A GUIDE TO INVESTING WITH OPTIONS covers everything from calls and puts to collars and rolling up, over, or out. It takes the mystery out of options contracts, explains the language of options trading, and lays out some popular options strategies that may suit various portfolios and market forecasts. If you’re curious about options, this guide provides the answers to your questions.

INVESTING STRATEGIES INVESTING STRATEGIES before , the loss you’d face if MAKE A COMMITMENT the were exercised and assigned Once you’ve decided on an appropriate to you is unacceptable. But if it moves , it’s important to stay only 10% in-the-money, you’d be focused. That might seem obvious, confident that there remains enough Introduction to but the fast pace of the options market chance of it moving out-of-the-money and the complicated nature of certain to make it worth the potential loss. Options Strategies transactions make it difficult for some inexperienced investors to stick to their A WORD TO THE WISE Planning, commitment, and research will prepare you plan. If it seems that the market or under- By learning some of the most common for investing in options. lying isn’t moving in the direction mistakes that options investors make, you predicted, it’s possible that you’ll you’ll have a better chance of avoiding AN OVERVIEW OF STRATEGIES minimize your losses by exiting early. But them. Before you buy or sell options you need It’s helpful to have an overview of it’s also possible that you’ll miss out on a Overleveraging. One of the benefits a strategy, and before you choose an the implications of various options future beneficial change in direction. options strategy, you need to understand strategies. Once you understand the That’s why many experts recommend of options is the potential they offer for . By investing a small amount, how you want options to work in your basics, you’ll be ready to learn more that you designate an exit strategy or you can earn a significant percent- portfolio. A particular strategy is suc- about how each strategy can work for cut-off point ahead of time, and hold age return. It’s very cessful only if it performs in a way that you—and what the potential risks are. firm. For example, if you plan to sell a important, however, helps you meet your goals. , you might decide that if to remember that If you hope to increase the income you the option moves 20% in-the-money receive from your , for example, leverage has a potential you’ll choose a different strategy from an downside too: A small investor who wants to lock in a purchase decline in value can price for a she’d like to own. mean a large percentage loss. ? Investors who aren’t aware of the One of the benefits of options is the flexibility they offer—they can risks of leverage are in danger of over- POTENTIAL complement portfolios in POTENTIAL leveraging, and might face bigger losses YOUR MARKET RETURN many different ways. So POSSIBLE RISK than they expected. it’s worth taking the time FORECAST Theoretically Another mistake OBJECTIVE Limited to the Lack of understanding. to identify a goal that suits unlimited Bullish premium paid some options traders make is not fully you and your financial plan. CALL Profit from increase in price understanding what they’ve agreed to. Once you’ve chosen a goal, BUYING An option is a contract, you’ll have narrowed the of the underlying security, or and its terms must be range of strategies to use. As met upon . with any type of investment, lock in a good purchase price Limited to the It’s important to only some of the strategies Unlimited for understand that if you Neutral to premium received will be appropriate for Profit from the write a covered call, for CALL bearish, your objective. premium received, writing, limited example, there is a very WRITING though or lower net cost for covered real chance that your covered call SIMPLE AND of purchasing call writing stock will be called away from writing may NOT-SO-SIMPLE a stock you. It’s also important to understand Some options strategies, such be bullish Substantial, as Limited to the how an option is likely to behave as as writing covered calls, are the stock price Bearish premium paid expiration nears, and to understand that relatively simple to under- PUT Profit from approaches zero once an option expires, it has no value. decrease in price • Puts and Calls stand and execute. There are BUYING A serious mistake more complicated strategies, of the underlying Not doing research. however, such as spreads security, or that some options investors make is not and collars, that require two protect against researching the underlying instrument. opening transactions. These losses on stock Options are deriva- Limited to the strategies are often used to already held Substantial, as tives, and their value further limit the risk associ- Neutral to premium received depends on the price Profit from the stock price ated with options, but they PUT bullish, though behavior of another the premium approaches zero may also limit potential WRITING -secured financial product—a received, or stock, in the case of return. When you limit risk, puts may • Equity Options lower net be bearish equity options. You there is usually a trade-off. Limited Simple options strategies purchase price Limited have to research avail- Bullish or are usually the way to begin Profit from the able options data, and be confident in SPREADS bearish, investing with options. By difference in your reasons for thinking that a particu- depending on mastering simple strategies, values of the lar stock will move in a certain direction the particular you’ll prepare yourself for options written before a certain date. You should also be spread advanced options trading. Limited alert to any pending corporate actions and purchased Limited In general, the more compli- Neutral or such as splits and mergers. Protect unrealized cated options strategies COLLARS bullish 21 are appropriate only for profits experienced investors. 20 • Index Options • ETF Options

• LEAPS® • WeeklysSM

Lightbulb Press, Inc. lightbulbpress.com Phone: 212-485-8800 VIRGINIA B. MORRIS

12 11 1 2 10 3 9 4 8 5 7 6 T he Options Industry Council (OIC) is pleased to introduce A Guide to Investing with Options, a primer on options investing. The guide clarifies options basics, explains the options marketplace, and describes a range of strategies for trading options. The Guide helps fulfill OIC’s ongoing mission to educate the investing public and the advisors who serve them about the benefits and risks of exchange listed options. We believe that education is the key to sound and intelligent options investing, and that the tremendous growth of the options market in recent years can be attributed, at least in part, to the value of this education. Formed in 1992, OIC is your options education resource. We are always available to answer your questions and to expand your options knowledge. To contact OIC, please visit our website at OptionsEducation.org or email Investor Services at [email protected]. The Options Industry Council OptionsEducation.org

1 CONTENTS

Disclaimer: Options involve risks and are not suitable for everyone. Individuals should not enter into options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, available by visiting OptionsEducation.org or by contacting your broker, any exchange on which options are traded, or The Options A GUIDE Corporation at 125 S. Franklin St., #1200, Chicago, IL 60606. In order to simplify the calculations used in the examples in these materials, commissions, fees, , interest and taxes have not been included. These costs will impact the outcome of any stock TO INVESTING and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative WITH OPTIONS and educational purposes and should not be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results.

THE BASICS

4 What Is an Option? 10 Where Are Options Listed? 6 How Does Options 12 What Are the Benefits? Investing Work? 14 What Are the Risks? 8 On Which Securities Are 16 How Do You Get Started? Options Offered? 18 Key Terms and Definitions

INVESTING STRATEGIES

20 Introduction to 32 Spread Strategies Options Strategies 34 Understanding Spreads 22 Selecting the Right Security 36 Transactions 24 Call Buying 38 Exit Strategies 26 Call Writing 40 Rolling Up, Over, 28 Put Buying and Out LIGHTBULB PRESS Project Team 30 Put Writing 42 Index Options Design Director Kara W. Wilson Editor Mavis Wright Production Thomas F. Trojan RESEARCH AND INFORMATION SPECIAL THANKS TO Bess Newman, Gary Kreissman, The Options Industry Council 44 Trading Options 50 Graphing Profit and Loss 46 52 Options Information Options Chains LEAPS® is a registered trademark and -term Equity AnticiPation Securities and Weeklys are Sources 54 Option Symbology service marks of Cboe Exchange, Inc. (Cboe). 48 Applying Options and Sources ©2004, 2005, 2009, 2011, 2013, 2014, 2015, 2016, 2019 BY LIGHTBULB PRESS, INC. ALL RIGHTS RESERVED. Information and Analysis 56 Strategy Screener www.lightbulbpress.com Tel. 212-485-8800 ISBN: 978-1-933569-11-6 No part of this book may be reproduced, stored, or transmitted by any means, including electronic, mechanical, photocopying, recording, or otherwise, without written permission from the publisher, GLOSSARY AND INDEX except for brief quotes used in a review. While great care was taken in the preparation of this book, the author and publisher disclaim any legal responsibility for any errors or omissions, and they disclaim any liability for losses or damages incurred through the use of the information in the book. This publication 58 60 is designed to provide accurate and authoritative information in regard to the subject matter covered. Glossary Index It is sold with the understanding that neither the author nor the publisher is engaged in rendering financial, legal, accounting, or other professional service. If legal advice, financial advice, or other expert assistance is required, the services of a competent professional person should be sought. THE BASICS THE BASICS

What Is an Option? An options contract gives the buyer rights and An option is a contract to buy or sell commits the seller to a specific financial product officially TYPES OF OPTIONS known as the option’s underlying CONTRACTS an obligation. instrument or underlying interest. For equity options, the underlying instru- Calls Puts ment is a stock, exchange traded fund (ETF), or stock index. The contract itself is very precise. It establishes a specific price, called thestrike price, at which the contract may be exercised, HOLDER or acted on. And it has an expiration date . When an option expires, it no RULE OF longer has value and no longer exists. THUMB calls Options come in two varieties, For options expiring in puts and , and you can buy or sell either the same month, the type. You make those choices—whether more in-the-money to buy or sell and whether to choose a an option is, the call or a put—based on what you want higher its premium. to achieve as an options investor. WRITER BUYING AND SELLING If you buy a call, you have the right to buy the underlying instrument at the on or before the expiration AT A PREMIUM the premium. If the option is never exer- date. If you buy a put, you have the right When you buy an option, the purchase cised, you keep the money. If the option Finding values For example to sell the underlying instrument on or price is called the premium. If you sell, is exercised, you still get to keep the before expiration. In either case, as the market price $ 25 the premium is the amount you receive. premium, but are obligated to buy or sell option holder, you also have the right to – Exercise price – $ 20 The premium isn’t fixed and changes the underlying stock if you’re assigned. sell the option to another buyer during = Intrinsic value = $ 5 constantly—so the premium you pay its term or to let it expire worthless. today is likely to be higher or lower than THE VALUE OF OPTIONS Premium $ 6 The situation is different if you write, the premium yesterday or tomorrow. What a particular options contract is – Intrinsic value – $ 5 or sell, an option, since selling obligates What those changing prices reflect is worth to a buyer or seller is measured you to fulfill your side of the contract = Time value = $ 1 the give and take between what buy- by how likely it is to meet their expec- if the holder wishes to exercise. If you ers are willing to pay and what sellers tations. In the language of options, sell a call, you’re obligated to sell the are willing to accept for the option. that’s determined by whether or not the OPTIONS PRICES underlying interest at the strike price, if The point at which there’s agreement option is, or is likely to be, in-the-money Several factors, including supply and you’re assigned. If you sell a put, you’re becomes the price for that transaction, or out-of-the-money at expiration. A call demand in the market where the option obligated to buy the underlying interest, and then the process begins again. option is in-the-money if the current is traded, affect the price of an option, if assigned. If you buy options, you start out with market value of the underlying stock is as is the case with an individual stock. As a writer, you have no control over what’s known as a net debit. That means above the exercise price of the option, What’s happening in the overall invest- whether or not a contract is exercised, you’ve spent money you might never and out-of-the-money if the stock is ment markets and the economy at large and you need to recognize that exercise recover if you don’t sell your option at a below the exercise price. A are two of the broad influences. The is always possible at any time until the profit or exercise it. And if you do make is in-the-money if the current market identity of the underlying instrument, expiration date. But just as the buyer money on a transaction, you must sub- value of the underlying stock is below how it traditionally behaves, and what it can sell an option back into the tract the cost of the premium from any the exercise price and out-of-the-money is doing at the moment are more specific market rather than income you realize to find your net profit. if it is above it. If an option is not ones. Its is also an important exercising it, as a As a seller, on the other hand, you in-the-money at expiration, the option factor, as investors attempt to gauge writer you can begin with a net because you collect is assumed to be worthless. how likely it is that an option will move purchase an off- An option’s premium has two parts: in-the-money. setting contract an intrinsic value and a time value. and end your WHAT’S A FINANCIAL PRODUCT? Intrinsic value is the amount by which OLD AND NEW obligation to The word product is more likely to conjure up images of the option is in-the-money. Time value American-style options can be meet the terms vegetables or running shoes than stocks or stock indexes. is the difference between whatever the exercised any time up until expiration of the contract. Similarly, instrument might suggest a trombone or a while European-style options can be exercised scalpel rather than a security or a currency. intrinsic value is and what the premium is. The longer the amount of time for only at the expiration date. Both styles are But both terms are used to refer to the broad traded on US exchanges. All equity options are range of investment vehicles. market conditions to work to your benefit, the greater the time value. American style and index options are European style. 4 5 THE BASICS THE BASICS

QUADRUPLE How Does Options WITCHING DAY In the last month of each Investing Work? quarter—on the third Friday of March, June, September, You should know whether you’re opening or closing, and December—the markets ® SM buying or purchasing, writing or selling. LEAPS AND WEEKLYS OPTIONS typically experience high trading volume Long-term Equity AnticiPation due to the simultaneous expiration of stock SecuritiesSM, or LEAPS, and Weeklys are options, stock index options, stock index Options trading can seem important parts of the options market futures, and single stock futures. This day complicated, in part because it OPEN CLOSE and trade like standard options. Both is known as quadruple witching relies on a certain terminology are American style and can be exercised day—up one witch since the introduction and system of standardization. POSITION at any time up to expiration. Unlike of single stock futures. But there’s an established standard options, however, which have process that works smoothly expiration dates of up to one year, LEAPS anytime a trade is initiated. have expiration dates of up to three years. 1 Your brokerage firm ensures the At the other end of the scale, Weeklys 1 exercise notice is sent to The Options OPEN AND CLOSE OR WRITE ELL A expire the week following their issue. Clearing Corporation (OCC), the When you buy or write a new A EW OTRAT EITI OTRAT LEAPS allow investors greater flex- guarantor of all listed options contracts. contract, you’re establishing ibility in implementing a strategy since OCC assigns fulfillment of your an open position. That means there is more time for an option to move 2 2 contract to one of its member firms that you’ve created one side of a contract in-the-money. Weeklys, in contrast, that has a writer of the series of option and will be matched anonymously with allow investors to implement targeted • An options buyer purchases a you hold. a buyer or seller on the other side of contract to open or close a position -term strategies and capitalize on the transaction. If you already hold an market events, such as earnings reports If the brokerage firm has more An options holder buys a contract 3 option or have written one, but want to •  and government announcements. 3 than one eligible writer, the firm to open a long position get out of the contract, you can close allocates the assignment using an your position, which means either selling • An options seller sells a contract EXERCISE AND ASSIGNMENT exchange-approved method. the same option you bought, or buying to open or to close a position Most options that expire in a given The writer who is assigned must the same option contract you sold. month usually expire on the third 4 An options writer sells a contract 4 deliver or receive shares of the There are some other options terms •  Friday of the month. This is also the to open a short position underlying instrument—or cash, if to know: last day to trade expiring equity options. it is a cash-settled option. All options transactions, whether If you plan on exercising your options, STANDARDIZED TERMS opening or closing, must go through be sure to check with your brokerage a brokerage firm, so you’ll incur firm about its cut-off times. Firms Every option contract is defined by EXERCISING OPTIONS transaction fees and commissions. may establish early deadlines to allow certain terms, or characteristics. Most OCC employs administrative procedures that It’s important to account for the themselves enough time to process listed options’ terms are standardized, provide for the exercise of certain options impact of these charges when exercise orders. so that options that are listed on one that are in-the-money by specified amounts calculating the potential profit or When you notify your brokerage or more exchanges are fungible, or at expiration on behalf of the holder of the loss of an options strategy. firm that you’d like to exercise: interchangeable. The standardized options unless OCC is instructed otherwise. terms include: Individual brokerage firms often have their own policies, too, and might automatically Contract size: For equity settled, which means the adjust the contract is made on a submit exercise instructions to OCC for any options, the amount of in-the-money holder case-by-case basis in accordance with options that are in-the-money by a certain underlying interest is receives a certain amount OCC by-laws. amount. You should check with your broker- generally set at 100 shares of stock. of cash upon exercise. An options class refers to all the age firm to learn whether these procedures Expiration month: Every Style: Options that can be exercised calls or all the puts on a given under- apply to any of your long positions. This option has a predetermined at any point before expiration are lying security. Within a class of options, process is also referred to as “exercise expiration and last American style. Options that contracts share some of the same terms, by exception.” trading date. can be exercised only on such as contract size and exercise style. the day of expiration are An options series is all contracts Exercise price: This is the European style. that have identical terms, including the same class, while all XYZ price per share at which expiration month and strike price. February 90 calls are part of the 100 shares of the underlying Contract adjustments: In For example, all XYZ calls are part of same series. security can be bought or sold response to a stock split, at the time of exercise. merger, or other corporate action, a decision to Options Class Options Series Type of delivery: Most equity options are physical delivery contracts, which means that shares of stock must change hands at the time of exercise. Most index options are cash 6 THE BASICS THE BASICS Foreign INDEXING THE MARKET On Which Securities Index options, which were introduced Currency in 1983, are also popular with individual investors. The underlying instrument Are Options Offered? is an index instead of a single equity. Because they track the prices of many You can buy or sell options on stocks, indexes, component stocks, equity indexes can and an orchestra’s worth of other instruments. reveal a movement trend for broad or narrow sectors of the . The S&P 500 index tracks 500 large-cap In 1973, the first year that options were listed, investors could US stocks, for example, while the Dow write or purchase calls on 16 different stocks. Puts weren’t Jones Utility Average, an index of 15 available until 1977. Today the field of option choices has ADR utility companies, is used to gauge the widened considerably—as of 2018, investors can buy or write strength or weakness in that industry. calls and puts on over 4,200 different Unlike options on stock, index stocks ETFs, and stock indexes. options are cash settled, which means The most frequently traded options, Single that upon exercise, the writer is or those with the greatest volume, are obligated to give the holder a certain those on broad-based stock ETFs and Equity amount of cash. The total settlement on individual stocks issued by large, is usually $100 times the amount widely held companies. It’s generally the option is in-the-money. quite easy to find current informa- tion about those ETFs and companies, making it possible A 90 call on the 3 for investors to make informed DJIA at 9300 x $ 100 decisions about how the price of the DJX is 93 You receive $300 underlying is likely to perform over a period of months—something that’s In addition to those For example, if you exercised a 90 call essential to options investing. These minimum qualifica- on the DJIA when the index is at 9300 options may also be multiply listed, Stock Index tions, stocks are chosen and DJX is at 93, you’d receive $300 (or or traded on more than one exchange. based on the stock’s most companies welcome the listing 3 x $100), before fees and commission. TO LIST OR NOT TO LIST volatility and volume of options, since historically a stock’s Index options can be more expensive of trading, the com- trading volume tends to rise after a new than stock options, but they may offer Options aren’t listed on every stock, and pany’s history and options class is issued on that stock. more leverage and less volatility. each exchange doesn’t list every available management, and option. The Securities and Exchange perceived demand for OFF THE LIST Commission (SEC) regulates the standards An index reflects changes in a specific options. This subjective It’s possible for exchanges to decide to for the options selection process, and , in a number of related component to the deci- delist options, or remove them from the beyond that, exchanges can make indepen- markets, or in an economy as a whole. Each sion-making process trading market. If the trading volume dent decisions. There are some rules, though. index—and there are a large number of explains in part why for an option remains low for a long On every options exchange, a stock on them—measures a market, sector of the some exchanges may period of time, an exchange may decide which options are offered must: market, or economy. Each is tracked from a choose to list an option that a lack of investor interest in that specific starting point, which might be as • Be listed and traded on the while others do not. option makes it not worth listing. In recent as the previous trading day or many National Market System In general, options addition, exchanges must delist options years in the past. are available on the if they fail to meet certain criteria. Have a specified minimum •  most well-known, In general, options that have already number of shareholders and publicly traded companies, since those been listed on a particular stock at the GROWTH SPURT shares outstanding are the stocks that are most likely to time that option is delisted may be The total number of options trades • Have a specified minimum interest options investors. Although traded until they expire. No new expira- that takes place each year has grown dra- average trading price during an companies are not responsible for tion months will be added on that class. matically, as have the variety of available established period of time options being listed on their stocks, options. On the first day of trading, there were 911 transactions on the 16 listed securities. Today, an average It’s important to understand the difference a predetermined price after a certain date. OTHER OPTIONS daily volume might be close to between equity options and employee stock Employee stock options cannot be traded on While the most popular options are those offered on one million on a single exchange. options.* Unlike listed options, which are stan- the . Employers usually grant individual stocks, ETFs, and stock indexes, contracts are In 1973, 1.1 million dardized contracts, employee stock options are stock options as part of compensation packages, also available on limited partnership interests, American contracts changed hands. In individual arrangements between an employer hoping to provide an incentive for Depository Receipts (ADRs), American Depository Shares 2009, the year’s total volume and an employee. Usually, stock employees to work hard, since (ADSs), securities, and foreign currencies. was more than three billion options grant the employee they’ll share in any company Many debt security and currency options transactions contracts on the seven exchanges the right to purchase success that is expressed in are initiated by institutional investors. More recently, that were operating. In 2018, that company’s shares at a higher stock price. retail investors have begun to trade cash- that number increased to over 5 settled foreign currency options. *This guide does not cover features of programs. billion contracts. 9 THE BASICS THE BASICS

Where Are Options Listed? CRYING OUT In the early years of options trading, the on to brokers working on the floor of Transactions in listed options take place on exchanges floors of exchanges operated as open outcry the exchange. The manner in which through open outcry or electronic matching. auctions. Buyers and sellers negotiated directly a trade is filled is invisible to the with each other, using shouts and hand investor, regardless of whether signals to determine prices in a seemingly it happens electronically If you’ve been trading stocks for some system on some exchanges. Instead of chaotic—but in reality, very structured— or through open outcry. time, you’re already familiar with the traders gathering in a pit or on a floor, process. Open outcry is similar to the auction In either case, when basic procedures that govern options transactions are executed electronically, system used for stock trading, but relies on a trade has been trading. Individual investors who wish with no physical interaction between a more frenetic negotiating atmosphere. successfully completed, to buy or sell options place orders traders. Auction prices are tracked and Today, however, nearly all options investors are notified by through their brokerage firms. Where listed on computers, and orders may be transactions take place electronically, and their brokerage firms. an order goes from that point depends filled within a matter of seconds. only rare orders above a certain size or those on both the brokerage firm’s policy and Some options exchanges are totally with special contingencies attached are passed the exchange or exchanges on which electronic, and many use a hybrid of the options contract is traded. open outcry and electronic trading. The majority of the orders that come A JOB FOR A SPECIALIST to those exchanges are filled by an auto- OPTIONS EXCHANGES Traders acting as specialists lead the matic execution computer that matches Before 1973, options trading was unregulated and options traded over the auctions for each options class, and the request with a buyer or seller at counter (OTC). The Chicago Board Options Exchange was the first to open, are in charge of maintaining a fair the current market price. Transactions and the list has expanded regularly over the years. For a current list of exchanges, and orderly market, which means requesting an away-from-the-market please see OIC’s website. that contracts are easily obtainable, price, or one that is higher or lower and every investor has access to the than the current market price, are held best possible market price. in an electronic limit order book. Once INTRODUCING MORE PLAYERS CLEARING THE WAY Each exchange has a particular trading reaches the requested price, These organizations all have a role to One of the innovations that made structure of specialists, who may some- those orders are the first to be handled. play in options trading: trading listed options workable from times be known as designated primary Proponents of electronic trading the start was establishing a central market makers (DPMs), lead market argue that the anonymous nature clearinghouse to act as issuer and makers (LMMs), competitive market of the transactions means that all guarantor for all the options makers (CMMs), or primary market customers—whether represented by contracts in the market- makers (PMMs). Other traders, some- an experienced broker or not—have OCC is the place. That clearinghouse, times known as agents, trade options equal footing, which makes the market actual buyer and seller which became The Options for their clients, sometimes buying fairer. They also point out that since of all listed options contracts, Clearing Corporation in 1975, from and selling to the specialists. the costs of running an electronic which means that every matched trade has approximately 130 member exchange are lower, the transaction is guaranteed by OCC, eliminating any counter- firms who clear trades for the ELECTRONIC TRADING fees for trades may also be lower. party credit risk. brokerage firms, market makers, New technology has supplemented or and customers who buy and replaced the traditional open outcry STANDARD OF EXCHANGE sell options. Listed options are traded on regulated Because of OCC, investors exchanges, which must adhere to SEC who open and close positions, trade rules designed to make trading fair for contracts in the secondary market, or all investors. Nearly all equity options The Options Industry Council (OIC) choose to exercise can be confident are multiply listed, which means they’re is a resource provided by OCC. OIC offers education that their matched trades will be available for purchase and sale on BUY for investors about the benefits and risks of settled on the day following the trade, multiple exchanges. trading options. that premiums will be collected and Contract terms paid, and that exercise notices and pricing are will be assigned according to standardized established procedures. so that the Like the options exchanges, contracts are OCC has streamlined the clearing fungible, or The Securities and Exchange process—evolving from runners interchangeable. Commission (SEC) is a US federal agency who made the rounds of member You might give an that governs the securities industry, including firms twice a day to a totally order to purchase the options industry. The SEC protects investors electronic environment. an option that is by enforcing US securities laws and regulating executed on one markets and exchanges. exchange, and later give an order to sell the same option that is executed on a different exchange. 10 11 THE BASICS THE BASICS

A LITTLE DOES A LOT 100 shares of stock, she purchases one XYZ call Options allow holders to benefit from movements option at a strike price of $115. The premium What Are the Benefits? in a stock’s price at a fraction of the cost of owning for the option is $2 a share, or $200 a contract, that stock. For example: Investors A and B think since each contract covers 100 shares. If the Whether you’re hedging, seeking income, or speculating, that stock in company XYZ, which is currently price of XYZ shares rises to $120, the value you can put options to work for your portfolio. trading at $100, will rise in the of her option might rise to $5 or higher, next few months. Investor A and Investor B can sell it for $500, making spends $10,000 on the a $300 profit or a 150% return on her Although options may not be appro- remember that all carry some Investor A purchase of 100 shares. investment. Investor A, who bought priate for everyone, they’re among the risk, and returns are never guaranteed. But Investor B doesn’t 100 XYZ shares at $100, could make most flexible of investment choices. Investors who use options to manage invests in stock have much money to $2,000, but only realize a 20% return Depending on the contract, options risk look for ways to limit potential loss. invest. Instead of buying on her investment. can protect or enhance the portfolios They may choose to purchase options, $ Investor B invests of many different kinds of investors in since loss is limited to the price paid in options $ rising, falling, and neutral markets. for the premium. In return, they gain the right to buy or sell the underlying REDUCING YOUR RISK security at an acceptable price for them. Both invest in XYZ at $100 a share For many investors, options are useful as They can also profit from a rise in the with $115 strike tools of risk management, acting as a way value of the option’s premium, if they Amount invested = $10,000 Premium = $2 per share to protect your portfolio against a drop choose to sell it back to the market 100 shares = 1 contract Number of shares purchased = 100 in stock prices. For example, if Investor rather than exercise it. Since writers Contract price = $200 A is concerned that the price of his shares of options are sometimes forced into She purchases 1 contract in XYZ Corporation is about to drop, he buying or selling stock at an unfavorable and now has a stake in 100 shares can purchase puts that give him the right price, the risk associated with certain to sell his stock at the strike price, no short positions may be higher. XYZ stock price rises to $120 matter how low the market price drops before expiration. At the Her 100 shares are worth $12,000 Premium rises to $5 a share cost of the option’s premium, New contract price = $500 Investor A has protected himself Profit = $2,000, or 20% She sells her option for a profit against losses below the strike of $300, or 150% price. This type of option prac- tice is also known as hedging. While hedging with options may help you manage Long-term. Investors can protect Bullish. Investors who anticipate a risk, it’s important to long-term unrealized gains in a stock market upturn can purchase calls on stock by purchasing puts that give them the to participate in gains in that stock’s right to sell it at a price that’s accept- price—at a fraction of the cost of able to them on or before a particular owning that stock. Long calls can Bearish. Investors date. For the cost of the also be used to lock in a purchase who anticipate a market premium, a minimum price for a particular stock during downturn can purchase puts on profit can be locked a bull market, without taking stock to profit from falling prices or to in. If the stock price on the risk of price decline protect portfolios—regardless of whether rises, the option will that comes with they hold the stock on which the put expire worthless, but stock ownership. is purchased. the cost of the pre- Conservative. mium may be offset Aggressive. Investors with a by gains to the value Investors with conservative attitude can RULE OF THUMB of the stock. an aggressive outlook use options to their portfolios, If you buy a call, you have a bullish use options to leverage or provide some protection against outlook, and anticipate that the value of a position in the market possible drops in value. Options SPECULATIVE the underlying security will rise. If you buy a when they believe they writing can also be used as a conser- put you are bearish, and think the value CLIMB know the future direction of vative strategy to bolster income. For of the underlying security will fall. a stock. Options holders and example, say you would like to own writers can speculate on market 100 shares of XYZ Corporation now MODEST PROFITS movement without committing trading at $56, and are willing to pay Even those investors who use options in Most strategies that options investors use have limited large amounts of capital. Since $50 a share. You write an XYZ 50 speculative strategies, such as writing uncovered risk but also limited profit potential. For this reason, options offer leverage to investors, put, and pocket the premium. If calls, don’t usually realize dramatic returns. The poten- options strategies are not get-rich-quick schemes. it’s possible to achieve a greater prices fall and the option is exercised, tial profit is limited to the premium received for the Transactions generally require less capital than percentage return on a given rise or you’ll buy the shares at $50 each. If contract, and the potential loss is often unlimited. equivalent stock transactions, and therefore return fall than one could through stock prices rise, your option will expire While leverage means the percentage returns smaller dollar figures—but a potentially greater ownership. But this strategy can unexercised. If you still decide to buy can be significant, here, too, the amount of cash percentage of the investment—than equivalent be a risky one, since losses may be XYZ shares, the higher cost will be changing hands is smaller than with equivalent stock transactions. larger, and since it is possible to offset by the premium you received. stock transactions. lose the entire amount invested. 12 13 THE BASICS THE BASICS

WASTING TIME Time is a luxury for stock- What Are the Risks? One risk particular to holders, but a liability for options is time decay, options holders. If the under- The risks of options need to be weighed against their because the value of an lying stock or index moves in option diminishes as the an unanticipated direction, potential returns. expiration date approaches. there is a limited amount of For this reason, options are time in which it can correct Many options strategies are designed more. As an options holder, you risk the considered wasting assets, itself. Once the option to minimize risk by hedging existing entire amount of the premium you pay. which means that they expires out-of-the-money portfolios. While options can act as But as an options writer, you take on a have no value after a certain it is worthless, and you, as safety nets, they’re not risk free. Since much higher level of risk. For example, date. Stockholders, even if the holder, will have lost the transactions usually open and close in if you write an uncovered call, you face they experience a dramatic loss entire premium you paid. the short term, gains can be realized unlimited potential loss, since there is no of value on paper, can hold onto Options writers take advantage very quickly. This means that losses can cap on how high a stock price can rise. their shares over the long term. As of this, and usually intend for mount quickly as well. It’s important However, since initial options long as the company exists, there is the the contracts they write to expire to understand all the risks associated investments usually require less capital potential for shares to regain value. unexercised and out-of-the-money. with holding, writing, and trading than equivalent stock positions, your options before you include them in potential cash losses as an options your investment portfolio. investor are usually smaller than if you’d bought the underlying stock or THE LONG AND RISKING YOUR PRINCIPAL sold the stock short. The exception to SHORT OF IT Like other securities—including stocks, this general rule occurs when you use In investing, the words long and bonds, and mutual funds—options options to provide leverage: Percentage short are used to describe what carry no guarantees, and you must be returns are often high, but it’s important holders and writers, respectively, are aware that it’s possible to lose all of the to remember that percentage losses can doing. When you purchase an option, you principal you invest, and sometimes be high as well. are said to have a long position. If you write an option, you have a short position. The same terminology is used to describe ownership of stock: You can go long on 100 shares of XYZ by purchas-ing them, or go short by borrowing shares through your brokerage firm and selling them.

WHAT YOU OWN have the right to vote on issues relating It’s also important for you as an options to the management of the company. investor to understand the difference Options holders don’t have those between owning options and owning benefits and rights. stock. Shares of stock are pieces of a company, independent of what their PAY ATTENTION price is now or the price you paid for Since options are wasting assets, losses them. Options are the right to acquire and gains occur in short periods. If you

A or sell shares of stock at a given price followed a buy and hold strategy, as you and time. Options holders own the might with stocks, you’d risk missing the S rights to what’s sometimes described as expiration date or an unexpected event. S price movement, but not a piece of the It’s also important to fully understand all E company. potential outcomes of a strategy before UNDERSTANDING PREMIUM T Shareholders can benefit in ways you open a position. And once you do, The value of an equity option is composed of two separate factors. The first,intrinsic value, other than price movement, including you’ll want to be sure to stay on top of is equal to the amount that the option is in-the-money. Contracts that are at-the-money or the distribution of . They also changes in your contracts. out-of-the-money have no intrinsic value. So if you exercised an at-the-money option you wouldn’t make money, and you’d lose money if you exercised an out-of-the-money option. Neither would be • Since an option’s premium may worth the cost of exercise transaction fees. But all unexercised contracts still have time value, change rapidly as expiration nears, which is the perceived—and often changing—dollar value of the time left until expiration. The you should frequently evaluate longer the time until expiration, the higher the time value, since there is a greater chance that the the status of your contracts, and underlying stock price will move and the option will become in-the-money. determine whether it makes financial sense to close out a position. Premium = intrinsic value + time value • Regularly check OCC’s website, The entire premium of an at-the-money or out-of-the-money option is its time value, since its theocc.com, for any pending intrinsic value is zero. In contrast, the entire premium of an in-the-money option at expiration is corporate actions, such as splits its intrinsic value, since the time value is zero. and mergers, that might prompt contract adjustments.

14 15

OTIO ERE TO Options Stock Holder Holder THE BASICS THE BASICS

DOING THE PAPERWORK WATCH THE MARGINS Even if you have a general investment Some brokerage firms require that How Do You Get Started? account, there are additional steps certain options transactions, such as to take before you can begin trading writing uncovered calls, take place in It takes forethought and planning to begin investing options. First, you’ll have to fill out a margin account. That means if you successfully in options. an options agreement form, which is write a call, you’ll have to keep a bal- a document brokerage firms use to ance in your account to cover the cost measure your knowledge of options of purchasing the underlying stocks if Since there are so many available AND HOW TO GET IT and trading strategies, as well as your the option is exercised. Thismargin options—and so many ways to trade Once you’ve decided upon an objective, general investing experience. requirement for uncovered writers is them—you might not know where to you can begin to examine options Before you begin trading options, set at a minimum of 100% of options begin. But getting started is easier than strategies to find one or more that can you should read the document titled proceeds plus 20% of the underlying you think, once you determine your goals. help you reach that goal. For example, Characteristics and Risks of Standardized security value less the out-of-the-money if you want more income from the Options, which contains basic informa- amount, but never less than the option KNOW WHAT YOU WANT… stocks you own, you might investigate tion about options as well as detailed proceeds plus 10% of the security value. Before you begin trading options it’s strategies such as writing covered calls. examples of the risks associated with If the value of the assets in your critical to have a clear idea of what you Or, if you’re trying to protect your particular contracts and strategies. In margin account drops below the hope to accomplish. Options can play a stocks from a market downturn, you fact, your brokerage firm is required required maintenance level, your variety of roles in different portfolios, and might think about purchasing puts, to distribute it to all potential brokerage firm will make amargin picking a goal narrows the field of appro- or options on an index that tracks the options investors. call, or notify you that you need to add priate strategies you might choose. For type of stocks in your portfolio. You can request a free copy of capital in order to meet the minimum example, you might decide you want more Characteristics and Risks of Standardized requirements. If you don’t take appro- income from the stocks you own. Or MORE THAN JUST A BROKER Options from your firm, order it by priate action, your brokerage firm can maybe you hope to protect the value of Once you’re ready to invest in options, emailing [email protected], or liquidate assets in your account without your portfolio from a market downturn. you need to choose a brokerage firm. download a copy at: your consent. Since options can change No one objective is better than another, Your firm may offer helpful advice as in value over a short period of time, it’s just as no one options strategy is better well as execute your trades. Some firms OptionsEducation.org •  important to monitor your account and than another—it depends on your goals. go further by working with clients to theocc.com •  prevent being caught by a margin call.

1. Open an 2. Find Your Level of 3. Pick Your 4. Choose a 5. Communicate 6. Start Trading Account Options Trading Objective Strategy with Your Brokerage Write calls Firm 1 2 3 4 5 •  Writing Buying Debit Credit Writing • Write puts covered calls, spreads, spreads naked Purchase calls options puts, cash- options, •  secured straddles Purchase puts puts • 

ensure that options trading fits into ARE YOU ELIGIBLE? In both visible and invisible ways, their individual financial plans. They Based on the information you provide in The Options Industry Council also advise clients about potential the options agreement, your brokerage (OIC) and The Options Clearing objectives and strategies, and outline firm will approve you for a specific level RULE OF Corporation (OCC) play a part as any the risks and benefits of various of options trading. Not all investors are THUMB investor prepares to trade options for the first transactions. allowed to trade every kind of strategy, The more time until time. OIC provides educational material on Some options investors choose since some strategies involve substantial expiration, the higher the options trading as well as information about discount firms that charge lower risk. This policy is meant to protect option premium, because individual options, contract adjustments, and commissions, but don’t offer person- brokerage firms against inexperienced or the chance of reaching the changes in federal regulations. OCC protects alized advising services. But others, insufficiently funded investors who might strike price is greater. investors by guaranteeing every transaction, including both inexperienced and end up defaulting on margin accounts. which means that call holders, for example, veteran investors, prefer to consult It may protect investors from trading don’t have to worry that the writer might not their brokers before opening or beyond their abilities or financial means. belt, and the more liquid assets fulfill the obligation. closing out a position. The levels of approval and required you have to invest, the higher your qualifications vary, but most brokerage approval level. Firms may also ask firms have four or five levels. In general, you to acknowledge your acceptance the more trading experience under your of the risks of options trading. 16 17 THE BASICS THE BASICS

GREEKS ON OPTIONS nears. As time decays, options prices Key Terms and Definitions When used to describe options, the can decrease rapidly if they’re out-of- usually compare the movement the-money. If they’re in-the-money near Learn the language of the options world. of an option’s theoretical price or vola- expiration, options price changes tend tility as the underlying stock changes in to mirror those of the underlying stock. price or volatility, or as expiration nears. While many of the terms used to describe GREEKS ON STOCKS . An estimate of how much the price buying and selling options are the same When used to describe stocks, these . A measure of how much an of an option—its premium—changes terms used to describe other investments, measurements compare the stock’s option price changes when the under- when the changes. For some are unique to options. Mastering performance to a benchmark index. lying stock price changes. The delta of example, higher interest rates may mean the new language may take a little time, an option varies over the life of that that call prices rise and put prices decline. . A measure of how a stock’s but it’s essential to understanding options option, depending on the underlying volatility changes in relation to the Vega. An estimate of how much an strategies you’re considering. stock price and the amount of time left overall market. A beta may help you option price changes when the volatility until expiration. determine how closely a stock in your assumption changes. In general, greater IT’S GREEK TO ME Like most of the Greeks, delta is portfolio tracks the movement of an volatility means a higher option The terms that estimate changes in the expressed as a decimal between 0 and +1 index, if you’re considering hedging premium. Vega is also sometimes prices of options as various market or 0 and –1. For example, a call delta of with index options. A beta of 1.5 means referred to as , , or tau. factors—such as stock price and time 0.5 means that for every dollar increase a stock gains 1.5 points for every point to expiration—change are named after in the stock price, the call premium the index gains—and loses 1.5 points GREEKS ON GREEKS Greek letters, and are collectively known increases 50 cents. A delta between 0 for every point the index loses. Some Greeks work as secondary as the Greeks. Many investors use the and –1 refers to a put option, since put measurements, showing how a particular Greeks to compare options and find an . A measure of how a stock premiums fall as stock price increases. Greek changes as the option changes in option that fits a particular strategy. It’s performs in relation to a benchmark, So a delta of –0.5 would mean that for price or volatility. important to remember, though, that independent of its beta. A positive alpha every dollar increase in the stock price, the Greeks are based on mathematical means that the stock outperformed what the put premium would be expected to . A measure of how much formulas. While they can be used to the beta predicted, and a negative drop by 50 cents. the delta changes when the price of the assess possible future prices, there’s alpha means the underlying stock changes. You might . The rate at which premium no guarantee that they’ll hold true. stock didn’t think of gamma as the delta of an decays per unit of time as expiration perform as well option’s delta. as predicted.

A VOLATILE SITUATION Volatility is an important component OTHER of an option’s price. There are two MEASUREMENTS kinds of volatility: historic and implied. . The number Historic volatility is a measure of how of open positions for a parti- much the underlying stock price has cular options series. High open HEDGING moved in the past. The higher the interest means that there are many open If you hedge an investment, you historic volatility, the more the stock positions on a particular option, but it protect yourself against losses, usually price has changed over time. You can is not necessarily a sign of bullishness with another investment that requires LEVERAGE use historic volatility as an indication of or bearishness. additional capital. With options, you When you leverage an investment, how much the stock price may fluctuate might hedge your long stock position you use a small amount of money to Volume. The number of in the future, but there’s no guarantee by writing a call or purchasing a put on control an investment that’s worth much contracts—both opening that past performance will be repeated. that stock. Hedging is often compared more. Stock investors have leverage and closing transactions— is the percentage to buying on an investment, when they trade on margin, committing traded over a certain of volatility that justifies an option’s since you spend some money protecting only a percentage of the capital needed period. A high daily volume market price. Investors may use implied yourself against the unexpected. and borrowing the rest. As an options means many investors opened volatility to predict how volatile the investor, you have leverage when you or closed positions on a given day. underlying asset will be, but like any purchase a call, for example, and profit prediction, it may or may not hold true. Liquidity. The more buyers and from a change in the underlying stock’s Volatility is a key element in the time sellers in the market, the greater price at a lower cost than if you owned value portion of an option’s premium. the liquidity for a particular the stock. Leverage also means that In general, the higher the volatility— options series. Higher liquidity profits or losses may be higher, when either historic or implied—the higher may mean that there is a calculated as a percentage of your the option’s premium will be. That’s demand for a particular original investment. because investors assume there’s a option, which might increase greater likelihood of the stock price the premium if there are lots of moving before expiration, putting the buyers, or decrease the premium option in-the-money. if there are lots of sellers. 18 19 INVESTING STRATEGIES INVESTING STRATEGIES

MAKE A COMMITMENT A WORD TO THE WISE Introduction to Once you’ve decided on an appropriate By learning some of the most common options strategy, it’s important to stay mistakes that options investors make, focused. That might seem obvious, you’ll have a better chance of avoiding Options Strategies but the fast pace of the options market them. and the complicated nature of certain Overleveraging. One of the benefits Planning, commitment, and research will prepare you transactions make it difficult for some of options is the potential they offer for inexperienced investors to stick to their for investing in options. leverage. By investing a small amount, plan. If it seems that the market or you can earn a significant percent- underlying security isn’t moving in the Before you buy or sell options you need AN OVERVIEW OF STRATEGIES age return. It’s very direction you predicted, it’s possible that a strategy, and before you choose an It’s helpful to have an overview of important, however, you’ll minimize your losses by exiting options strategy, you need to understand the implications of various options to remember that early. But it’s also possible that you’ll how you want options to work in your strategies. Once you understand the leverage has a poten- miss out on a future beneficial change portfolio. A particular strategy is suc- basics, you’ll be ready to learn more tial downside too: in direction. cessful only if it performs in a way that about how each strategy can work for A small decline in That’s why many experts recommend helps you meet your investment goals. you—and what the potential risks are. value can mean a that you designate an exit strategy If you hope to increase the income you large percentage or cut-off point ahead of time, and receive from your stocks, for example, loss. Investors who aren’t aware of the hold firm. you’ll choose a different strategy from an risks of leverage are in danger of over- investor who wants to lock in a purchase leveraging, and might face bigger losses price for a stock she’d like to own. than they expected. One of the benefits of options is Lack of understanding. Another mis- the flexibility they offer—they can take some options traders make is not complement portfolios in ? fully understanding what they’ve agreed many different ways. So to. An option is a contract, and its terms it’s worth taking the time POSSIBLE YOUR MARKET POTENTIAL POTENTIAL must be met upon exercise. It’s impor- to identify a goal that suits OBJECTIVE FORECAST RISK RETURN tant to understand that if you write a you and your financial plan. covered call, for example, there is a very Once you’ve chosen a goal, CALL Profit from Bullish Limited to the Theoretically real chance that your you’ll have narrowed the BUYING increase in price premium paid unlimited stock will be called range of strategies to use. As of the underlying away from you. It’s with any type of investment, security, or also important to only some of the strategies lock in a good understand how an will be appropriate for purchase price option is likely to your objective. CALL Profit from the Neutral to Unlimited for Limited to the behave as expiration WRITING premium received, bearish, naked call premium received nears, and to under- SIMPLE AND or lower net cost though writing, limited NOT-SO-SIMPLE stand that once an of purchasing covered call for covered option expires, it has Some options strategies, such a stock writing may call writing no value. as writing covered calls, are be bullish relatively simple to under- Not doing research. A serious mistake stand and execute. There are PUT Profit from Bearish Limited to the Substantial, as that some options investors make is not more complicated strategies, BUYING decrease in price premium paid the stock price researching the underlying instrument. however, such as spreads of the underlying approaches zero Options are derivatives, and their value and collars, that require two security, or depends on the price behavior of another opening transactions. These protect against financial product—a stock, in the case strategies are often used to losses on stock of equity options. You have to research further limit the risk associ- already held available options data, and be confident ated with options, but they in your reasons Profit from Neutral to Substantial, as Limited to the may also limit potential PUT for thinking that a the premium bullish, though the stock price premium received return. When you limit risk, WRITING particular stock will received, or cash-secured approaches zero there is usually a trade-off. move in a certain lower net puts may Simple options strategies direction before a purchase price be bearish are usually the way to begin certain date. You investing with options. By SPREADS Profit from the Bullish or Limited Limited should also be alert mastering simple strategies, difference in bearish, to any pending cor- you’ll prepare yourself for values of the depending on porate actions such advanced options trading. options written the particular as splits and mergers. In general, the more compli- and purchased spread cated options strategies are appropriate only for COLLARS Protect unrealized Neutral to Limited Limited experienced investors. profits bullish

20 21 INVESTING STRATEGIES INVESTING STRATEGIES Selecting the Right Security Don’t let yourself be overwhelmed by the options.

Choosing a strategy is the first step when investing in options. The second—and equally important—step is finding the right security on which to purchase or write an option. You might choose a stock or another type of equity as the underlying instrument.

INVESTIGATING OPTIONS ACCEPTING RISK When choosing a stock to No matter how well you’ve researched the equity on which purchase, you probably look you buy or write an option, there’s no guarantee that your for a company with growth potential trade will be successful. Some advisers recommend that you consider the or a strong financial outlook—a company whose stock price you probability of the success of a particular trade. Probability is a measurement think will increase over time or one that will pay regular dividends. But as of the odds that you’ll achieve the goal behind your options strategy, an options investor, you might be looking for a company whose stock price will which might be making a profit or purchasing stock, rise or one whose price you think will fall in a finite period. What’s important is for example. that you correctly predict whether the price will rise or fall, and by how much. Probability is based on factors including Buying stock also allows you a virtually unlimited amount of volatility, since an out-of-the-money option time to realize a price gain. As an options holder or writer, on an underlying instrument with high however, you need to be accurate in your prediction volatility—or one that often changes of the speed with which the stock price will move, in price—is more likely to move as well as how far and in which direction. in-the-money. It’s important to estimate the probability of success APPLYING RESEARCH before committing yourself to a There’s no one best research method trade. You’ll have more realistic for choosing a security when trading expectations and a better options any more than there is when sense of what you stand trading stocks. You might prefer a technical to gain and to lose. analysis, which emphasizes an assessment of price trends and trading patterns in market sectors or overall markets, or consult Both MANAGING YOUR CASH a fundamental analyst, who studies the Investor A How you’re going to manage your • If you’re not particulars of a certain company. and Investor capital is another important deci- very experienced, For example, Investors A and B are B could use sion to make before you trade options. you might consider both interested in the stock of corpora- their research to trading options with If you’ve already allocated all your tion XYZ. They know that a quarterly estimate whether •  risk capital only, or investment funds to other types of secu- earnings report will be released in a the earnings report money that you could tolerate losing rities, you’ll have to reallocate in order to month, and they’d like to predict will be good news, entirely, particularly when purchasing free up capital for options. Most experts whether the stock will rise in response neutral, or bad news simple puts or calls. recommend that you use options to to a good report, or fall in response to for XYZ, and whether complement a diversified investment You should also take into account the low earnings—though, of course, it stock will rise or fall in the •  portfolio instead of dedicating your impact that trading options on margin could do something they don’t expect. months after the report’s release. entire trading capital to options. will have on your cash allocation. If They both conduct further research. How you apply your research will you write an uncovered call, you’ll Investor A prefers , depend on your style of analysis, as well as have to deposit a minimum and looks at statistics such as the market’s your own experience with investing, your percentage of the value of moving average and the recent perfor- knowledge of the stock market, and your RESEARCH SOURCES the underlying shares into mance of XYZ’s sector, in order to gauge intuition. Many experts recommend that Corporate websites, the websites of financial a margin account with the overall outlook of the company. you use elements of both tech- •  research firms, and magazines provide company your broker. This might Investor B, however, relies on a funda- nical and news and market trends mean tying up funds mental analyst who looks at XYZ’s recent when researching an equity, Your broker or can make recom- that you would have product launches and analyzes the to get a balanced perspective. •  mendations as well as provide professional research invested elsewhere. performance of its CEO to predict  the nature of the earnings report. • Options newsletters often offer information on particular equities and trading strategies 22 23 INVESTING STRATEGIES INVESTING STRATEGIES

Some experienced investors may purchase calls in order to hedge against short sales of stock they’ve made. Investors who sell short hope to profit Call Buying from a decrease in the stock’s price. If the shares increase in value instead, they can face heavy losses. Buying calls allows short sellers to protect You can profit from an increase in a stock’s price by themselves against the unexpected increase, and limit their potential risk. purchasing a call. EXERCISING YOUR CALLS Buying calls is popular with options INVESTOR OBJECTIVES Most call contracts are sold before expiration, allowing their holders to investors, novices and experts alike. Call buying may be appropriate for realize a profit if there are gains in the premium. If you’ve purchased The strategy is simple: You buy calls on meeting a number of different objectives. a call with the intent of owning the underlying instrument, how- a stock or other equity whose market For example, if you’d like to establish a ever, you can exercise your right at any time before expiration, price you think will be higher than price at which you’ll buy shares at some subject to the exercise cut-off policies of your brokerage firm. the strike price plus the premium by point in the future, you may buy call However, if you don’t resell and don’t the expiration date. Or, you buy a call options on the stock without having to exercise before expiration, you’ll face the whose premium you think will increase commit the full investment capital now. loss of all of the premium you paid. If enough to outpace time decay. In either Or, you might use a buy low/sell high your call is out-of-the-money at expira- case, if your expectation is correct, you strategy, buying a call that you expect to tion, you most likely won’t exercise. If CHOOSING A SECURITY may be in a position to realize a positive rise and hoping to sell it after it increases your option is at-the-money, transaction In general, purchasing calls indicates a bullish return. If you’re wrong, you face the loss in value. In that case, it’s key to pick a fees may make it not worth exercising. sentiment, so you should consider a stock or of your premium—generally much less call that will react as you expect, since But if your option is in-the-money, you stock index whose price you think is set to than if you had purchased shares and not all calls move significantly even should be careful not to let expiration rise. This might be a stock you feel will rise in they lost value. when the underlying stock rises. pass without acting. the short term, allowing you to profit from an increase in premium. You might also look for a stock with long-term growth potential that CALLING FOR LEVERAGE you’d like to own. Purchasing calls allows you One major appeal of purchasing calls is the possibility of leveraging your investment, and to lock in an acceptable price, at the cost of realizing a much higher percentage return than if you made the equivalent stock transaction. the premium you pay. Investor A buys 100 shares of company XYZ In the next year, the stock Investor A sells and makes $500, or a 11 stock at $10 each, investing a total of $1,000. 22 rises in value to $15. 33 50% return on his initial investment. $ 1,500 Sale price 100 Shares 100 Shares – $ 1,000 Investment x $ 10 Per share x $ 15 Per share = $ 500 Profit or = $ 1,000 Investment = $ 1,500 Sale price 50% return

However, if the stock price falls at expiration to $9, Investor A will lose Investor B, however, invests the same $1,000 in When the stock goes up $100, or 10% of his investment. 1 2 At expiration the 20 contracts are now worth 1 options, buying 20 calls at a strike price of $12.50. 2 to $15, her options are 33 $5,000, or $4,000 above what she invested, a Investor B will lose $1,000, or Each call cost her $50, or 50 cents per share, since her contract in-the-money by $2.50. 400% return. 100% of her investment. covers 100 shares. Therefore the value of her calls rises from 50 cents at $ 5,000 Sale price purchase to at least $2.50 per CALLS Strike price share, a $200 gain per contract. CALLS – $ 1,000 Investment $50 (50¢ per share) $12.50 $250 ($2.50 per share) = $ 4,000 Profit or $ 50 Per call $ 250 Per call 400% return x 20 Calls x 20 Calls held = $ 1,000 Investment = $ 5,000 Sale price

PERFECT TIMING Medium term. Long term. BETTER THAN MARGIN cash to meet the margin requirement, Buying calls can provide an advantage Over a matter of LEAPS allow For certain investors, buying calls is an liquidate a portion of your position, over several different time periods: several months, investors to attractive alternative to buying stock on or face having your brokerage firm investors can use call purchase calls Short term. Investors can profit margin. Calls offer the same leverage liquidate your assets. options to minimize at a strike if they sell an option for that you can get from buying on mar- If you purchase calls, you have the the risk of owning price they’re more than they paid gin, but you take on less potential risk. same benefit of low initial investment stock in an uncertain market. comfortable with, for it, for example if If you buy stock on margin, you as the margin trader, but if the value Investors who want to lock in a and accumulate the there is an increase must maintain a certain reserve of cash of the stock drops, the main risk you purchase price for a year or longer capital to purchase those in the stock’s price in your margin account to cover the face is loss of the premium, an amount can buy LEAPS, or periodically shares in the intervening before expiration. possible loss in value of those stocks. If that’s usually much smaller than the purchase new options. time until expiration. the stock price does fall, you must add initial margin requirement. 24 25 INVESTING STRATEGIES INVESTING STRATEGIES

If you have written an option on a stock firms. If your brokerage firm receives an Call Writing with an upcoming distribution, assignment on an options series on which it’s important to know that the likelihood you hold a short position, you may be You can write covered calls to earn income on your stocks. of exercise is much higher right before a selected to fulfill the terms of the contract dividend payout. If the stock’s dividend date if you were the first at your brokerage firm to open the position, or by random Writing calls is a straightforward options CALCULATING RETURN on a call you’ve written is approaching, you selection, depending on the policy of the strategy. When you write a call, you In order to calculate the should re-evaluate and determine whether firm. It is extremely rare for the writer of receive cash up front and, in most cases, return on a written call, to close out your position. an in-the-money call to not have to sell hope that the option is never exercised. It you’ll have to take into the underlying stock at expiration. can be conservative or risky, depending account the transaction EXITING AND EXERCISE on whether you’re covered or uncovered. costs and brokerage fees If the stock or other equity on which COVERED CALLS you pay for opening you wrote a call begins to move in the Writing covered calls the position, which opposite direction from what you anti- is a popular options will be deducted from INVESTOR OBJECTIVES cipated, you can close out your position strategy. If you the premium you receive. And if by buying a call in the same series as the buy shares You might write calls in order to receive short-term your option is exercised, you’ll have one you sold. The premium you pay may at the income from the premium you’ll be paid. If that’s to pay another round of fees. But $ be more or less than the premium you same time your strategy, you anticipate that the option you since you probably plan for your received, depending on the call’s intrinsic that you write calls on them, write will expire out-of-the-money, and won’t option to expire unexercised, if value and the time left until expiration, the transaction is known as a be exercised. In that case, you’ll retain all of the you’re successful you won’t face any among other factors. You can also close buy-write. If you write calls premium as profit. If you’ve written this call on exit transaction fees or commission. out your position and then write new on shares you already hold, stocks you already own, known as a covered If you write a call on stock you calls with a later expiration, a strategy it is sometimes called an call, the premium can act as a virtual dividend hold in a margin account, you should known as rolling out. overwrite. This strategy that you receive on your assets. Many investors use consider the margin requirement If the call you wrote is exercised—as is combines the benefits of this strategy as a way to earn additional income imposed by your firm when calculat- possible at any point before expiration— stock ownership and options on nondividend-paying stocks. ing return. If your trade is successful you will have to deliver the underlying trading, and each aspect provides some Alternately, you could view the premium as you retain all of your capital, but it security to your brokerage firm. The risk protection for the other. If you write a way to reduce your cost basis, or the amount will be tied up in the margin account assignment for an exercised call is made a covered call, you retain your share- that you paid for each share of stock. until expiration. That means you can’t by OCC to any of its member brokerage holder rights, which means you’ll receive invest it elsewhere in the meantime. dividends and be COVERED CALLS able to vote on the company’s direction. When you write a covered That means that Even if the option is 11 33 the $50 you paid 44 exercised, you’ll receive Writing covered call, you own the stock. 100 Shares CALL calls is a way to For example, say you purchased x $ 50 Per share $55 for each share is offset by $55 per share, which is a profit $ ($3 per share) the $3 you received, so of $8 per share, or $800. receive additional 100 shares of XYZ stock at $50. = $ 5,000 Investment income from stocks your net price paid is actually $47 per share. $ 5,550 you already own. It – 4,700 can also offer limited downside protection You write a 55 call on the stock, $ 5,000 = $ 800 Profit 22 – $ 300 against unrealized and receive a $300 premium, or However, if the stock price rises gains on stocks you’ve $300 $3 for each share covered by this contract. = $ 4,700 significantly above $55, you held for some time, or $ 47 Per share won’t share in that gain. since you lock in a price at which to sell the stock, should the NAKED CALLS If the stock price goes up to $59 and the 55 call is exercised, option be exercised. A much more risky strategy is writing naked calls, or options on stock you don’t own. 33 you receive $55 a share or $5,500. But you’ll have to buy You should realize, Also known as uncovered call writing, this strategy appeals to bearish investors the stock at market price, or $5,900. The premium reduces your however, that if a who want to capitalize on a decline in the underlying shares. $400 loss to $100. stock on which you’ve written a $ 5,900 Purchase covered call rises You write a 55 call on – $ 5,500 Exercise If you choose this strategy, 11 a stock, and receive a CALL you’ll have to keep the mini- in value, there’s a $55 = $ 400 very real chance $300 premium, or $3 for each ($3 per share) mum cash margin requirement share covered by this contract. – $ 300 Premium in your margin account, to that your option $300 will be exercised, = $ 100 Net loss cover the possibly steep losses and you’ll have While this loss is moderate, every you face if the option is exer- If the price doesn’t go up and cised. If you are assigned, you to turn over your 22 the option expires unexercised, additional dollar that the stock price shares, missing increases means your loss increases must purchase the underlying you keep the $300 premium as profit. stock in order to deliver it and out on potential by $100—and there’s no limit to gains above the how high your loss could climb. fulfill your obligation under the contract. strike price of your option. 26 27 INVESTING STRATEGIES INVESTING STRATEGIES

Put Buying CALCULATING RETURN You can hedge your stock positions by going long with puts. Whenever you buy a put, your anticipate experiencing a maximum loss is limited to the loss and sell your option Buying puts is a simple strategy that can GETTING amount you paid for the premium. before expiration, you MARRIED help protect your assets or let you profit That means calculating the poten- $ may be able to make back even in a bear market. If you think the If you buy tial loss for a long put position is some of the premium you market is going to decline, buying puts shares of the as simple as adding any fees or paid and reduce your loss, might be more advantageous than either underlying commissions to the premium though the market price selling the stocks you own or selling stock stock at the you paid. You’ll realize this loss of the option will be short through your margin account. same time that if the option expires unexercised less than the premium you purchase a or out-of-the-money. If you you paid. INVESTOR OBJECTIVES put, the strategy Put buying is a strategy some investors is known as a use to hedge existing stock positions. married put. If you purchase a put on For the cost of the premium, you an equity that you’ve held for some time, can lock in a selling price, protecting the strategy is known as a protective yourself against any drop in asset value put. Both of these strategies combine the below the strike price until the option benefits of stock owner- expires. If you exercise your option, the ship—dividends put writer must purchase your shares at and a shareholder’s the strike price, regardless of the stock’s vote—with the current market price. downside protec- But if the stock price rises, you’re still tion that a put able to benefit from the increase since provides. you can let the option expire and hold Holding the onto your shares. Your maximum loss, underlying stock Purchasing to Purchasing to in that case, is limited to the amount generally indicates Hold or Sell the Option Hedge a Stock Position you paid for the premium. a bullish market Speculators who forecast a bearish opinion, in contrast to other long put equity market often buy puts in order to positions. If you would like to continue If you purchase a put and later sell it, you can If you purchased the put to hedge a stock profit from a market downturn. As the owning a stock, and think it will rise in calculate return by figuring the difference position, calculating your return means price of the underlying equity decreases, value, a married put can help protect between what you paid and what you received. finding the difference between your total the value of the put option theoretically your portfolio’s value in case the stock investment—the price of the premium added For example, say you purchase one XYZ put rises, and it can be sold at a profit. The price drops, minimizing the risks associ- to the amount you paid for the shares—and for $300, or $3 per share. potential loss is predetermined—and ated with stock ownership. In the same what you would receive if you exercised usually smaller—which makes buying way, a locks in unrealized A month later, the price of the underlying your option. puts more appealing than another bearish gains on stocks you’ve held, in case they equity falls, placing the put in-the-money. For example, if you purchased 100 XYZ shares trading strategy, selling stock short. begin to lose value. You sell your option for $600, or $6 per share. at $40 each, you invested $4,000. Your return is $300, or 100% of If you purchased one XYZ put with a strike your investment. SHORT A STOCK OR LONG A PUT price of $35 for $200, or $2 per share, you’ve invested $4,200 total in the transaction. If you sell stock short, you borrow shares on margin from your brokerage firm and sell them on the $ 600 Sale price stock market. If—as you hope—the stock price drops, you buy the equivalent number of shares back at – $ 300 XYZ put price If you exercise the option, you’ll receive $3,500, a lower price, and repay your brokerage firm. The difference in the two prices is your profit from the trade. for a $700 loss on your $4,200 investment. For many investors, buying puts is an attractive alternative to shorting stock. = $ 300 or 100% return Shorting stock requires a margin account with Puts are purchased outright, usually for a much $ 4,200 Total investment If the price of the stock has risen after a – $ 3,500 Receive at exercise your brokerage firm. A short seller also faces the lower amount than the margin requirement, month, the put is out-of-the-money, and the possibility of a margin call if the stock price rises, so you don’t have to commit as much cash to premium drops to $200. = $ 700 Loss and could be forced to sell off other assets. the trade. You decide to cut your losses and sell the put. A $700 loss might seem big, but keep in mind Shorting stock involves potentially unlimited loss A long put poses much less risk to an investor You’ve lost $100, or 33% of your investment. if the price of the stock begins to rise and the than shorting stock. The holder of a put always that if the price of the stock falls below $35, shares have to be repurchased at a higher price faces a predetermined, limited amount of risk. you would face a potentially significant loss if than they were sold. $ 300 XYZ put price you didn’t hold the put. By adding $200 to your – $ 200 Sale price investment, you’ve guaranteed a selling price of Under certain conditions, investors can short stocks Puts can be purchased regardless of a stock’s $35, no matter how low the market price drops. only on an uptick, or upward price movement. The current market price. = $ 100 or 33% loss uptick rule is meant to prevent a rush of selling as the price of a security drops.

28 29 INVESTING STRATEGIES INVESTING STRATEGIES

RISKY BUSINESS Put Writing Writing options is generally considered • At exercise, the potential loss you riskier than holding options. face is substantial if the price of the You can earn income or lock in a purchase price with a put. underlying instrument falls below With any put writing transaction, •  the strike price of the put. your maximum profit is limited to While writing puts can sometimes be a risky the amount of premium you receive. Due to the risks involved, and the transaction, there may be room for the strategy complications of margin requirements, in more conservative portfolios. By writing If you decide to close out your •  writing puts is an options strategy puts on stocks you’d like to own, you can lock position before expiration, you might that may be most appropriate for in a purchase price for a set number of shares. have to buy back your option at a experienced investors. But if the stock price increases, you may still higher price than what you received profit from the premium you receive. for selling it.

INVESTOR OBJECTIVES Investors who choose to write puts out-of-the-money. You’ll keep the $200. stock drops to $42, your short put with are often seeking additional income. If A more conservative use of put a strike of $45 is in-the-money. If you you have a neutral to bullish prediction writing combines the options strategy are assigned, you’ll have to purchase for a certain stock or stock index, you with stock ownership. If you have a the stock for $4,500. That amount is can sell a put on that underlying instru- target price for a particular stock you’d partially offset by the $200 premium, ment, and you’ll be paid a premium. like to own, you could write put options so your total outlay is $4,300. If the underlying instrument doesn’t at an acceptable strike price. You’d You would pay a net price of $43 drop in price below the strike price, receive the premium at the opening for each share of XYZ stock. If its price the option will most likely expire of the transaction, and if the option is rises in the future, you could realize unexercised. The premium is your You could write one XYZ put with exercised before expiration, you’ll have significant gains. profit on the transaction. a strike price of $45, set to expire in to buy the shares. The premium you Or, you could close out your position For example, say you think that six months, and sell it for $200. If the received, however, will reduce your prior to assignment by purchasing the the stock of XYZ, currently trading at price of XYZ rises, stays the same, or net price paid on those shares. same put. Since the option is now $52, won’t drop below $50 in the next even drops to $46, your option remains For example, if the price of XYZ in-the-money, however, its premium few months. may cost you more than you col- Write Put for Income Write Put to Own Stock lected when you sold the put.

Buy back the put for $300 with a loss of $100, or purchase the stock.

CALCULATING RETURN If you write a put and it expires unexercised, your return may seem Keep the $200 CASH- simple to calculate: SECURED Subtract any fees and PUTS commissions from the Cash-secured puts may help protect premium you received. against the risk you face in writing put But writing puts usu- options. At the time you write a put ally requires a margin option contract, you place the cash account with your needed to fulfill your obligation to buy brokerage firm, so you in reserve in your brokerage account or should include in your in a short-term, low-risk investment calculations any investing capital that to be held on reserve in your margin put, the $200 premium reduces what you such as Treasury bills. That way, if the was held in that account, since it could account. The capital is still yours, but pay for the stock from $4,500 to $4,300. option is exercised, you expect to have perhaps have been profitably invested it is tied up until the put expires or you If you plan to hold the shares you pur- enough money to purchase the shares. elsewhere during the life of the option. close out your position. chase in your portfolio, then your cost Securing your put with cash also For example, if you write the If you write a put that is exercised, the basis is $43 per share plus commissions. prevents you from writing more contracts XYZ 45 put, you’d receive $200. But premium you receive when you open the If you don’t want to hold those than you can afford, since you’ll commit your brokerage firm would require that position reduces the amount that you pay shares, you can sell them in the stock all the capital you’ll need up front. premium, along with a percentage of the for the shares when you meet your obli- market. But if you sell them for less than $4,500 needed to purchase the shares, gation to buy. In the case of the XYZ 45 $43 per share, you’ll have a loss.

30 31 INVESTING STRATEGIES INVESTING STRATEGIES

If the stock price rises to $60 at expiration: Spread Strategies INVESTOR Investor A’s short call is You can limit your exposure using two A in-the-money, and she must sell 100 XYZ shares at $40 each. or more options on the same stock. However, her long call is Write in-the-money as well, which 40 means she can buy those same A spread is an options strategy that HOW YOU call requires two transactions, usually exe- shares for $55 each. Her net loss HEDGE WITH Purchase for each share is $15, or $1,500 cuted at the same time. You purchase SPREADS one option and write another option 5 total. This is offset by the premium If stock XYZ is 5 on the same stock or index. Both call she received, reducing her trading at $45: options are identical except maximum potential loss to $910. Investor A sells a call for one element, such as with a strike price of $40, and If the stock price falls strike price or expiration purchases a call with a strike price below $40 at expiration: date. The most common of $55. She receives $720 for the Both of Investor A’s options expire are vertical spreads, in call she sells, since it is in-the- out-of-the-money, and she keeps which one option has a money, and pays only $130 the $590 for the maximum profit. higher strike price than for the call she purchases, the other. The difference between the If the stock price rises since it is out-of-the-money. higher strike price and the lower strike to $60 at expiration: Her cash received, or net price is also known as the spread. Investor B’s short call is credit, so far is $590. Different spread strategies are appro- in-the-money, and he must sell Investor B writes a 40 call on priate for different market forecasts. 100 XYZ shares at $40 each, for XYZ, and receives $720. His net You use a if you a total loss of $2,000 over their investment is the margin his broker- anticipate a decline in the stock price. market price. His credit offsets this age firm requires for a naked call. You use a if you antici- by $720, reducing his maximum pate an increase in the stock price. Write potential loss to $1,280. INVESTOR 40 call B If the stock price falls Each options transaction is below $40 at expiration: known as a leg of the overall CREDIT OR DEBIT? Investor B’s option expires strategy, and most options If, like Investor A, you receive more out-of-the-money, and he keeps spreads stand on two legs— money for the option you write than his entire $720. though there are some strategies you pay for the option you buy, you’ve with three or more legs. opened a . The difference Credit spread: between the two premiums is a credit premium you receive > premium you pay you receive, and it will be deposited in EXECUTING A STRATEGY WHAT ARE THE BENEFITS? your brokerage account when you open : The first step in executing a Many options investors use spreads the position. In most cases, the goal of premium you receive < premium you pay 1 1 strategy is choosing an underlying because they offer a double hedge, which a credit spread is to have both options security on which to purchase and write means that both profit and loss are lim- expire worthless, retaining your credit ARE YOU QUALIFIED? the options. ited. Investors who are interested in more as profit from the transaction. Although spreads aren’t always specula- aggressive options strategies that might If you pay more for your long option Next, you’ll have to choose the tive or aggressive, they are complex 2 expose them to significant potential losses than you receive for your short option, 2 strike prices and expiration dates strategies that aren’t appropriate for all can hedge those risks by making them you’re taking on a debit spread. You’ll that you think will be profitable. That investors. Your brokerage firm may have one leg of a spread. The trade-off is that have to pay your brokerage firm the means calculating how far you think a its own approval levels for debit spreads the potential profit is limited as well. difference between the two premiums stock will move in a particular direction, and credit spreads, to ensure that you’re It might help to think of spreads as a when you open the transaction. as well as how long it will take to do so. financially qualified and have adequate form of self-defense. Just as you can open In most cases, the goal of a debit investing experience. Additionally, man- You should be sure to calculate the an options position to protect against spread is to have the stock move beyond 3 aging spreads as expiration nears requires 3 maximum profit and maximum loss losses in a stock position, you can open the strike price of the short option so time and attention, so you should be sure for your strategy, as well as the circum- an options position to protect against that you realize the maxi- you want to take on the challenge. stances under which you might experience losses in another options position. mum value of the spread. them. Having realistic expectations is essential to smart options investing. MORE TYPES OF SPREADS A is the purchase or A is the purchase A is the purchase of writing of both a call and a put or writing of a call and a put 44 Finally, most spreads need to be one option and writing of on an underlying instrument with the same expiration held in a margin account. A typical CALENDAR another with a different with the same strike price and the same expiration date and different—but both debit spread requirement is that they expiration date, rather than date. A buyer expects the underlying stock to move out-of-the-money—strike be paid in full while a credit spread with a different strike price. significantly, but isn’t sure about the direction. A seller, prices. A strangle holder hopes for a large move requirement is the difference between This is usually a neutral on the other hand, hopes that the underlying price in either direction, and a strangle writer hopes strike prices minus the credit received, strategy. remains stable at the strike price. for no significant move in either direction. times $100.

32 33 INVESTING STRATEGIES INVESTING STRATEGIES

EARNING INCOME Understanding Spreads Spreads can also be used to create income Bulls and bears, calls and puts, and credits from stocks you hold. and debits don’t have to be confusing. For example, say you bought 100 XYZ shares at $50. Now the stock is trading at $30, and you don’t think it will rise much in the near There are four common future. strategies: the bull put, the bull call, You’d like to receive income on your shares, the bear put, and the bear but you don’t want to have them called away Credit or Long leg Short leg Market Max profit Max loss from you, incurring a loss for the call. Each of these has one debit? forecast long leg, or an option you tax year. buy, and one short leg, or Credit Put at lower Put at higher Neutral or Net credit Spread times You write a slightly out-of-the-money an option you write. strike strike bullish 100, less call at $32.50, receiving $250. You Bull put credit simultaneously buy a 35 call for $150. Your net credit is $100. Debit Call at lower Call at higher Moderately Spread times Net debit Many brokerage firms strike strike bullish 100, less If the options stay permit you to enter both Bull call debit out-of-the-money legs of a transaction simultaneously. With Debit Put at higher Put at lower Moderately Spread times Net debit $ 250 Receive on 32.50 call others, you must execute strike strike bearish 100, less – $ 150 Purchase of 35 call separate transactions in Bear put debit = $ 100 Net credit an approved sequence. Credit Call at higher Call at lower Neutral or Net credit Spread times If the price of the stock stays below $32.50, strike strike bearish 100, less you pocket the $100. Bear call credit If the stock price increases above $35, you can close out both options positions at a loss of $250 (the amount of the spread times the EXIT A SPREAD OFFSET number of shares covered), which is reduced YOUR to $150 after accounting for your credit. This LOSSES loss is one you may be willing to accept as When you exit a spread, both legs are exercise and your shares of XYZ gain value. usually closed out, rather than exercised, assignment since buying and selling the underlying occurred at expi- Offsetting your If the options are in-the-money stock means committing large amounts ration, your firm spread position, $ 100 Number of shares of capital to the strategy. Instead, you would probably net or buying back x $ 2.50 Amount of the spread might close out the spread, by making the difference. the spread you an offsetting purchase of the option you You’d earn $500, sold, can be = $ 250 Loss wrote, and an offsetting sale of the option and after subtracting advantageous if – $ 100 Credit you had originally purchased. If the options are in-the-money the underlying stock has moved against = $ 150 Net loss For example, if you were moderately you. If you are bearish on XYZ when bullish on stock XYZ, which is trading at $ 6,500 Sell shares it is trading at $55, you might open a $55, you might open a bull call spread. – $ 6,000 Purchase shares bear call spread. The loss of $500 would be partially offset You could buy a 60 call for $350 and write = $ 500 Proceeds You can purchase a 65 call for $150, by the original $200 credit. a 65 call, receiving $150. Your net debit – $ 200 Debit and sell a 60 call, receiving $350. Your If the stock is $66 at expiration, is $200, which is also your maximum loss = $ 300 Profit net credit is $200, which is also the you can assume your short call will be if the stock price stays below $60. amount of your maximum profit, if assigned, obligating you to sell 100 XYZ the debit of $200, your profit would be XYZ stays below $60 and both options shares at $6,000. You’d exercise your If the options stay out-of-the-money $300. You would have invested $200 for expire out-of-the-money. long call, and buy 100 XYZ shares for $ 350 Purchase of 60 call that $300 profit. Alternatively, at or near $6,500. Your firm would probably net expiration, you could close out your short If the options expire the difference, creating a $500 loss in – $ 150 Receive on 65 call out-of-the-money = $ 200 Net debit call by buying it back for about $100 your account that would be partially and selling your long call for about $600, $ 350 Receive on 60 call offset by your original $200 credit. If the price of the stock rises to $66 at leaving you with a profit of about $300, – $ 150 Purchase of 65 call expiration, both options will be in-the- after the initial $200 debit. = $ 200 Net credit If the options are in-the-money money, and it’s reasonable to assume the You committed only $300 in cash (the $ 600 Buy back 60 call option you wrote will be exercised. If that’s debit plus the cost of offsetting your short If your expectations were wrong and – $ 100 Sell 65 call the case, you can exercise your long call call), instead of the $6,000 necessary if the stock price rises to $66, both XYZ and purchase 100 XYZ shares for $6,000, you were to exercise your long call. Either options will be in-the-money. At or near = $ 500 Loss and then sell those shares for $6,500 to way, you have given up the opportunity expiration, you might sell your 65 call for – $ 200 Credit meet your short 65 call assignment. If to profit if the stock continues to rise. $100, and buy back the 60 call for $600. = $ 300 Net loss 34 35 INVESTING STRATEGIES INVESTING STRATEGIES

Collar Transactions YOUR OPTIONS You can use a collar to rein in profits you haven’t AT EXPIRATION yet realized, but you might have to give up Depending on the direction the stock moves, your choices at expiration of the legs of future gains in return. your collar vary: If the price of the stock rises A collar is a spread strategy designed to protect unrealized profits above the strike price of the on stock you already own. You purchase a protective put on your short call: long stock position, and offset the cost of that put by writing a If assigned, you can fulfill your short call call that is covered by your long stock position. obligation and sell your shares at the strike In most cases, both the long put and the short price. You’ll lock in profits over what you call are out-of-the-money. If the call you write is initially paid for the stock, but you’ll miss less expensive than the put you buy, you’ll pay out on any gains above the strike price. more premium than you Alternately, you could close out your position receive, and will establish by purchasing the same call you sold, quite a debit collar. If the put possibly at a higher price than what you paid for it. RULE OF you buy is less expensive THUMB This may be worth it if the difference in premiums than the call you write, is less than the additional profit you anticipate Call and put options you’ll receive more move in opposition. you’ll realize from gains in the stock’s value, or if premium than you one of your goals is to retain the stock. Call options usually rise pay, and will establish in value as the underlying a credit collar. If the price of the stock remains market prices go up. Put between both strikes: options usually rise in INVESTOR You can let your put expire unexercised, or value as the market prices OBJECTIVES sell it back, most likely for less than what you go down—but time A collar is most often paid, since its premium will have decreased from decay and a change used as a protective time decay. Your short call will probably expire in volatility also strategy. If you hold a unexercised, which means you keep the entire have an effect. stock that has made premium. Depending on whether your collar was significant gains, you might a credit or debit spread, you’ll retain your initial want to lock in those gains, protecting your credit as a profit, or debit as a loss. position against a future drop in price. Writing If the price of the stock falls below a covered call can fully or partially offset the cost the strike price of the long put: of purchasing a protective put. Just as with other By exercising your put, you can sell your shares spread strategies, the risk you face with a collar is at the strike price. Your short call will probably limited—and, in return, so is the potential profit. When executing a collar, it’s important to expire unexercised, and you keep all of the For example, say you purchased 100 shares of proceeds from the sale of the call. XYZ at $15 two years ago, and its current market price is $30. define your range of return, or the strike prices If you purchase a 25 put, you’ll have for both the put you purchase and the call you 100 Shares the right to sell those shares at $25 before write. The strike price of the protective put x $ 15 Per share expiration, locking in a $10 profit on each should be high enough to lock in most of COMMISSIONS AND FEES = $ 1,500 Original cost share, or a total of $1,000. Suppose that your unrealized profit. The strike price of the As with stock transactions, options trades put costs you $275, or $2.75 per share. covered call should be high enough to allow incur commissions and fees charged by your Let’s say you also write a 35 call with you to participate in some upward price brokerage firm to cover the cost of executing the same expiration month, and receive movement, but not so far out-of-the-money a trade. You’ll pay fees when opening a $250 in premium, or $2.50 per share. that the premium you receive does little to position as well as when exiting. The amount offset the cost of your protective put. of these charges varies from brokerage firm $275 Put price paid to brokerage firm, so you should check with – $250 Call price received yours before executing any transaction. Be = $ 25 Net cost at a minimum profit of $10 per share, sure to account for fees when calculating or $1,000 per contract. the potential profit and loss you face. If the price of XYZ rises above $35 at In most cases, a collar works best if You should also keep in mind that spread expiration, your call most likely will be exer- you have a neutral to bearish market transactions that require two legs mean you cised. You’ll receive $3,500 for your shares, forecast for a stock that has behaved may face double commissions at entry. And or a $2,000 profit, but you’ll miss out on bullishly in the past, leaving you with it also helps to consider that any strategy any further gains the stock may have. unrealized gains you’d like to protect. that ends with an unexercised option, such Since the put you purchased cost more Some investors use collars as income- as a covered call, means—if you’re not than the call you wrote, your net cost is producing strategies by selling them assigned—you won’t pay any commissions $25—less than one tenth of the price of for a credit. While that approach can or fees at exit. the protective put alone. It would cost be profitable, it also requires time and you only $25 to ensure that you could sell attention to manage the strategy. 36 37 38 should alsokeep exit. Youbest out mightbethe exercised, closing were theoption would have faced less thanwhatyou net loss. received, takinga pay more thanyou might alsohave to net profit. But you received, makinga pay lessthanyou back, you might want tobuyit mium whenyou the option’s pre- Depending on be assigned. sure you won’t way tomake out istheonly option, closing If you writean before expiration. often exercised stock optionsare that in-the-money in mind,though, expiration. Keep close outbefore assuming you instrument— the underlying tion tobuyorsell fulfill anobliga- never forced to you’re almost options writer or buybackanoptionyou sold, asan Since you cancloseoutyour position, the trade. or out-of-the-money—before you open option isin-the-money, at-the-money, means establishinghow you’ll exitifyour loss andabiggerone.Smart investing small profit andabiggerone,orsmall difference between a aprofit andaloss, in puttingitintoeffectmightmeanthe exit strategyyou chooseandyour timing have more thanonealternative. But the point before expiration,andyou may You canexitanoptionsstrategyatany The besttimetoplan your exitisbefore you’ve entered. Exit Strategies CLOSING UP SHOP If thatlossis INVESTING STRATEGIES

PUT CALL for theoption: share you received inthe$2per factor you $200,you can put that earned wrote 90 anXYZ For example, ifyou or reduce your loss. add to your gain you received will option, thepremium If you’re an short and whento exit: when decidinghow spent ontheoption $2 pershare you have to inthe factor cost you $200,you’ll that 90call XYZ if you holdan gains. For example, might reduce your you paidinpremium option, theprice If you’re longan HOLDERS OPTIONS FOR CHOICES WRITERS OPTIONS FOR CHOICES

premium hasgoneupsinceyou bought rather thanexercising it.If theoption’s out your position by sellingtheoption, not toexercise. You mightstillclose how toexit,sinceyou have thechoice have more flexibilitywhendeciding capital gainsorlossesfortheyear. of anoption,sinceitmightaffect your or acquiringstockthrough theexercise in mindthetaxconsequencesofselling If you’re anoptionsholder, you’ll • • below $88 thestockIf price is • • above $92 thestockIf price is

choose thisexit strategy. purchase optionsfor leverage often it, making aprofit. Investors who more thanthe$200you paidfor  You possiblyselltheoptionfor can a profit. $200 you spent, andstillmaking for more than$92,offsettingthe or possiblysellitonthemarket $90. You thenretain can thestock exercisecan andbuyshares for  Your optionisin-the-money. You taking aloss. for itthanyou received, and before itisexercised, paying more  You might buytheoptionback market price, taking aloss. 100 shares for more thantheir which meansyou’ll have to buy will mostlikely beexercised,  The optionisin-the-money, and

hold, andonethatyou’ll wanttoclose between a positionthat’s profitable to underlying stockmightbethedifference a onedollarchangeinthepriceof fortheoptionsinvestor.important Just value can change quickly, timingisvery out-of-the-money. Since theintrinsic is in-the-money, at-the-money, or depends onwhetheryour option The profit orloss you’ll faceatexit ofwhatyou paid. least part cutting your lossesandoffsettingat decreased, closingoutwouldmean a profit. If theoption’s premium has it, closingoutwouldmeanmaking IMPORTANCEOF TIMING • • • between $88and $90 thestockIf price is • • • $90 and$92 thestockIf price isbetween

the $200would remain your profit. if itisat-the-money, inwhichcase  The optioncould expire unexercised pay asmuch asyou received for it. and you may ormay nothave to  You could buythe optionback, small profit. sell themonthemarket for a to $88ashare, soyou could still premium reduces your netprice paid have to buytheshares at $90,but the at thediscretion oftheputholder. You’ll $90—and might beexercisedexactly ifthestock priceat-the-money is  The optionisin-the-money—or this case. costly exit, in $200. This may bethemost  You lettheoptionexpire, can losing back someofthepremium you paid.  You selltheoption,hopingto can earn if thestock rises. might gainbackyour $200inthefuture, it allows you to purchase them,andyou want to shares, own theXYZ exercising to offsetthe cost ofthepremium. If you the shares won’t provide enoughprofit $90—but exercising itandthenselling at-the-money, ifthestock isexactly  The optionisin-the-money—or INVESTING STRATEGIES

exercise deadlines. to determinethefirm’s tradingand Check withyour broker aheadoftime your option orcloseoutaposition. minute todecidewhetherexercise means you can’t waituntilthelast firm imposesbefore expiration.This is theexercise cut-off your brokerage the statusofyour option. gets closertoexpiration,dependingon work foror againstyou astheoption or forclosingout. Time decaymay your predetermined pointforexercise monitor your positionsincasetheypass time value drops quickly, you should out. Especiallyasexpirationnears,and Another important timingfactor Another important • above $90 thestockIf price is • • than $90 thestockIf price isless

offset what you paid for it. selltheoptiontocan partially  If there isany timevalue left, you on thepremium. money ontop ofwhat you spent their market value. You’d lose purchasing shares at more than and exercising itwould mean  The optionisout-of-the-money, your profit. $200 as You keep the not beexercised. and mostlikely will  The optionisout-of-the-money,

39 INVESTING STRATEGIES INVESTING STRATEGIES Rolling Up, Over, and Out WORD TO THE WISE If you don’t want to exit, While rolling may be used effectively you can roll into another to increase your profits, it’s important to make sure that you base a decision to roll on options series. your research and market forecast. If you chose a strategy and the stock moved against you, it’s If you’ve been successfully earning income by possible that rolling out—or up or down—could make writing covered calls and would like to extend that strategy profitable. But if you roll out of frustration that strategy over time, or if your options with an unsuccessful strategy, you’re just committing strategy hasn’t worked out as you planned but more capital to a misguided trade. If you’re you think your initial forecast still holds true, not confident about what will come next, you might consider rolling your options. ROLLING UP ROLLING DOWN it might be better just to cut your Rolling means first closing out an existing If the new position If the new position you losses and exit the strategy. position, either by buying back the option you open has the same open has the same expira- you sold, or selling the option you bought. expiration date but a higher tion but a lower strike price, Next, you open a new position identical strike price, you’re rolling up. you’re rolling down. This strategy to the old option but with a new strike You might roll up if you’ve written might appeal to investors who’d like ROLLING OUT price, new expiration date, or both. a covered call on a stock that has to receive income from writing calls on If you are long an option, and you increased in price, and you’d like to a stock for which they have a long-term roll with enough time remaining maintain your short options position— neutral prediction. If the new position you open has the before expiration, your old or continue to generate income—with- same strike but a later expiration date, option will have some time out having your stock called away For example, say you write a you’re rolling out. If your options premium left, which means from you. Rolling up also appeals to covered call on stock XYZ. strategy hasn’t yet been successful but it’s likely that you can earn call holders who have a more bullish You predict it will be neutral or fall you think you need more time for it to back some of what you market forecast on the underlying stock. slightly below its current trading price of work, or if it has been successful and paid. But on the opposite $74, so you write an 80 call, and receive you think it will continue to be in the side, if you write a covered For example, say you think that $250 in premium. As expiration nears, future, you might roll out. call, rolling might reduce XYZ, a stock that’s trading at $16, the stock price has fallen to $72, and your profit from the will increase in price in the next your short call is still out-of-the-money. For example, say you purchased initial transaction. But few months. That means it will likely expire unexer- 100 shares of XYZ stock for you might roll anyway, You buy a call with a strike price of cised, leaving you a $250 profit. But you $44 a share. if you don’t want your $15, for a premium of $200. think the stock will remain neutral or stock called away At the same time, you purchased a As expiration nears, XYZ has risen fall in the next few months, and would from you. protective 40 XYZ put to prevent and is trading at $19. Your call is now like to repeat your profitable trade. losses of more than $4 a share. You worth $550. But you think XYZ will You buy back the option you sold paid $100 for the protection. continue to rise, so you decide to roll for $50, locking in a profit of $200. As expiration nears, XYZ is your call up. You then sell a 75 call and receive WHEN TO ROLL trading at $45, but you still think $150 in premium. Deciding when to roll an options $550 Received from sale of there’s a chance it will fall below $40 position depends on several factors, long call $250 Received from long call in the coming months. You sell your including the costs involved, and – $50 Purchase of call out-of-the-money put for $50, earning your market prediction. – $200 Purchase of call back some of what you paid for it. You purchase a new 40 XYZ put As a covered call writer, you = $350 Profit = $200 Profit •  with a later expiration for $100, and might roll down or out to extend + $150 Received from new You purchase a new 20 call with extend your downside protection at your successful strategy and long call a later expiration, paying $300. You a net cost of $150. maintain the income provided earned $350 by closing out the older = $350 Total cash plus profit by the premiums you receive call, a profit that offsets the cost of the from rolling down – $100 Purchase put • If you use long puts to hedge your new call, leaving you with a net credit + $50 Received from put investment, rolling your options of $50 on the transaction. When rolling down a covered call, it’s to ones with later expirations may important to keep an eye on the price = – $50 extend the protection you seek $350 Profit from existing call you paid when you initially bought – $100 Purchase of new put – $300 Purchase of new call the stock. If the market price falls near You might also consider rolling = – $150 Total cost •  your original cost, it may make sense to if a strategy you chose hasn’t been = $50 Net profit of rolling up consider closing out your position and successful, but you think that selling the stock. But, if the price has your prediction for a stock’s fallen below your initial cost but begins movement is applicable for to rise, you might have to scramble and the coming months buy back your call.

40 41 INVESTING STRATEGIES INVESTING STRATEGIES

HOW MUCH INSURANCE? Index Options If you’re using index puts to hedge your You can balance your portfolio by investing in options on portfolio, you’ll have to calculate the number of contracts to purchase in order to match a stock index, which tracks an entire market or sector. the size of your portfolio. Determine the current aggregate Index options are puts and calls on a 11 value of the index option: stock index, rather than on an individual ______Current index value stock. For many investors, the appeal x $100 of index options is the exposure they provide to the performance = Aggregate value of a group of stocks. Holding the Divide the value of your portfolio equivalent stock positions of one USING LEVERAGE 22 index option—say the 500 stocks Index options also appeal to investors by the aggregate value. in the S&P 500—would require because of the leverage they provide. ______Your portfolio’s value much more capital and numer- Investors can participate in moves for ÷ Aggregate value ous transactions. your portfolio to hedge your a fraction of the cost of purchasing the from above Another attraction is that investments. Or, if you feel that the equivalent assortment of stocks. And = index options can be flexible, fitting biotech industry is headed for record even a small change can result in large into the financial plans of both conser- gains, you could purchase a call on the percentage gains. The downside of The result is the number of contracts vative and more aggressive investors. Biotech Industry Index. leverage, of course, is that if the market that will protect your entire portfolio. If you’ve concentrated your portfolio Most index options are European moves against expectations, the percent- Once you’ve determined the number on large US companies, you might sell style, which means they can only be age loss can be high, and might be all of contracts that will cover your portfolio, options on an index that correlates to exercised at expiration, not before. of your investment. you should calculate how much downside The leverage of index options also protection you want. The strike price you means that if you’re confident a certain choose should match that amount, so that HEDGING YOUR PORTFOLIO sector is going to make gains, but you the insurance will kick in if the index drops Conservative investors may use index protect yourself against a loss of more don’t know which individual stock will that far. For example, if you want to protect options to hedge their portfolios. If your than 5%, or $5,000. You purchase a rise, you can purchase an index call to against a decline greater than 10% in your portfolio drops in value, an index that 900 put on the XYZ Index. benefit from the broader market shift. portfolio, your strike price should be 90% corresponds to the movement of your In the next few months, your portfolio of the current value of the index, which portfolio will drop as well. By purchasing drops in value by about 10%, to $90,000. WHAT’S THE RISK? would be the value of the index if it drops a put on that index, you’re entitled, at Since XYZ has a similar makeup, it has The risk of buying index options is the 10% from current value. expiration, to an amount of cash propor- also dropped by a little more than 10%, same as the risk of buying tionate to the drop of the index below to 850. Your put is now in-the-money by stock options: It’s limited in your margin account. Since the aggre- the strike price. 50 points, and at expiration you receive to the amount of pre- gate value of an index option changes For example, say you have $100,000 $5,000 minus the premium you paid for mium you pay. If you’re daily, the amount of the margin main- invested in a portfolio that contains the put and any sales charges. Your overall considering buying a tenance requirement fluctuates, which some of the larger stocks in the broad- loss is reduced to about $5,000, or 5%, put, it’s important to means you’ll need to pay close attention based XYZ Index, which is currently which was your predetermined acceptable weigh the cost of hedg- to your account to avoid a margin call. trading at about 950. You’d like to level. Keep in mind, though, that what ing your portfolio against you pay for the put the benefits of the hedge. affects your return. Index options writers, If your goal is to hedge your portfolio with 1,050 If the index however, face substantial potential risk. index puts, the key is to find an index that doesn’t drop before Since the value of the index might drop mirrors the movement of your portfolio. expiration, your suddenly, a put writer might owe a lot Otherwise, what happens to the index 1,000 option will remain of cash. The same risk applies to a call won’t accurately reflect what happens to OUT-OF-THE-MONEY out-of-the-money writer, if the index increases sharply. your portfolio, and you may not offset any or at-the-money. And index call writers usually can’t cover of its declining value. The first step is to find 950 You can decide themselves by holding the underlying indexes that cover the same market or sec- whether to extend instrument, as they can with individual tor as your portfolio. Once you’ve narrowed your hedge by buy- stock options. your choices, you might use the past perfor- ing another option mance of an index or judge its volatility to 900 with a later expira- MARGIN CONSIDERATIONS find one that closely mirrors your portfolio’s tion, or rolling out. The margin requirements are movement. But unless your different for writing index options portfolio exactly matches the 850 The 900 put than for writing options on indi- makeup of an index—which IN-THE-MONEY reduces the vidual equities. In general, you is very unlikely—you’ll total loss by 5% initially need to deposit the entire always face the risk that it 800 premium, and at least 15% of the won’t move the same way TIME EXPIRATION contract’s aggregate value, or the your portfolio does. level of the index multiplied by $100, 42 43 RESEARCH AND INFORMATION RESEARCH AND INFORMATION

COMPARATIVE TOOLS Options screener. You Trading Options In order to be competitive, many can find specific options brokerage firms offer their customers that match a strategy, When you’re choosing a brokerage firm, consider the tools advanced tools and technology to help a particular market fore- and the expertise at your disposal. them research and track securities and cast, or other condition. strategies. You might have access to For example, if you were looking for some or all of the following tools options with a very high implied volatility, There have been some major changes in They range from traditional full-service through your firm’s website: an options screener would provide equity options investing since the mid- firms to discount firms that operate a list of options with the highest 1990s. Thanks to the Internet, you have exclusively online. Some firms specialize Options calculator. If you implied volatility. easier access to a wide range of timely in options, while others offer options enter the details of a parti- information that allows you to research accounts in addition to regular brokerage cular options trade, this Options chains. If you select a underlying investments on which options accounts. If you choose an online firm or electronic tool can calculate particular stock or stock index, are available, track real-time or near real- an online account with a traditional firm, the potential profit and loss you can see a chart of all put time prices changes, and follow trading you should ask how you’d trade if the of adopting the strategy, as and call series offered on it, the activity in contracts that interest you. Internet connection isn’t working. Many well as your breakeven point delayed or real-time premiums, You also have a broader selection of firms offer phone service, though it may and any margin require- and other characteristics such as brokerage firms to handle your orders. cost more to trade that way. ment. An options calculator can also volume and open interest. be used to determine the Greeks for a Options information. You can particular option and the annualized research options, finding out EXECUTING A TRADE returns for various strategies, which about underlying stocks and Depending on the firm you use, you’ll find differences in the cost of trading and your access to allows you to compare options stock indexes, as well as price professional advice. But whether you enter your options trading order yourself using your online strategies with different time periods. history, volatility, and other data. account or you telephone your order to your broker, you put the same process in motion.

11 Initiate a trade 22 Confirm 33 Receive 44 Execution 55 Monitor your order confirmation status

In order to initiate a trade, you provide The next step is After submitting the the details of your trade, which include: confirming your order order, you should before it is placed, receive a confirma- The symbol of the option or the • double-checking the tion that it has been underlying stock information displayed placed—but not Whether you’re buying to open, buying to When your option order has • online or repeated yet executed. There close, selling to open, or selling to close been executed—it may be a back to you by your may be a lapse between Whether you want a put or call matter of minutes or several You can monitor the status • broker to make sure when your order is placed and The strike price hours, depending on the type of your options positions • it’s correct. when your brokerage firm can The expiration date of order—you should receive a through your brokerage • fill it. Some firms’ websites offer A specific buy or sell price, or a market order to buy or notification that will include the firm’s website. • an order status page, where sell at the current market price price at which it was executed. you can view your executed Whether you’d like to use a cash account or a margin account Because most options are not • orders and any current, With some brokers, you can request a multi-part transaction, traded as heavily as most stocks, • pending orders. such as a spread execution can take longer.

SPECIAL CONSIDERATIONS EDGAR database (sec.gov/edgar.shtml) THE LANGUAGE OF ORDERS if they’re not filled by the end of the If you’re just beginning to trade to search for information and regulatory There are ways to restrict an order you trading day. Alternatively, you might options, you may want to work with filings on any firm. If you’ve already place if you’d like it to be executed only place a good ‘til canceled order (GTC), an experienced investment adviser at opened an account with a brokerage at a certain price, for example, or within which means it is pending until your a full-service firm who can advise you firm but you’re not satisfied with the a specific period of time. Alimit order brokerage firm fills the order, unless on the options strategies or the specific tools they offer or the execution of your restricts the transaction to the highest you cancel it. Some brokerage firms contracts that may be most appropriate orders, shop around. price you’re willing to pay if you’re have 90-day limits on GTC orders, for you. Or, if you’d prefer to trade on You can find reviews of brokerage purchasing, or the lowest price you’re so check with yours for their policy. your own, you may want to choose an firms in financial publications, and willing to accept if you’re selling. As A stop-loss order is a request online firm. some firms’ websites allow you trial with stock orders, if the market has to automatically close your options The first step is often to ask your access to their account holder services. passed your buy limit, your order will position if its price moves beyond a other professional advisers, friends, You may also want to compare the range not be filled. The opposite of a limit certain predetermined level. Stop-loss or colleagues who trade options for of services offered by several firms. For order is a market order, which means orders are often used on stock trans- referrals. You can check the OIC example, some brokerage firms offer a you’re willing to pay whatever the market actions to stem losses if prices drop website,EDGAR OptionsEducation.org, for a wide variety of educational information, price is at the time your trade is entered. dramatically. Some brokerage firms list of firms, and you can use the SEC’s and others have more experience Most orders are day orders, which allow stop-loss orders on options. executing complex transactions. means they will be automatically canceled 44 45 RESEARCH AND INFORMATION RESEARCH AND INFORMATION

to test your knowledge. Also Options Information Sources offered are descriptions of options terms and strate- The smart approach is to prepare for trading by gies and how options can work in your port- researching your options. folio. The site also provides timely The key to smart investing is being information well informed. As an options investor, COLLEAGUES AND FRIENDS on live educa- this means you’ll want to research the Don’t neglect your personal connec- tional events underlying stock for a particular options tions and business contacts when and an easy series, as well as the options class and researching investments. Discussing way to reach the overall market. While this takes options and financial markets with the Investor time and requires effort on your part, colleagues and friends lets you Services depart- the good news is that the information compare other perspectives with ment at the OIC. you need is readily available through your own. Someone else’s investing When using the a variety of sources—and much of it experience might serve as a Internet for research, it’s is free. cautionary tale or introduce you important to be discriminating to a particular investment or a certain about the reliability of a source, just PUT A LOOK ONLINE market sector that you might not have as you would when using any BROKER TO WORK Today, most options investors use the investigated on your own. And if you investment research. You can find a If you already work with a brokerage Internet as a source for at least some know people who have been investing list of reputable options websites at firm, you might be able to find options of their research. The Internet is easy longer or more successfully than you OptionsEducation.org. They might serve information and analysis through their to access for most people, much of the have, you might be able to learn a lot as good starting points for your research. website or office, just as you might when information is free, and news is almost from them. Don’t forget, though, that researching a stock purchase. If your always up-to-date, since financial web- a tip from an acquaintance is never a brokerage firm specializes in trading sites are updated frequently. Even those substitute for doing your own research. options, they are likely to have a greater investors who don’t give their buy and Ultimately, you’re responsible for all wealth of resources for you. Even if the sell orders online can research options of your investment choices. firm focuses primarily on stocks, you and underlying stocks on the Internet. might be able to use their research on • OIC’s website, OptionsEducation.org, an option’s underlying instrument. But and OCC’s website, theocc.com, both it’s a good idea to support that research provide general options education, with options-specific information. plus industry-wide volume, open If you’re comfortable working with interest, contract adjustments, SEC your broker for research and analysis on filings, and expiration cycles, among your other investments, it might make other topics. sense to do the same for options research as well. You should check first, however, The websites of the options exchanges •  to find out whether your broker has offer information on the options they options trading experience. list as well as real-time and delayed quotes, volume, and open interest. A DISCRIMINATING READER • Both online and traditional full-ser- vice brokerage firms offer their clients SUBSCRIBING TO NEWSLETTERS Newsletters and online columns website access to information about Financial newsletters are another often provide an analysis of options specific options and strategies, as well popular source of options informa- information and recommend specific as analysis and recommendations. tion. Most options newsletters are trades and strategies based on that paid services that offer subscribers analysis. They can also be good A range of commercial sites are exclu- •  a periodic update on options news, places to learn more about individual sively devoted to options information. educational information, and specific benchmarks or indicators, and how Most of these are accessible by paid recommendations on options and to use them as the basis for creating subscription only, so you’ll have to use strategies. Newsletters are usually strategies. If you subscribe to a your own judgment to decide whether written by options experts who offer newsletter or regularly read an their education and analysis is reliable their opinion and analysis—but online options column—and you and worth paying for. who can’t guarantee the success of consider it to be a trustworthy • Many of the leading financial • OIC offers a free mobile-friendly any strategy. Some newsletters are source of analysis—you can use information sites offer substantial website with a variety of educational tailored to the needs of specific their recommendations as a starting data as well. These sites are usu- materials and resources about invest- groups of investors, so it’s important point. But you should always do ally free, and include MarketWatch ing in options. Featured are mobile to look for one that suits you, as well your own independent research to (MarketarketWatch.com) and Yahoo! courses so you can learn at your own as one you trust to deliver accurate, see if the information you come Finance (finance.yahoo.com). pace and convenience, and quizzes reliable analysis. across backs up any assertions or predictions they’ve made.

46 47 RESEARCH AND INFORMATION RESEARCH AND INFORMATION

WHAT’S THE INDICATION? Applying Options Indicators are part of a technical analysis toolbox. A variety of different data and measurements can serve as indicators Information and Analysis of larger market trends and movement. For example, the put/call ratio is an Once you do your research, indicator used to measure market put it to work for your portfolio. sentiment. The ratio is simply a comparison of the number of put contracts opened and There’s a wealth of information about trading the number of call contracts options at your fingertips. But the sheer opened. Since puts amount often seems overwhelming. So you are usually a sign of need to know how to use that information to a bearish market forecast, create options strategies. and calls are usually a sign of a USING BENCHMARKS bullish forecast, when investors buy more puts than calls, it’s an indication that they Benchmarks are measurements that you anticipate a drop in a particular stock or can use to judge the relative position of the the broader market. Many options investors security you’re interested in, compared to tend to be contrarians, and view negative the market. One benchmark many options as a buying opportunity. investors use is the CBOE Volatility Index, which is commonly known by its ticker BE CONSISTENT symbol, VIX. In the same way that stock Whatever benchmark, indicator, or analysis you rely on to shape your indexes are compilations of stock prices, VIX options strategies, it’s important that you determine which information is a compilation of the implied volatilities of is important to you. If you choose one or two pieces of data as indica- S&P 500 index options. You can use VIX as a tors or benchmarks, be consistent and stick with them over the long benchmark to measure how volatile investors term. That way, you can easily track the small number you’ve chosen, rather feel the S&P 500 index—and by extension, than being overwhelmed by trying to follow every piece of market data available. the stock market—will be. In general, a higher volatility Consistency is also important when you’re evaluating your options positions. indicates a bearish market sentiment, though there are exceptions. Say you bought an option because your research and calculations indicated it was And keep in mind, that’s only how investors predict the market will undervalued, and you think its premium will go up. But you’ve recently looked at behave. The actual market movement may or may not match predictions. the put/call ratio, and you’re worried that the market is about to dip. You could close out your position, but if you believe the option is still underpriced, you’ll forfeit the whole strategy, which might have proved successful. Instead, when you buy or write an option, you should have a plan in place for evaluating whether to close the position, based on the same benchmark or indicator that prompted you to open the position. If you’re consistent in how you evaluate positions, you’ll be more confident when deciding whether to hold a position, or exit and cut your losses.

PRICING MODELS Another benchmark you can use to analyze options is an options pricing The Black-Scholes formula, though The limitation of all pricing models is that model that estimates the theoretical fair value for a given options position. perhaps the best known, isn’t the only method actual premiums are determined by market In 1973, three mathematicians—Fischer Black, Myron Scholes, and Robert for computing an option’s theoretical value. Equity forces, not by formula—no matter how Merton—published their formula, known as the Black-Scholes model, for options are typically priced using sophisticated that formula might be. calculating the premium of an option, accounting for the variety of factors either the Cox-Ross-Rubenstein Market influences can actually result in that affect premium. You can find the actual formula on many options model, which was developed highly unexpected price behavior during websites, but what’s most important to know are the variables in 1979 for American-style the life of a given options contract. that go into the formula. These are the variables affecting an options that allow early But while no model can reliably predict option’s premium: exercise, or the Whaley what options premiums will be available to model. Inputs to any you or other investors in the future, some of these models can be investors do use pricing models to anticipate tweaked, or manually an option’s premium under certain future adjusted, to illustrate the circumstances. For instance, you can calculate impact of stock movement, how an option might react to an interest rate volatility changes, or other factors that may increase or a dividend distribution to help influence an option’s actual value. For example, you better predict the outcomes of your you could adjust the quantities of a potential options strategies. spread to see how that change would affect the delta, gamma, and other Greeks. 49 RESEARCH AND INFORMATION RESEARCH AND INFORMATION

Graphing Profit and Loss ment. Since the price of the underlying of option you hold and is immediately can’t be less than $0, the X axis begins apparent in a profit and loss graph. A visual depiction of an option strategy’s gain and loss at the Y axis rather than intersecting it. For example, if you hold a long The prices increase from left to right. position, your possible loss is limited potential can help you appreciate its risks. The graph line, whose shape is to the premium you paid to purchase determined by the type of strategy the option plus commissions and fees. As you consider different options Each graph is composed of a vertical, being depicted, changes with each Your gain, on the other hand, could be strategies to meet your investment or Y, axis, an intersecting horizontal, or change in the price of the underlying. substantial if the price of the underlying goals, you may want to investigate X, axis, and a graph line drawn on a grid. It shows the option’s strike price, its changed as much as you anticipated. what you can learn from profit and The Y axis shows profit or loss. Any breakeven point, and the direction of In contrast, if you hold a short loss graphs, which indicate the break- point above the juncture with the X axis the profit or loss. position, your gain is limited to the even point of a particular transaction indicates a positive return, and any point premium you collected, but your loss and the potential profit or loss it might below the juncture indicates a loss. ILLUSTRATING THE RISK could be substantial if you were assigned produce as the market price of the The X axis shows a series of potential The extent of your potential loss with to meet your obligation to buy or sell. underlying investment changes. prices of the option’s underlying invest- an options contract depends on the type

MAKING DISTINCTIONS resentations do not show is the cost of Every options strategy, from the most achieving the potential gain. Strategies SHORT CALL LONG PUT basic to the most complex, can be that involve taking two positions require PROFIT PROFIT illustrated with a profit and loss chart. two premiums. So it may cost more to In each case the graph line follows a achieve the same gain than using a strat- distinctive pattern that shows the egy requiring a single purchase or sale. relationship between potential risk On the other hand, a complex strategy $0 $0 and potential profit. What these rep- may provide greater loss protection.

LONG CALL PROFIT LOSS LOSS 33 11 Breakeven BEAR PUT SPREAD LONG CALL (OR PUT) 55 Point PROFIT PROFIT

22 $0 $0 $0

Strike 44 Price LOSS Lower STOCK PRICE Higher LOSS LOSS

strike price LONG STRADDLE SHORT STRADDLE The vertical axis shows the scale 4 The you choose 11 of profit and loss, measured in 4 determines where the profit and PROFIT PROFIT dollars. The center of this axis is a break- loss line bends, since if the stock is even line, where your profit or loss is $0. below that price you’ll face a loss. Above that price your loss drops The horizontal axis, shown in black, 2 until you begin to realize a profit. $0 $0 2 shows the price of the underlying breakeven point stock: The farther to the right, the higher 5 Your is the the stock price. 5 stock price at which you’ll neither lose money nor make a profit on the The blue arrow tracks the profit LOSS LOSS 3 investment. With a long call, the break- 3 or loss you’d realize at a particular even point is to the right of—or higher stock price. If you pick a stock price on than—the option’s strike price. Since the horizontal axis, and find the height this strategy calls for spending money USE ‘EM OR LOSE ‘EM? of the arrow at that stock price, you’ll to purchase the option, you’ll have to While it’s possible to graph a profit and this tool might be helpful. You can find have an idea of your potential profit. The earn back the premium before you can loss chart using the numbers from a specific profit and loss charts for each of the basic loss is fixed at the premium you paid and realize a profit. If this chart were for purchase or sale you’re considering, many options strategies on the OIC website, will not increase. It decreases as the stock call writing, your breakeven point investors use generic profit and loss charts to OptionsEducation.org. What a chart can price rises above the strike price, but you would be to the left of—or lower get an overview of what will happen as the help clarify is whether a strategy’s potential don’t realize a profit until the stock price than—the strike price, since premium underlying stock price increases or decreases. If for gain or loss is limited, as it is with a spread, moves past the breakeven point. received would partially offset loss. you’d like to be able to visualize your strategies, or unlimited, as with long or short calls.

50 51 RESEARCH AND INFORMATION RESEARCH AND INFORMATION

BID AND ASK makers can profit is by buying option contract Options Chains The bid is the price that a buyer is willing to pay at the current bid price and selling them at the for an option, and the ask is the price that a seller higher ask price. Without a change in the under- Learn how to translate the specialized options tools is willing to accept. In general, the two prices are lying stock price, they may make a profit from the slightly different, and the gap between them is spread of only a few cents per contract. But they you can find online. known as the spread. So how does that affect may trade in high volume every day, so the small individual investors? profits can add up. Instead of options tables, many websites the option chain, you’ll find its When you buy or sell an option—or a As a rule of thumb, the more actively traded offeroptions chains or options strings. theoretical value, implied volatility, stock—you’re possibly buying from and selling an option is, the smaller the spread will be. But You select a particular underlying and a calculation for each of to a market maker. One role of market makers is the bid and ask spread for any particular option instrument, and can see a chain of all the Greeks. to provide liquidity in the marketplace, making contract may vary on the different exchanges the options currently available, so that it easier to buy or sell one or more options with- where the contract is listed. So option brokers you can compare the prices for calls and out changing the market price. One way market focus on getting their customers the best puts, different strike prices, and different execution price among the various exchanges expiration months. where the option is traded. You can choose whether to display all option strike prices, or only those that are in-the-money, at-the-money, or out-of-money, or any combination of the three. You can also select the expiration months to be displayed and whether to include LEAPS or not. In addition to price information for each contract that appears in

The uppermost area of the option chain indicates the name of the underlying stock, its ticker symbol, and the primary exchange on which the underlying stock is listed.

Just below you’ll find information about the underlying stock, including its current market price, its net change up or down, the 52-week high and low, and the stock volume. Options statistics include the average daily option volume for the option class as well as the average open interest.

You can find the month, day, and year of option expiration as well as the number of days until expiration.  You can find the symbology key for each available option series. Bid indicates what buyers are willing to pay for the option, Volume is the current number of Implied volatility is the and ask indicates which sellers contracts traded for each option volatility percentage that are willing to take for the option. series during the trading day. Some produces the best fit for The option symbol column indicates option chains allow you to view only each option series. the option symbol for calls and puts Change is a measurement of options with a certain daily volume. on the underlying stock. For each the percentage change in the strike price, the chain will display option’s price for the day. A Open interest indicates the total information for calls (C) and puts (P). positive number indicates a number of open contracts outstanding. price increase, while a negative number indicates a decrease. 52 53 RESEARCH AND INFORMATION RESEARCH AND INFORMATION

Option Symbology INDUSTRY ORGANIZATIONS The Options Industry Council (OIC) Securities and Exchange and Sources and OCC Commission (SEC) 125 S. Franklin Street sec.gov Suite 1200 The SEC is a government agency In 2010, the options industry overhauled led to bookkeeping and order entry errors. Chicago, IL 60606 that regulates the securities industry the way it identifies exchange-listed OCC and the various US option Email: [email protected] option contracts, creating a simpler, more exchanges use the new symbology to and protects individual investors. standardized symbology. The method it identify option contracts. Brokerage You can email OIC and OCC You can also research individual replaced, which had been in use since firms use it to identify and track option at [email protected] to speak with companies using EDGAR, a database exchange-trade options were introduced positions in your account. And you experienced representatives. While they of the mandatory corporate reports in 1973, was confusing to both investors may see symbology keys on your trade don’t provide investment advice, they and filings. and option professionals and commonly confirmations and monthly statements. can answer options-related questions you might have—whether about the basics of options trading or about a THE EXCHANGES DECODING SYMBOLOGY specific, advanced strategy. With the new methodology, an option series • Option type. Call contracts are identified The websites for OIC’s participant can be identified and distinguished from all other with “C” and put contracts are identified OIC website exchanges offer directories of all the series by its formal symbology key. Each of these with “P”. OptionsEducation.org options they list, as well as the latest specific keys contains the same four elements: trading data, delayed and real-time quotes, • Strike price. Strike prices are expressed Learn about options and strategies, product specifications, and an expiration • Option symbol. It is generally the same to two decimal places representing dollars find free educational seminars near calendar for those options. The exchanges as the ticker symbol of the underlying stock. and cents. you, and get the latest news on also provide market information for the • Expiration date. It is identified by its Here’s an example of the four pieces of information options trading at the OIC website. stock, index, or other options that they explicit year, month, and day. strung together to form a symbol key: • Take online classes on list, their official trading hours and their options trading trading technology. In addition most of these websites • OIC offers a printable online offer educational tools, the latest options glossary defining all of the XYZ is the option symbol that specifies the news, explanations of basic options terms commonly used in underlying stock information, and details about a variety options trading of options strategies. You can also find profit and loss diagrams, stock charts, OCC website links to downloadable documents and theocc.com brochures, glossaries of options terms, On the OCC website, you can answers to commonly asked questions, find educational tools and volume and links to outside resources. For a information, as well as a database current list of exchanges, please see 20 06 18 is C indicates the The option’s of all listed options. OIC’s website. the contract’s option is a strike price You can view an options symbol expiration date call contract is $50.00 directory, new listings, and contract of June 18, 2020 adjustment memos.

FINRA finra.org You can find resources about THE MORE THINGS CHANGE PLACING OPTION ORDERS a variety of securities on the Depending on the source, you might You’re responsible for entering the website of the Financial Industry find symbology keys displayed in correct order information for the specific Regulatory Authority. different formats, but with the same call or put you want to trade. But you • Find tips for protecting your four pieces of information identifying may or may not need to use the appro- investments and avoiding fraud the same option contract. priate symbology key. Many brokerage firms allow you to place orders directly • Learn about the markets and XYZ 20 06 18 C 50.00 from option chains on their website, other educational topics XYZ 20/06/18 C 50.00 by simply clicking on the key for the • You can also use the FINRA option contract you want to buy or sell. website to check the background XYZ 200618C00050000 But if you have any questions about of a brokerage firm or broker XYZ 20/06/18 Call 50.00 the symbology key or another other you’re considering data you’re entering, it’s important to XYZ June 18 2020 C 50.00 check with your firm before placing XYZ June 18 2020 Call 50.00 your order. Getting the details right is ultimately your responsibility. 54 55 RESEARCH AND INFORMATION RESEARCH AND INFORMATION

Strategy Screener Your Risk Your Possible Tolerance Expectation Strategy* You can screen for strategies based on your risk tolerance and market forecast. SPECULATE OR Low Very bullish Buy out-of-the-money RECEIVE INCOME calls As you consider whether to add equity from very bearish to very bullish, either on Low Bullish Buy calls options to your investment portfolio, an individual stock, or on the market as a you might find it helpful to review these whole. You’ll find a potential strategy that Low Moderately bullish Open bull call spread strategy screeners. First, if you’ve identified fits your particular situation and forecast. an objective you’re trying to achieve—to These tables are far from comprehen- Low Neutral or bullish Open bull put spread hedge a stock position, for example, or sive, but they can be helpful shortcuts Low Neutral or bearish Open bear call spread receive income—look at the correspond- to identifying an appropriate options ing table. Next, choose the level of risk strategy. Once you’ve begun considering Low Moderately bearish Open bear put spread that you’re willing to take. If you’re new a strategy, you’ll have to do some research to options, you’ll probably want to choose on your own to match it with an under- Low Bearish Buy puts a low-risk strategy to begin with. Finally, lying security that might work to meet find a forecast that fits your expectations, your objective. Low Very bearish Buy out-of-the-money puts Moderate Neutral to moderately Write covered calls on EXPIRATION CYCLES bullish stock you own If you’re considering opening an options High Neutral to bullish Write naked puts position on a particular stock, you’ll always Cycle 1 Cycle 2 Cycle 3 have the choice of contracts expiring in (January) (February) (March) Extremely high Neutral to bearish Write naked calls four different months. That’s the easy part. January February March What can be a little more complicated is IMPROVE YOUR Low Neutral to slightly Buy calls to lock in figuring out which months those are. April May June That’s because there are three factors PURCHASE PRICE bullish purchase price at work: OR PROTECT July August September PROFITS Low Neutral to bullish Buy-write to reduce your net price paid 1 Options are always available for the 1 current month and the following October November December one. So on January 1, you can buy or Low Neutral, long-term Write puts to reduce bullish your net price paid sell options that expire in January and in 3 The current month’s options February on all stocks with listed options. 3 expire on the third Friday, and a Low Neutral to moderately Open a collar to lock in On February 1, you can buy options new options series with a new expiration bearish potential gains expiring in February and March for all is added on the following Monday. If, stocks—and so on through the year. for example, January 20 were a Monday, Low Very bearish, Buy puts new options series expiring in March The two other months in which long-term bullish 2 would be added to the January and 2 options on a specific stock expire February cycles, and a new series are determined by the expiration cycle Low Bearish, long-term Buy out-of-the-money expiring in September would be to which the underlying stock is bullish puts added for stocks in the March cycle. assigned. There are three cycles, begin- Low Bullish Buy index calls ning in January, February, and March, If LEAPS are available on an PROFIT FROM A MARKET OR each including four months, one in each options class, there might be five SECTOR MOVE Low Bearish Buy index puts calendar quarter. Stocks are assigned expiration months trading at a given randomly to one of those cycles. time, in addition to the LEAPS, since Extremely high Neutral to bearish Write index calls LEAPS convert into regular options So, on January 1, options on a stock with a January expiration in the final Extremely high Neutral to bullish Write index puts assigned to the January cycle would be year of the contract. available in April and July, the next two If you’d like to find out the avail- * These strategies are described as possibilities, not recommendations. No strategy guarantees success, and you are responsible months in the cycle, as well as January able expirations for an option class for doing adequate research and making your own investment choices. and February. Those on a stock assigned you’re considering, you can email to the February cycle would be avail- [email protected], or check on OIC’s able in May and August in addition to website, www.OptionsEducation.org. January and February. Stocks assigned You can also check the third and fourth to the March cycle would have options expiration months of an options chain, expiring in June and September. which will tell you the cycle to which Due to an approved pilot program, the underlying stock has been assigned. some options may be available for trading in additional months. 56 57 GLOSSARY GLOSSARY

American-style An option that you can European-style An options contract Mark to market This tax rule requires Seller If you sell an option, whether exercise at any point before expiration. that you can exercise only at expiration, you to calculate the theoretical profit opening a new position or closing an Equity options are American style. not before. you’d earn on an asset if you sold it at existing position, you’re a seller. the end of the tax year. You owe tax on Ask The price that market makers or Exercise If you’re an options holder, Short When you have written an that unrealized gain. This rule applies sellers will accept to sell an option. exercise means you give an order to option. You may hold a short position, to broad-based index options. act on an option, and the options writer or be short. Assignment When an options holder must transfer to you or receive from you Married put You simultaneously exercises the contract, an options writer Specialist A trader who leads the the shares of stock—or amount of purchase shares of stock and a put on is chosen to fulfill the obligation. auction for an options class or a set of cash—covered by the option. that stock. underlying securities, and maintains a At-the-money When the price of the Expiration date The date after which Naked call You write a call on stock fair and orderly market. underlying stock is the same as or close an option is no longer valid, and you can you don’t hold. to your option’s strike price. Spread An options strategy that calls for no longer exercise it. Open If you purchase or write an you to hold two or more simultaneous Black-Scholes formula A pricing model Fungible Able to be bought and sold on option, creating a new position on that positions. Spread may also refer to that calculates the theoretical value of multiple exchanges or markets. option, you establish an open position. the difference between an option’s an option, based on factors including bid-ask price. volatility and time until expiration. Good ‘til canceled order (GTC) An order Open interest The number of contracts you place to purchase or sell an option in existence in the market on a certain Stop-loss order An order you place Breakeven point The stock price at that is valid until it is filled, you cancel option. to purchase an option or security that which, if you exercise your option, you it, or your brokerage firm’s time limit on comes with an order to sell if the price would earn back your initial investment. Options chain A tool that lets you see GTC orders expires. drops below a certain limit in the future, all the available options for an underlying Buyer If you purchase an options or rises, if you’ve sold an option. Hedge An investment that’s intended stock, including their prices and other contract, regardless of whether you’re to limit or reduce potential losses on trading data. Strike price The price at which you opening or closing a position, you’re another investment by returning a profit may buy the underlying stock, if you a buyer. Options class All the calls or all the puts under the opposite conditions. hold a call, or sell the underlying stock, on an underlying security. Buy-write You simultaneously purchase if you hold a put. Holder If you purchase an option to shares of stock and write a call on Options series All the calls or puts open a position, you’re a holder. Terms The characteristics of your that stock. on an underlying stock with identical option, including strike price, exercise In-the-money When the strike price of terms, including expiration month and Bid The price that market makers or style, and expiration date. an option is below the market price for strike price. buyers will accept to buy an option. the underlying stock, in the case of a call, Time decay The decline in value of your Out-of-the-money When a call’s strike Call If you buy a call, you hold the right and above the underlying stock price, in option as the expiration date approaches. price is above the underlying stock price, to purchase a certain security at the strike the case of a put. or a put’s strike price is below the Time value The perceived and often- price, on or before the expiration date. If Intrinsic value The value of an option stock price. changing value of the time left until an you write a call, you face an obligation to if you exercised it at a given moment. option’s expiration. sell a certain security at the strike price, Physical delivery An option that calls Out-of-the-money and at-the-money on or before the expiration date, if the for you to deliver if you’re the writer, or Vertical spread You simultaneously options have no intrinsic value. For call is exercised. receive if you’re the holder, 100 shares purchase and write two or more options in-the-money options, the intrinsic of stock at exercise. with different strike prices and the same Cash-settled An option contract, value is the difference between the strike expiration month. usually an index option, that requires price and the underlying stock price. Premium The price you pay if you’re an cash to change hands at exercise. The options buyer, or the amount you receive VIX The Volatility Index, or a compila- Leg Each separate options position exact amount of cash is calculated by if you’re an options writer. tion of volatility of several S&P 500 in a strategy that calls for you to hold a specific formula, using the option’s options. You might use VIX as a multiple positions at the same time, Protective put You purchase a put on intrinsic value. benchmark for the market’s perception such as a spread. stock you already own. of volatility. Close If you buy or sell an option in Leverage If you leverage, you use a Put If you buy a put, you hold the order to offset a position you previously Volatility How much an option price small amount of money to control an right to sell a certain number of shares opened, you’re closing. fluctuates. Historical volatility is a investment of much larger value. at the strike price, on or before the measure of past actual fluctuations. Collar You simultaneously purchase a expiration date. If you write a put, Limit order An order you place to Implied volatility is a gauge of the protective put and write a covered call. you face an obligation to buy a certain purchase or sell a security or financial market’s prediction for its future Also known as a . number of shares at the strike price, instrument, such as an option, only at fluctuation. on or before the expiration date, if the Covered call You write a call on stock a certain price or better. put is exercised. Volume The number of positions that you hold. Also known as an overwrite. Long When you own a security or are traded, or opened and closed, during Put/call ratio A ratio of the number of Day order An order you place to option. You might have a long position, a time period for a specific option. puts traded compared to the number of purchase an option that is canceled if or be long. calls traded for a particular options class. Wasting asset A security that loses it is not filled before the end of the value over time, and has no worth after trading day. Long-term Equity AnticiPation Securities Rolling Extending your options strategy a certain date. (LEAPS®) An option whose expiration by closing an existing position and open- Equity option A contract to buy or sell date is between one and three years away. ing a new one on the same underlying Writer If you sell an option to open a shares of a stock, an exchange traded instrument with a different expiration new position, you’re a writer. fund (ETF), or other equity interest at Market order An order to purchase or or strike price. a certain price before a certain time. sell an option at its current market price. 58 59 INDEX INDEX

Collar...... 20-21, 36-37, 58 Newsletters...... 47 A Commissions and fees...... 6, 37 H New York Stock Exchange (NYSE)...... 8 Competitive market makers (CMMs)...... 10 19 Adjustment...... 15 Conservative investors...... 12 Hedging...... 12, , 25, 28-29, 40 Index 42 O Agreement form...... 17 Consistency...... 49 ...... -43 Spreads 32 Alpha...... 18 Contracts...... 5, 11, 15 ...... American Depository Receipts Historic volatility...... 18 Online resources. See Internet Physical delivery...... 6, 59 Open position...... 6, 59 (ADRs)...... 9 Covered call...... 26-27, 36-37, Holder...... 5, 6 Exit strategies Open interest...... 18, 53, 59 American Depository Shares 40-41, 58 ...... 38-39 Stockholder vs. Open outcry auctions...... 11 (ADSs)...... 9 Cox-Ross-Rubenstein model...... 49 ...... 15 5 58 Options basics...... 4-19 American-style option...... , 6, Credit, net...... 4-5 52-53 58 See also Equity options; Stock options; Ask...... , Credit collar...... 36-37 27 58 I Trading options Assignment...... , Credit spread...... 32 At-the-money...... 25, 58 Options calculator...... 45 Implied volatility...... 18, 53 Options chains (strings)...... 45, 52-53, 59 Automatic exercise...... 7 Income...... 35, 37, 40 Away-from-the-market price...... 10 D Options charts...... 50-51 Index options...... 6-7, 9, 18, 42-43 Options class...... 7, 59 Day order...... 45, 58 Indicators...... 51 Options order...... 44-45 55 B Debit, net...... 4, 34 Industry organizations...... 11, Options Clearing Corporation, The Debit spread...... 32, 37 Instrument...... 4 (OCC)...... 7, 11, 16-17, 46, 55 Bear call/put...... 34-35 Delta...... 19 Interest rates...... 19 Options series...... 7, 59 Bearish investor...... 12, 28 Designated primary market makers Internet Options Industry Council, The 32 Brokerage firms Bear spread...... (DPMs)...... 10 ...... 46 (OIC)...... 11, 16-17, 45-46, 51, 55 48 Information 46-45 55 Benchmarks...... -49 Discount brokerage firms...... 16 ...... 45, , 51, Options prices...... 59 Options chains Beta...... 18 Dividend...... 26-27 ...... 52-53 Out-of-the money...... 19, 25-26, 52-53 58 Trading Bid...... , Double hedge...... 32 ...... 44 33-37, 39, 42, 59 Black, Fischer...... 48 Dow Jones Utility Average...... 9 In-the-money...... 5-7, 18, 21, 27, Overleveraging...... 21 Black-Scholes model...... 48-49, 58 33-35, 38-39, 58 Overwrite...... 27 Breakeven point...... 51, 58 Intrinsic value...... 5, 14, 39, 58 Brokerage firms...... 7, 10-11, 16-17, E 26-27, 31, 33-34, L P 39, 44-47 Earning income...... 35, 37, 40 Employee stock options...... 8 Physical delivery...... 6, 59 Commissions and fees...... 6, 37 Last price...... 50 Tools...... 44-45, 47 Equity options...... 4-19, 58 Premium...... 4-5, 14-15, 17-19, Lead market makers (LMMs)...... 10 25-26, 28, 31, 33, 37-38, 59 Bull call/put...... 34-35 See also Stock options; Trading options ® European-style options...... 5-6, 58 LEAPS ...... 7, 24, 50, 58 Prices...... 5, 31, 48, 50 Bullish investors...... 12, 25, 30 58 Exchange-traded funds (ETFs)...... 4, 9 Leg...... 32, 34, 37, Away-from-the-market...... 10 Bull spread...... 32 19 43 58 Exercised option...... 4, 6-7, 9, 25, 27, 58 Leverage...... , 24, , Bid and ask...... 52-53, 58 Buy backs...... 38 45 58 Exiting...... 27, 34, 37, 38-39, 40 Limit order...... , Employee stock options...... 8 Buying/selling...... 4 18 Expiration date...... 4, 6-7, 18, 31, Liquidity...... Exercise...... 6, 27 See also Trading options Long...... 6, 15 Buy-write...... 27, 58 38, 42, 58 Greeks...... 18-19 Collar legs...... 37 Long calls...... 13, 24-25, 51 Index...... 9, 42-43 Cycles...... 56 Long puts...... 28-29, 40 Movement...... 15, 18-19, 22 C Long-Term Equity AnticiPation See also Stock price; Strike price Exit strategies...... 39 ® Options premium...... 17 Securities ...... 7, 24, 50 Primary market makers (PMMs)...... 10 26 29 30 Calculating return...... , , Rolling options...... 40 Long-term investors...... 13 Principal...... 14 44 Calculator, options...... Spread management...... 33 Probability...... 23 32 Calendar spread...... Theta measure...... 19 Profit and loss...... 12, 19, 26, 31, 4 M Calls...... -5, 7-8, 12-14, 16, Time decay...... 15, 19 33-35, 36, 38-39, 41 20-21, 23-27, 33, Margin account...... 17, 25-29, 33 Charts...... 51 40-41, 58 Index options...... 43 Protective put...... 28, 36, 59 Bear and Bull...... 34-35 F Margin call...... 17 Put...... 4-5, 13, 20-21, Buying...... 20-21, 24-25, 27 Market order...... 45, 58 23, 28-31, 33, 40, 59 Exiting...... 38-39 Fees. See Commissions and fees Fence...... 36 Market price...... 50 Bear and Bull...... 34-35 Index...... 42-43 59 Financial product...... 4 Mark to market...... Buying...... 28-29 Margin...... 17 Married put...... 28, 59 Cash-secured...... 31 Movement...... 36 FINRA...... 55 Foreign currencies...... 9 Medium-term call option...... 24 Exit strategy...... 38-39 Put ratio...... 49, 59 Merton, Robert...... 48 Index...... 42-43 Writing...... 26-27 Fundamental analyst...... 22 Fungible...... 6, 11 Mistakes, common...... 21 Movement...... 36 Cash management...... 23 Writing...... 30-31 Cash margin requirement...... 27 Put/call ratio...... 49, 59 Cash-secured put...... 31 G N Cash-settled option...... 6, 9 26 59 CBOE Volatility Index...... 48 Gamma...... 19 Naked calls...... , Q Charts and tables...... 50-51 Generalists...... 10 National Market System...... 8 4-5 Clearing...... 11 Go long/go short...... 15 Net credit...... Quadruple witching day...... 7 4 Close position...... 6, 58 Good ‘til canceled order (GTC)...... 45, 58 Net debit...... , 34 Quarterly earnings report...... 22 Closing out. See Exiting Greeks, the...... 18-19, 44, 52 Net price paid...... 31

60 61 INDEX

Strangle...... 33 R Strategies...... 20-43, 56-57 Exit...... 38-39 Range of return...... 37 Overview...... 20-21 Regulated exchanges...... 11 Rolling...... 40-42 Research and information...... 21-22, Screener...... 56 41, 44-59 Spread...... 32-37 Application...... 48-53 Strike price...... 4, 7, 12, 24, 27, 32-33, Sources...... 23, 46-47, 55 37, 40-41, 54, 59 Return rate...... 13, 37 Symbols...... 52, 54 Calculation...... 26, 29-30 Greeks...... 18-19, 44, 52 Rho...... 19 Symbology...... 54 Risk capital...... 23 Risk management...... 12, 24 Risks...... 14-15, 17, 20 T Acceptance of...... 23 Index options...... 43 Technical analysis...... 22 Naked calls...... 26 Theta...... 19 Selling short...... 28 Ticker symbol...... 52 Spread strategies against...... 32, 36 Time decay...... 15, 19, 36, 59 Writing puts...... 30-31 Time value...... 5, 14, 17, 59 Risk tolerance...... 57 Timing...... 24, 38, 39 Rolling...... 27, 40-41 Trading options...... 4-19, 44-57 Down...... 41 Covered calls...... 26-27 Out...... 27, 41-42 Execution of trade...... 44-45 Up...... 40 Exit strategies...... 38-39 Fees and commissions...... 6, 37 Getting started...... 16-17 S Information sources...... 23, 46-47, 55 Key terms...... 18-19 S&P 480 Index...... 9 Mistakes...... 21 Scholes, Myron...... 48 Options order...... 44-45 Securities. See Shareholders; Stock options Risks...... 14-15, 17, 20 Securities and Exchange Commission Spreads...... 20-21, 32-37, 59 (SEC)...... 8, 11, 55 Taxes...... 38 Seller...... 4, 6, 13, 59 Selling short...... 28 Shareholders...... 15 U-V Put buying...... 28 Spreads...... 32-37 Uncovered calls...... 17, 26 See also Stock options Value...... 5, 39, 58 Shorting stock...... 28 Benchmarks...... 48-49 Short position...... 6, 15, 59 Call vs. put movement...... 36 Short-term call options...... 24, 26, 33 Covered call writing...... 27 Specialist...... 10, 59 Factors...... 14 ...... 13, 28 Vega...... 19 Spread...... 20-21, 32-37, 59 Vertical spread...... 32, 34-35, 59 Stock exchanges...... 10-11, 55 VIX (Volatility Index)...... 48, 59 Stock index...... 7, 9, 18, 42-43 Volatility...... 18-19, 23, 48 Stock options...... 8-9, 32-35 Volume...... 18, 50, 53, 59 Covered call...... 26-27 Equity vs. employee...... 8 W Expiration date...... 7 Holder vs. shareholder...... 15 Wasting asset...... 15, 59 Investment objectives...... 16-17 Websites...... 45-47, 51, 55 Selection criteria...... 22-23, 25 Whaley model...... 49 Spreads...... 32-35 Writer...... 5-7, 14-16, 17 See also Shareholders Call...... 20-21, 26-27, Stock price...... 18, 25, 36, 41, 50 36, 40-41 Exercised option...... 27 Closing out...... 38-39 Exit strategies...... 38-39 Exit strategies...... 38-39 Expiration options...... 37 Index options...... 42 Short selling...... 28 Put...... 20-21, 30-31 Stop-loss order...... 45, 59 Return calculation...... 26 Straddle...... 32

62 A GUIDE TO INVESTING WITH OPTIONS covers everything from calls and puts to collars and rolling up, over, or out. It takes the mystery out of options contracts, explains the language of options trading, and lays out some popular options strategies that may suit various portfolios and market forecasts. If you’re curious about options, this guide provides the answers to your questions.

INVESTING STRATEGIES INVESTING STRATEGIES before expiration, the loss you’d face if MAKE A COMMITMENT the option were exercised and assigned Once you’ve decided on an appropriate to you is unacceptable. But if it moves options strategy, it’s important to stay only 10% in-the-money, you’d be focused. That might seem obvious, confident that there remains enough Introduction to but the fast pace of the options market chance of it moving out-of-the-money and the complicated nature of certain to make it worth the potential loss. Options Strategies transactions make it difficult for some inexperienced investors to stick to their A WORD TO THE WISE Planning, commitment, and research will prepare you plan. If it seems that the market or under- By learning some of the most common for investing in options. lying security isn’t moving in the direction mistakes that options investors make, you predicted, it’s possible that you’ll you’ll have a better chance of avoiding AN OVERVIEW OF STRATEGIES minimize your losses by exiting early. But them. Before you buy or sell options you need It’s helpful to have an overview of it’s also possible that you’ll miss out on a Overleveraging. One of the benefits a strategy, and before you choose an the implications of various options future beneficial change in direction. options strategy, you need to understand strategies. Once you understand the That’s why many experts recommend of options is the potential they offer for leverage. By investing a small amount, how you want options to work in your basics, you’ll be ready to learn more that you designate an exit strategy or you can earn a significant percent- portfolio. A particular strategy is suc- about how each strategy can work for cut-off point ahead of time, and hold age return. It’s very cessful only if it performs in a way that you—and what the potential risks are. firm. For example, if you plan to sell a important, however, helps you meet your investment goals. covered call, you might decide that if to remember that If you hope to increase the income you the option moves 20% in-the-money leverage has a potential receive from your stocks, for example, you’ll choose a different strategy from an downside too: A small investor who wants to lock in a purchase decline in value can price for a stock she’d like to own. mean a large percentage loss. ? Investors who aren’t aware of the One of the benefits of options is the flexibility they offer—they can risks of leverage are in danger of over- POTENTIAL complement portfolios in POTENTIAL leveraging, and might face bigger losses YOUR MARKET RETURN many different ways. So POSSIBLE RISK than they expected. it’s worth taking the time FORECAST Theoretically Another mistake OBJECTIVE Limited to the Lack of understanding. to identify a goal that suits unlimited Bullish premium paid some options traders make is not fully you and your financial plan. CALL Profit from increase in price understanding what they’ve agreed to. Once you’ve chosen a goal, BUYING An option is a contract, you’ll have narrowed the of the underlying security, or and its terms must be range of strategies to use. As met upon exercise. with any type of investment, lock in a good purchase price Limited to the It’s important to only some of the strategies Unlimited for understand that if you Neutral to premium received will be appropriate for Profit from the naked call write a covered call, for CALL bearish, your objective. premium received, writing, limited example, there is a very WRITING though or lower net cost for covered real chance that your covered call SIMPLE AND of purchasing call writing stock will be called away from writing may NOT-SO-SIMPLE a stock you. It’s also important to understand Some options strategies, such be bullish Substantial, as Limited to the how an option is likely to behave as as writing covered calls, are the stock price Bearish premium paid expiration nears, and to understand that relatively simple to under- PUT Profit from approaches zero once an option expires, it has no value. decrease in price • Puts and Calls stand and execute. There are BUYING A serious mistake more complicated strategies, of the underlying Not doing research. however, such as spreads security, or that some options investors make is not and collars, that require two protect against researching the underlying instrument. opening transactions. These losses on stock Options are deriva- Limited to the strategies are often used to already held Substantial, as tives, and their value further limit the risk associ- Neutral to premium received depends on the price Profit from the stock price ated with options, but they PUT bullish, though behavior of another the premium approaches zero may also limit potential WRITING cash-secured financial product—a received, or stock, in the case of return. When you limit risk, puts may • Equity Options lower net be bearish equity options. You there is usually a trade-off. Limited Simple options strategies purchase price Limited have to research avail- Bullish or are usually the way to begin Profit from the able options data, and be confident in SPREADS bearish, investing with options. By difference in your reasons for thinking that a particu- depending on mastering simple strategies, values of the lar stock will move in a certain direction the particular you’ll prepare yourself for options written before a certain date. You should also be spread advanced options trading. Limited alert to any pending corporate actions and purchased Limited In general, the more compli- Neutral or such as splits and mergers. Protect unrealized cated options strategies COLLARS bullish 21 are appropriate only for profits experienced investors. 20 • Index Options • ETF Options

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