero-sum game.

We’ll reveal: Secret formulas and systems to make quick returns The habits needed to achieve options trading success Major mistakes made by rookie options traders and how to avoid them Some of the most powerful options trading strategies on earth What separates the winners from the losers And much more…

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ABOUT THE AUTHORS Larry Levin PRESIDENT & FOUNDER, TRADING ADVANTAGE

Starting over 25 years ago as a runner at the CME group, the world’s largest and most diverse futures exchange, Larry Levin quickly climbed the ranks to become one of the most successful traders in the S&P 500 pit. At the height of his trading career, career, Larry averaged between 2500-3000 S&P contracts per day.

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ABOUT THE AUTHORS Scott Bauer SENIOR OPTIONS INSTRUCTOR, TRADING ADVANTAGE

A respected market commentator seen on CNBC and other major financial networks, Scott Bauer has 20 plus years of professional equity and index options experience including over ten years as a Chicago Board Options Exchange (CBOE) market maker and a trader for Goldman Sachs. Scott graduated from the University of Illinois Business School and has taught classes both at his alma mater and at the CBOE.

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ABOUT THE AUTHORS Michael Shorr OPTIONS INSTRUCTOR, TRADING ADVANTAGE

Michael Shorr is a veteran derivatives trader of the CME, CBOT, and CBOE. He has broad market knowledge ranging from agricultural to treasury markets. Michael has taught options theory classes for a number of years and possesses an entertaining and relatable teaching style.

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TABLE OF CONTENTS Introduction

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Mechanics Of Options Trading

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The 25 Greatest Secrets, Tips and Techniques Top Secrets from Legendary Traders that Will Transform Your Options Trading

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The “Magic” 3-Step Formula that Rookie Traders are Using to Beat Wall Street

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The Key to Turning Your Portfolio into an Income Generating Machine

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Seven Habits of Highly Successful Options Traders

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The Three Deadly Sins of Options Trading

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A Go-To Strategy for the Next Market Crash

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The K.I.S.S. Strategy

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Next steps

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Glossary of Terms

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INTRODUCTION Welcome to the world of options trading... You have decided to embark on a journey that can potentially provide enormous financial rewards for the educated and disciplined. While many investors are afraid to use options and think they’re risky, options can be an extremely powerful tool in your trading arsenal. In fact, options are the most versatile financial instrument at your disposal. While options may appear complicated and difficult to master to the novice, they are an indispensable tool for the professional traders that must generate positive income to pay their bills.

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By utilizing the power of options, you can potentially: Trade market direction with less exposure and significantly lower margin requirements Generate income from stocks or instruments you already own Hedge your existing market exposure and/or tail risk Potentially profit from changes in implied volatility Potentially profit from nothing more than the passage of time So how do you become a profiting options trader? First, let’s take a look into the mechanics of options trading.


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THE MECHANICS OF OPTIONS TRADING Before we dive into the secrets, tips and techniques, we should first cover some basic terminology and concepts to make sure we’re all on the same page.

There are two types of Options: CALLS and PUTS. Call options give the owner the right to buy the underlying asset; put options give the owner the right to sell the underlying asset.

An option is a contract to buy or sell underlying instrument or underlying interest. Owning stock options is not the same as owning shares of stock. If you own an option, you have the right, but not the obligation to control your stock at a specified price, (STRIKE PRICE), until a specified time, (EXPIRATION DATE). If an option is not exercised before the expiration date, it will expire, or cease to exist.

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BASIC TERMS YOU NEED TO KNOW The STRIKE PRICE, or EXERCISE PRICE, is the price at which the underlying asset may be purchased or sold. Equity (stock) option strike prices are listed in increments of 0.50, 1, 2.5, 5, or 10 points, depending on the price level of the stock. The EXPIRATION DATE is the date the option expires. A stock option expires at the market's close on the 3rd Friday of the expiration month.

There are two definitions of options PREMIUM. The first refers to the price of the option. The second definition and the one we will generally use is the extrinsic (time) value of the option above and beyond any intrinsic value of an option. In either definition, an option's PREMIUM is determined by many factors, including the current price of the asset, the strike price of the option, the time remaining until expiration, interest rates, dividends and volatility.

All listed options can be traded with at least four expiration dates, and usually more. Some stocks and indices have options that trade as far out in the future as two years (LEAPS).

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9 An option's premium is on a per-share basis and represents 100 shares of the underlying asset. If the premium of an option is 6, the total premium for that option is 600 (6 x 100). Purchasing an option creates a debit to your trading account in the amount of the premium paid. There are no margin requirements when you purchase options because your risk is limited to the premium, the price of the option.

How do options offer an investor LEVERAGE? Option buyers can pay a small premium for market exposure as compared to the actual price of the asset to which it is attached. Investors can see large returns from even small, favorable percentage moves in the underlying equity. Option buyers also know their RISK . The maximum loss would be the premium amount paid for that option. However, an option seller potentially has unlimited risk.

Selling an option creates a credit to your trading account in the amount of the premium collected. However, because option sellers have an obligation to either buy or sell the underlying equity if their option is exercised by an option owner, selling an option requires a substantial margin.

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10 Trading stock options, especially in today's volatile market, can offer an investor the following advantages: Protection from a decline in the overall market or in the price of a long underlying security. The ability to purchase stock at a lower price or sell stock at a higher price. The ability to create additional income against a long OR a short position. Profit potential from a move in the price of a stock, regardless of direction. Now that we’ve got the basics covered, let’s look at top secrets from legendary traders and how you can begin to deploy these secrets today to catapult your own options trading.

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TOP SECRETS FROM LEGENDARY TRADERS THAT WILL TRANSFORM YOUR OPTIONS TRADING Throughout history, certain men and women have achieved great success in financial markets. These successes were not due to luck and were certainly not a fluke. Many of the most legendary traders achieved such status due to the consistency with which they were able to beat the market. While traders tend to have their own styles, habits and methodologies, the most successful traders share a number of traits-and secrets-that have helped them reach the top of an extremely competitive field.

Top Secret #1 FIND YOUR OWN STYLE

No two traders are exactly the same. Traders may have completely different goals and objectives and may trade all different kinds of markets. While some traders may utilize a very technical approach, others may be more reliant on market fundamentals. Some may trade options as a standalone instrument while others may use options in conjunction with stock, futures or other instruments. Whatever the case may be - find your own way .

So what are the top secrets of these trading superstars?

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12 Top Secret #2

Top Secret #3

BE PROPERLY CAPITALIZED FOR YOUR OBJECTIVES

LEARN TO LOVE LOSING

Many traders that have tremendous potential all too often are out of the game too fast because they are not properly capitalized. It is imperative to determine your trading goals and objectives. For example, a trader looking to make a full-time living from trading is going to need a substantially larger account than a trader who is simply looking to build wealth over a period of time. The products traded will also have a significant impact on the amount of capital required. For someone looking to day-trade, stocks will require more capital than futures or forex.

The ability to lose like a professional is key to your trading success. No one has a crystal ball - NO ONE. The difference between a novice trader that loses money consistently and a professional trader that makes money consistently is how they take losses. Novice traders tend to hold onto losing positions, and find themselves hoping and praying for the market to reverse course. Professional traders, on the other hand, understand that taking losses is part of the game, and do so with grace and objectivity.

Whichever path you choose, make sure you are working with adequate capital to endure the inevitable draw-downs that are part of trading.

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13 Top Secret #4

Top Secret #5

CONQUER YOUR OWN HUMAN NATURE

TREAT TRADING LIKE A BUSINESS

Trading is a psychological game. While methodology and strategy are important, without the right psychological mindset you are destined for failure. The emotions of fear and greed must be overcome to be successful in this endeavor. Top traders not only take losses like professionals, but they are happy to do so. They understand that by taking a loss, they are protecting their capital from further losses that can take them out of the game. On the other hand, professional traders know when to take profits. They have an uncanny ability to let their profits run, but do not get overly greedy in the process, allowing a big winner to turn into a small winner, or worse yet, a loser. Top traders remain objective at all times, and do not allow emotion to dictate trading decisions.

Trading for a living is a business and should be treated accordingly. To be a successful full-time trader, we recommend viewing your trading as a business that can provide a very good livelihood for you and your family. This means putting in the time to perform market research, doing technical analysis and structuring positions with care and attention to detail.

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14 Top Secret #6 ALWAYS STRIVE TO GET BETTER

Top traders are always, ALWAYS looking for ways to improve. Markets can and do change, and as traders one must be able to adapt strategies accordingly. Trading is a life-long journey, a journey with no end. In trading, just as in any other field or occupation, the best are always looking for ways to get better . The best never sit on their heels, and never allow themselves to become content and complacent. By always looking for ways to sharpen your skills, you can help ensure you stay at the top of your trading game.

business that can potentially provide enormous financial benefits while allowing you to live life on your own terms.

While there is no “Holy Grail” when it comes to trading, these simple guidelines from some of the world’s best traders can get you a step ahead. By putting in the time and effort, and with a willingness to be a life-long learner, you can catapult your trading into a

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The “Magic” 3-Step Formula Rookie Traders Are Using to Beat Wall Street You don’t have to trade on Wall Street to win like a Wall Street trader. More and more of today’s investors are putting their money into their own hands. These investors, having chosen to take control of their own destiny, could now also be referred to as traders. In fact, there are traders out there right now that are beating Wall Street as we speak. Many of these traders come from non-financial backgrounds, and some have had very limited experience in trading altogether.

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So How Are They Beating Wall Street?

Today’s financial markets have become more complex, more efficient and more competitive. The market is still, at its core, an auction. It is a market of buyers and sellers-nothing more and nothing less. Acknowledging this fact, and removing a lot of the common “noise” surrounding trading, is a great start. There are three key steps that even novice traders are taking right now to beat Wall Street.


16 Step #1 Know thy market. Successful traders do not generally go out and trade multiple financial instruments. Have you ever seen a successful S&P pit trader who was also a pro stock trader? Not likely. How about a successful stock trader that also killed it in the grain markets? Again, not likely.

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Today’s financial markets can lead to information overload. Most successful traders focus on a single product or arena to work in. For example, a treasury trader may trade bonds, 10 year notes and five year notes. Or an energy trader may focus on crude oil and natural gas futures. The point is this: When you begin to spread yourself out, you may dilute your trading abilities. Focus on one market or one area. Become intimately familiar with it. Feel like you know what it’s going to do before it does. Study your craft, and put all of your efforts into mastery of this single product or space.


17 Step #2 Understand Risk. When it comes to trading and investing, the name of the game is risk. One way to think of trading is simply a transfer of risk from one party to another. For example, if you sell a cash secured put on stock XYZ, you have just assumed the risk of that stock falling below the strike price, in which case you will have to take delivery of the shares. On the other hand, the person that purchased the put from you has effectively just transferred his risk of the stock moving lower to you.

Traders are out there beating Wall Street and other professional traders right now have a deep understanding of risk. They have risk management protocols in place, and they adhere to these protocols under even the most difficult of circumstances. For the layperson, it’s sometimes referred to as discipline. Risk is part of trading and investing, any way you slice it. Most people lose money trading because they have no concept of proper risk management.

Risk Mitigation and Risk Acceptance The ﬁrst step on the road to making money is not losing money!

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18 Step #3 Know the costs of doing business. Unfortunately for the public, Wall Street and other financial markets are set up in such a way that makes it extremely difficult for the average trader or investor to turn a profit. Markets and exchanges are in the game for the same reason as you are; to make money.

If you are trading stocks, find a reliable discount broker and negotiate your commissions and fees. If you are trading futures, go to a discount broker or even directly to an Futures Commission Merchant , or FCM, to get the lowest rates possible.

Commissions, data feeds, memberships – all of these costs of trading can add up quickly. In fact, many traders are able to make money in the market, but end up net losers overall after factoring in all of these costs. Traders currently beating Wall Street understand this, and take whatever steps are necessary to gain an edge.

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19 continued... Track your expenses, and always strive for ways to lower them. Commissions and fees can turn a winner into a loser

Make sure that any potential market opportunities are large enough to cover the costs of doing business. Do not turn into a “commission generator” for your brokerage or clearing firm

By following these three simple steps, you will gain an advantage over the majority of market participants.

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THE KEY TO TURNING YOUR PORTFOLIO INTO AN INCOME GENERATING MACHINE Many traders and investors do not realize how to utilize the power of their portfolios. When you think of your portfolio, you may think of a basket of stocks you have held for years, or perhaps mutual funds you may have owned since the Reagan Administration was still in office. You may have been told that “buy and hold” is the way to invest for the future…

How does this relate to trading options? Let me dig deeper… You see, when you own stocks for example, you own an asset that fluctuates in price. The stock may also pay you dividends. Many stocks, however, also have listed options contracts. These options contracts can be purchased to hedge your position, to play earnings, or to try to generate additional income.

In reality, your portfolio can be used for so much more. When used with proper risk management and sound investment strategies, your portfolio can give you the ammunition you need to potentially generate returns in any market condition. Up, down, sideways-it doesn’t matter.

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Markets may trend higher, they may trend lower, or they may simply stay in a sideways trading range. Many stocks spend a great deal of time within a certain range. Why not take advantage of that?


20 The covered call write strategy is one widely used and simple strategy to learn. Using this strategy, you will write one out-of-the-money (OTM) call option for every 100 shares of stock you are long. An OTM has no intrinsic value, but only possesses extrinsic or time value. When were are talking about call options, an OTM has a strike price that is higher than the market price of an underlying asset. Selling these calls may accomplish two things: First of all, the sale of out-of-the-money calls may provide a hedge against your position. Let’s look at an example: Suppose that you are long 500 shares of stock XYZ which is currently trading at $40 per share. The stock has stalled out a bit, and you believe it may remain around $40 for the next few months. You decide to sell five of the front month $42.5 call options on the stock for $.40 each, therefore collecting a total premium of $2.00

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not including any transaction costs. If the stock price drops, the calls will lose value and in the process partially offset your losses on the share price. In this case, each call for 100 shares was sold for $.40, so the breakeven on the position would be $39.60 per share. If the stock goes sideways, the calls may lose value through the power of time decay . In this case you are neither making nor losing money on the stock itself, but now you are potentially profiting as the short calls lose value as they approach expiration. Assuming the short calls expire worthless, you would then keep the entire $2.00 premium collected as profit.


21 If the stock price rises, you may still potentially make money. Your long stock position would gain in value as the share price goes up, however, your short calls may also be increasing in value. The key is where the stock is at expiration. If the stock price is below the strike price of $42.50 at expiration, the calls will still expire worthless. In this case, you have now potentially made money on the stock itself and the short calls.

Iron condors consist of a short call spread and a short put spread with the idea being that the market will remain between the two spreads, allowing all options to expire worthless. Iron condors can provide a very wide potential profit zone, and can possibly make money in two ways. The first way is through time decay. The second way is through a drop in implied volatility.

Range-bound = Opportunity

In addition to covered call writing, there are numerous other ways to potentially profit in markets that are consolidating or moving sideways and you don’t need to own the stock or contract to take advantage. Let’s talk briefly about another popular strategy that anyone can learn: The iron condor.

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22 Let’s look at a simple example:

You have collected a total of $10 in option premium.

You own 1000 shares of stock WWW. You have owned the shares for years, and the company pays a decent dividend. The stock has, however, traded in a relatively tight range for several years now, oscillating between $35 and $40 per share. In addition to earning dividends on your shares, you decide to use iron condors on the stock to try to generate additional income. With WWW currently trading at $37 per share, you initiate the following position: Sell 10 of the front month $41/$45 call spreads for a premium of $.50 each. Sell 10 of the front month $34/$30 put spreads for a premium of $.50 each.

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If WWW simply stays between the short strike process of $34 and $41, all options will expire worthless and you keep the entire $10 credit collected (Not including applicable transaction costs). This equates to $1000 in gross income that was generated. On the other hand, if the share price rises and is above the short call strike of $41 at expiration, you may lose your shares of the stock upon assignment (you’d be assigned a short position in the stock at $41 thus offsetting your existing long stock position). In this case, you would have made another dollar on the stock price going higher, and you would still keep the $10 of option premium collected.


23 In another scenario, if the stock price falls, you will be losing money on your long stock position and potentially losing money on the short put spreads. If WWW is below the short put strike of $34 at expiration, you will be assigned an additional long position from $34. In this case, the call spreads sold would expire worthless, and you would still keep the total option premium collected. You now, however, have a larger underlying position in the stock itself and therefore have more exposure.

Your portfolio does not have to be treated as a passive source of wealth building. Quite to the contrary, by using various options strategies, you have the potential to turn your existing portfolio into an income generation machine that can potentially build your wealth with greater speed or provide an additional source of income.

The Point is This: By using cash and/or securities already in your portfolio, you have the potential to generate some serious additional income.

Of course, trade selection and potential stocks or contracts with which to utilize such strategies should be carefully considered.

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SEVEN HABITS OF HIGHLY SUCCESSFUL OPTIONS TRADERS While options may seem perplexing to traders who are new to the game, once you have a deep understanding of options and options pricing, you will have a very powerful weapon in your trading arsenal. In fact, options are one of the most, if not the most, versatile financial instruments at your disposal. Like any other financial instrument, trading and using options successfully requires knowledge, perseverance and good trading habits. It is these solid trading habits that separate the novices from the professionals, and the winners from the losers. While some of these habits apply specifically to options traders,

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many of the habits of highly successful options traders can also be applied to trading in other instruments as well. Here we will briefly discuss seven habits of highly successful options traders:

Habit #1 HIGHLY SUCCESSFUL OPTIONS TRADERS UNDERSTAND HOW OPTIONS ARE PRICED, AND CONSISTENTLY PUT THAT KNOWLEDGE TO USE

This allows successful options traders to avoid paying too much for an option, or selling an option for too little. In fact, option pricing theories are the basis for options trading, and without habitually putting these theories to work, you will be giving up a great deal of “edge.” Highly successful


25 options traders understand the importance of having an edge, and will seek out any and all opportunities to gain one.

trading decisions on potential changes in implied volatility.

Habit #3 Habit #2 HIGHLY SUCCESSFUL OPTIONS TRADERS FOCUS ON VOLATILITY

Successful options traders understand that volatility is the name of the game. While options can be used to trade directionally or for premium collection strategies, pros understand that options derive a great deal of their value from volatility — both historical and implied. Successful options traders understand how implied volatility affects options, and structure their trades and strategies accordingly. In order to be successful in trading options, you must always consider volatility and how it may potentially affect your position. Successful options traders always consider this key component and base

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HIGHLY SUCCESSFUL OPTIONS TRADERS FOCUS ON RISK MANAGEMENT

If you do not have a solid understanding of risk management and employ concrete risk management techniques in your trading, you are likely going to be out of the game before long. Highly successful options traders place an emphasis on risk, and have parameters in place for trade risk and overall account management. These risk management habits help pros cut losing positions short, while maximizing winning positions. Highly successful options traders understand that the first step to making money consistently is not losing money.


26 Habit #4

Habit #5

HIGHLY SUCCESSFUL OPTIONS TRADERS THINK IN TERMS OF ODDS AND PROBABILITIES

HIGHLY SUCCESSFUL OPTIONS TRADERS DO NOT ALLOW THE POWER OF EMOTION TO CONSUME THEM

These traders will only put their capital at risk in positions that they feel have a high probability of success. They also have a thorough understanding of percentages and other basic mathematics involved in options trading. For example, successful options traders understand that if an option or asset loses 25 percent of its value, it will have to see a gain of 33 percent to break even. The most successful options traders focus on putting the odds and probabilities in their favor as much as possible. This is why you will not likely see a professional options trader buying extremely deep out-of-the-money options that have little statistical chance of making a profit.

Highly successful options traders understand and accept that losing is a part of winning. These successful traders strive to remain focused and objective at all times, and do not allow themselves to get attached to a position or become greedy. They understand that periods of losses can and do occur, and that even in the best of times, profits can be fleeting.

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Habit #6 HIGHLY SUCCESSFUL OPTIONS TRADERS NEVER STOP LEARNING

Markets can and do change over time, and successful options traders are constantly looking for ways to improve their trading skills. They are life-long students of the market, and they take complete responsibility for their ability to learn and grow as trader. They habitually read books, confer with other traders and stay in touch with the markets in which they trade.

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28 Habit #7 HIGHLY SUCCESSFUL OPTIONS TRADERS HAVE A LIFE OUTSIDE OF MARKET HOURS

The most successful traders realize and understand that trading is simply a means to an end. Even the most successful traders require a break now and then to recharge mentally and emotionally, and spending some time away from the trading screen allows them to do just that. This keeps them sharp and focused during market hours and may potentially allow them to achieve a higher level of success. Trading options for a living is a job, and like any other job one must distance themselves at times to regain perspective.

The most successful options traders understand the importance of employing these habits each and every day. Fortunately, numerous studies have shown that adopting habits does not take long. Start practicing the habits of highly successful options traders today, and before long these habits will become ingrained and second nature.

While there is no “Holy Grail” to options trading, by constantly adopting the habits of highly successful options traders you can greatly increase your odds of success.

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THE THREE DEADLY SINS OF OPTIONS TRADING Trading options, just like trading any other type of financial instrument, involves a number of potential pitfalls that can quickly drain your account. Knowing some of the possible traps traders commonly fall into, and how to avoid them, can give you an edge in your trading and potentially give you more staying power in the markets. Through our 20 years of trading education, we’ve identified three deadly sins of options trading and ways to keep your trading free from evil…

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Sin #1 BUYING OPTIONS AND LETTING THEM EXPIRE WORTHLESS

This one is really a no-brainer. When you purchase an option, whether it is to hedge, play market direction, or get long volatility, you should still draw a line in the sand. Just because your risk is limited on an options purchase to the premium paid, does not mean you have to sacrifice that entire premium! Many novice options traders make this simple, yet significant, mistake. Because of the defined-risk nature of long options, they consider it to be a “set and forget” type of trade and willingly lose all the money they paid for the option in many cases. Let’s look at a quick example:


30 Investor Joe believes that the price of crude oil is about to rise. Crude oil futures are currently trading at $50 per barrel. Joe does not want to buy a futures contract, and decides to purchase the front month at-the-money $50 call for a premium of 350, or $3500. Joe makes his purchase and watches as the days go by while oil trades sideways right around the $50 level. Joe’s option has four weeks until expiration. Two weeks after his purchase, with no real bullish market movement to speak of, Joe’s $50 call has lost half its value and is now only worth 175 or $1750.

Many novice options traders will hold the call until its value declines to zero! Don’t be that guy… Decide how much room you are willing to give the trade and then stick to it. A simple rule of thumb is to cut losses once a long option has lost 50 percent of its value.

Obviously, Joe’s market forecast was incorrect…

Joe could take his loss at this point, and move on to the next trade, or he can continue to hold the call option.

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31 Sin #2 BUYING DEEP OUT-OF-THE-MONEY OPTIONS

Let’s make this one easy to understand – trades are trades and lottery tickets are lottery tickets… Many novice options traders believe they can possibly turn a profit by purchasing very cheap, deep out-of-the-money options. Do people win the lottery? Yes… have you or I ever won it? Probably not… And to be clear, out-of-the-money options may be very useful for trading directional moves or for volatility plays. You want to make sure, however, that the options are not so far out-of-the-money as to make the probability of the trade working almost non-existent.

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While deep out-of-the-money options may represent less monetary risk due to their smaller premiums, these options also have a statistically significant low winning percentage. The underlying instrument would, often times, have to make extremely substantial moves in price in order for these options to pay off – not to mention the fact that the power of time decay is always working against you as well. If you are going to trade, look for trades that have an edge to them. Look for positions that can potentially payoff without an absurd move in the market. That $100 bucks you might have spent on an SP call that is 200 handles out-of-the-money, well that can buy a lot of lottery tickets…


32 Sin #3 SELLING OPTIONS WHEN IMPLIED VOLATILITY IS LOW

While option selling has the potential to provide an income stream, it also has the potential to drain your account with large losses, especially if you are selling naked options with unlimited market exposure. Many new options traders get this one wrong too. Options consist of many moving parts, and while market direction and time are important, implied volatility is a huge component of option values and pricing.

(high IV) and buy low (low IV). Many traders get caught in the trap of selling options that are currently low in IV, only to watch the option’s value explode as IV increases. Implied volatility has a tendency to revert to the mean, so only look for opportunities to sell options when IV is on the high side. Conversely, if you are going to buy an option, you will want to look for options that are currently on the low side for IV. Sell high and buy low...

Many professional options traders trade option volatility and nothing else… Just as with a stock you want to buy low and sell high, or sell high and buy low, the same goes for options.


ACCESS!

When selling premium, you want to sell high

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A GO-TO STRATEGY FOR THE NEXT MARKET CRASH The term “market crash” can evoke a great deal of emotion in traders and investors. Market crashes are, however, nothing new and due to many reasons, human nature being one of them, such crashes will likely happen from time-to-time.

Volatility in the S&P 500, as an example, has been essentially non-existent in recent years as the market has continued its multiyear ascent. In fact, stocks are in the seventh year of the current bull market (the average bull market typically lasts five years) and may finally be showing some signs of topping.

While many associate a market crash with a significant loss of market value and wealth, a crash can also represent huge opportunities…

This period of extremely low volatility has caused put options values to remain subdued…

There are numerous ways to potentially profit from a crash. In the world of options trading, volatility is a key ingredient in option pricing and behavior.

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34 A simple go-to strategy in such an environment is a basic Risk Reversal A risk reversal is a position designed to imitate a position in the underlying asset. Risk reversals can be both bullish and bearish in nature and there are many variations of such positions. Now, you could simply look to purchase relatively cheap puts in the current environment. There are two primary issues with this, however.

What you are looking for, then, is a position constructed in such a way as to minimize time decay while still providing large profit potential if a crash does occur. The risk reversal accomplishes both.

While there are many potential ways such a position could be initiated, here we will discuss a simple example… Let’s assume for a moment that the e-mini SP 500 futures contract is currently trading at the 2050 level.

First, puts that are significantly out-of-the-money may have to be purchased. Second, long puts would be exposed to time decay, and if such a crash does not materialize in the given time period, you could potentially watch your puts expire worthless.

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35 The market begins to show serious signs of weakness, and you believe that a crash is imminent. A crash that could potentially see stocks fall by 20, 30, even 40 percent or more.

If the market crashes, the long put will likely begin increasing in value as investors scramble for put protection. Volatility may potentially rise substantially, also causing the put to potentially gain in value.

Because implied volatility has been relatively low for some time, put options on the e-mini are cheap. You can purchase a put option with six months until expiration and a strike price of $1,850 for a premium of about 33 points, or $1,650. To negate the time decay of your puts, you then look for call premium to sell. In this case, let’s assume that you sell a call option with six months until expiration at a strike price of $2,150. Such a call can currently be sold for about 38 points, or $1,900.

As the market falls, the short call sold will likely be losing significant value.

To get in-the-money, the long put will need a move lower of about 10 percent. For the call option to go in-the-money, the market will need to move up by about five percent.

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In other words, you may potentially be proﬁting on both sides of the trade.

What if you are wrong? What if there is no crash? That’s the best part… If the market falls at a gradual pace, or even just goes sideways, you may still potentially profit. That is because both options will be subject to a loss of value through time decay. The loss of time value in the call will likely offset the loss of time value in the put.


36 And don’t forget, you collected a net credit of 5 points or $250

when you initiated the position! This means that if all options simply expired worthless, you still made money on the position. That’s the good – here is the bad: If the market begins to rise, the long put will be losing value while the short call may be gaining in value. If you sold a naked call to finance the long put position, that naked call carries with it unlimited market exposure to the upside. As with any other type of trade, you will have to have an “uncle” point, at which you take your loss and move on to the next one.

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There are, however, ways that you can mitigate an upside risk, such as selling call spreads instead of outright calls… The simple risk reversal provides a means of potentially catching a large downside move in the market while negating time decay risk. This type of position can potentially profit in several different scenarios, and can have huge profit potential if the market does, in fact, crash. There are tradeoffs, however. The upside call exposure should be carefully considered, and risk must be managed.


ACCESS!


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THE KISS STRATEGY When it comes to options trading, many traders fall into the trap of using overly complicated strategies in an attempt to make money. Some of these strategies may include: The Christmas tree spread 5:1 ratio spreads 4:1 back spreads Box spreads

The list of various option spread combinations goes on and on. We’re not saying that such spreads never have their place, but the reality is that for most options traders; the simpler the better. While initiating a multi-leg spread that gives you X amount of deltas may sound cool at a cocktail party, transaction costs on these positions will eat you alive… We teach a number of different strategies here at Trading Advantage, but one of the most important strategies we teach is: K.I.S.S.

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38 K.I.S.S. For those of you not in the “know,” this stands for Keep It Simple Stupid… Think about that for a moment… In your everyday, non-trading life, do you like to keep things simple and to the point or do you prefer to make them overly complicated?

The point is this: When trading options, use the easiest and simplest method of accomplishing your desired goal…

Here we will provide a few simple tips, tips that may potentially help keep you out of trouble and tips that may cost your broker tons of cash in lost commissions…

Assuming you like to keep it simple, why would you treat your trading any differently? Trading options is a means to an end…nothing more. Options are a vehicle with which to express a market opinion, collect premium or attempt to profit from changes in implied volatility. They may also be used to hedge a long or short stock position, and may even be used to hedge against tail risk.

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39 Tip #1

Tip #2

Stay away from multi-leg spreads. While some types of spreads can be quite useful in mitigating risk or gaining desired market exposure, others serve little purpose for the retail trader. In fact, they may serve no one but your broker. To be clear, we are not talking about a bull call spread or an iron condor. We are referring to more “creative” spreads, the kind that involves more than four legs.

If looking to trade a potential market move, look for ways to maximize leverage while keeping margin or capital requirements to a minimum. While many novice traders will look to buy straight calls or puts with fairly high deltas, these positions have heavy exposure to theta and vega. A much smarter use of capital, in our view, may be to utilize out-of-the-money call or put spreads based on your market forecast. These positions will put less capital at risk, while still allowing for a favorable profit potential. In addition, they will not be as sensitive to changes in implied volatility or to the passage of time, giving the trader more breathing room to let the market and the trade run its course.

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40 Tip #3 Always keep in mind that if you are trading long options, time is your enemy! Conversely, if you are trading short options, time is your friend. Either way, understand the effects of theta on an options position, and structure your trade and risk management strategy accordingly.

Tip #4 Always understand your P&L graph – how you may make money and how you may lose money. Understand what you are looking for in a market before putting a trade on. Knowing where you profit and where you lose can help make decisions when it comes time to take profits and when it comes time to take a loss. Options are not the complicated instrument many would have you believe

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Options are one of the most versatile financial instruments at your disposal. Like anything else in life, however, they should be used in moderation. Only trade options when you have a thorough understanding of the trade and its profit and loss potential. Use them to gain the long or short exposure that you are comfortable with, and nothing more. By keeping your options trading clean, crisp and simple, you can potentially avoid overtrading and the potentially negative impacts of overly complicated positions. Focus on the underlying market, your forecast for that market and your risk management strategy. And keep it simple stupid…


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THERE YOU HAVE IT… The very steps we have outlined in this brief yet powerful options trading guide can help pave the way for your success… Those that can master these versatile financial instruments have a distinct edge… An edge so powerful that you will not likely find anyone that makes a living from the markets not taking advantage of… Forget the mystery, the fancy terms and the mathematics involved for a moment. Options, if purchased, are nothing more than instruments that are used to achieve a precisely desired amount of exposure for a limited period of time. Options that are sold are nothing more than an assumption of risk for a specific period of time. Keep it simple…

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By just reading this informative options trading guide, you have taken an important first step. Now is the time to take the second step…

Regardless of what you may be trading now (stocks, futures, currencies, etc.), mastering options can potentially open up a whole new world of trading and investment. They can potentially hedge against risk, profit from directional market moves and profit from nothing more than the passage of time.


42 Don’t let the passage of time cost you another opportunity…

Discover the path to becoming a smarter options trader and join Trading Advantage now. Our world-class Online Campus is a must have resource to take your trading to the next level, offering more tips and techniques, invaluable lessons, exclusive options trading news… and so much more.

Click here now to get started with Free Access!

Remember, Knowledge = Power. It’s time to get the advantage you’ve been looking for.

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43

GLOSSARY OF OPTIONS TERMS ATM (At The Money): An ATM option's exercise price is equal to or near the price of the underlying asset. Beta: The correlation between stocks within the same industry. Calendar (Time) Spread: An options trade that involves the simultaneous purchase of an option with a particular expiration date and strike price, and the same option with a different expiration date but the same strike price. Call Options: Call options give the owner the right to buy the underlying asset.

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Delta: Measures the behavior, characteristics, and value of an option in relation to the underlying asset. Delta is the rate of change in the theoretical value of an option for a $1.00 change in the underlying asset. Exercise Price: The price at which the underlying asset may be purchased or sold. Extrinsic Value: The price of an option minus its intrinsic value. Expiration Date: The date the option expires. Far-Term Options: Options that expire in 7-12 months.


44 Gamma: Measures delta curvature. It is the rate at which an option gains or loses deltas over a $1.00 change in the price of an underlying security. Historical Volatility : A measurement of how much a contract's price has fluctuated over a period of time in the past. It is a very strong indicator of a stock's future performance. Implied Volatility: The implied volatility is what is implied by the current market prices. It is used with theoretical models. Intrinsic Value: The difference between an asset's price and the option's strike price or zero, whichever is greatest. ITM (In-The-Money): When a call option's exercise (strike) price is lower than the underlying asset price.

Leap Options: Options that expire more than one year away Mid-Term Options: Options that expire in 4-6 months. Near-Term Options: Options that expire in the first three expiration months. Options: A security that represents the right, but not the obligation, to buy or sell a stock at a specified price (STRIKE PRICE), until a specified time (EXPIRATION DATE). If an option is not exercised before the expiration date, it will expire, or cease to exist. OTM (Out-Of-The-Money): Has no intrinsic value. A call option is out-of-the-money when its exercise price is higher than the underlying asset's price. Parity: When options are trading at their intrinsic value.

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45 Premium: The price of an option. It is determined by many factors, including the current price of the asset, the strike price of the option, the time remaining until expiration, interest rates, dividends, and volatility. Put Options: Put options give the owner the right to sell an underlying asset. Ratio Vertical Spread: A strategy in which the a trader either buys 2 higher strike calls and sells 1 lower strike call (call spread) or when a trader buys 1 higher strike call and sells 2 lower strike calls (put spread). Resistance: Occurs at a price level where selling is strong enough to prevent a stock from rising higher.

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Rho: The change in option value that results from a change in interest rates. The theoretical value changes in relation to a one-percentage-point movement in the underlying interest rate. Risk/Reward: The amount of risk a trader is willing to take in relation to the reward in the particular trade. Spread Trading: An option spread is a position that consists of two or more options that are traded at the same time or as close in succession as possible. Strangle Swap: The strangle swap sets up when the stock has made a significant move, the front month implied volatility is still historically expensive, and the stock is trading between our support and resistance levels.


46 Strike Price: The price at which the underlying asset may be purchased or sold. Support: Occurs at a price level where buying is strong enough to prevent a stock from falling lower. Theta: The rate at which an option loses value as the amount of time to expiration changes. Theta is also known as the time decay factor; all options lose value as expiration approaches

Vertical Time Spread: A combination of the vertical spread and the calendar (time) spread. Volatility : A measure of the amount an asset or security is expected to fluctuate over a given period of time. Volume: How much is being traded in the market at a given time.

Vega: The amount by which the price of an option changes when the volatility changes. Vertical Spread: A trade in which a call (put) option is bought (sold) at one strike price and expiration date and another call (put) option with the same expiration date but different strike price is sold (bought).

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Ultimate Options Trading Guide

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