The Complete Guide to Option Strategies

Advanced and Basic Strategies on Stocks, ETFs, Indexes, and Stock Index Futures

Michael Mullaney

• Publisher: Wiley
• Year: 2009
• ISBN:
  9780470471296
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Important insights into effective option strategies In The Complete Guide to Option Strategies, top-performing commodity trading advisor Michael Mullaney explains how to successfully employ a variety of option strategies, from the most risky--selling naked puts and calls--to more conservative strategies using covered positions. The author covers everything from options on stocks, exchange-traded funds, stock indexes, and stock index futures to essential information on risk management, option "Greeks, " and order placement. The book provides numerous tables and graphs to benefit beginning and experienced traders. Written by a CTA who has successfully employed various options strategies to generate market-beating returns, The Complete Guide to Option Strategies will be an important addition to any trader's library. Michael D. Mullaney (Jacksonville, FL) is a high-ranking commodity trading advisor who specializes in option selling strategies.

PART ONE

Learning the Fundamentals

Part One provides the fundamentals necessary to build a solid foundation before you begin trading options. It includes how to get ready to trade, the all-important basics of options, factors that affect an option’s price, the Greeks, the advantages and disadvantages of buying versus selling options, spread terminology, and more. After learning the fundamentals, you should be ready to move on to other parts of this book and learn the four basic option strategies, advanced spread strategies, how to apply what you have learned to different underlying instruments, and advanced concepts.

CHAPTER 1

Getting Ready to Trade

The good news is that there are many different ways to make money by trading options. You may be attracted to buying call or put options because you want large gains for a relatively small price, or you may be attracted to selling options because you want consistent returns and the odds on your side. Option buying and selling is sometimes described in a manner that makes you think option trading is simple. The reality is that making money in the financial markets on a consistent basis over a long period of time is not easy. However, it can be accomplished with proper preparation. Probably the best way to maximize your chances of success in the financial markets is to become as knowledgeable as possible so you can make educated decisions.

To get the most out of this book, you should read the Preface to understand how the book is organized. This chapter will cover the reasons why you should trade options, the importance of developing a game plan, risk management, option basics, and key definitions.

WHY TRADE OPTIONS?

Options can be used to manage risk, generate income, take advantage of leverage, and potentially profit under almost any market condition. Options can enable you to speculate on whether a stock, exchange-traded fund (ETF), stock index, or futures will rise, decline, or move sideways within your selected time frame. With options, you can engage in a high- or low-probability trade or a trade with limited or unlimited risk. With options, you have the ability to take advantage of a price decline in a stock (or other instrument) just as easily as a price increase, and even potentially profit from sideways movement. The versatility of options, in combination with leverage, is what distinguishes options from other trading vehicles.

With options, you can generate income from the up, down, and sideways movements of a stock, ETF, index, or futures. The key is to first determine your view of a stock (or market) and time frame and then determine the option strategy that can meet that perspective.

Sometimes the markets go through periods in a trading range that can last for weeks, months, or years. In these periods of consolidation, markets seem to fluctuate sideways and back and forth. Traditional stock and mutual-fund investing is typically not profitable in such an environment and can cost you the opportunity of earning interest on the money (or investing elsewhere) while you are waiting for the markets to move higher. Using options, you can speculate that a stock (or futures) will be stuck in neutral and you can design option strategies to profit from the lack of movement. For example, the S&P 500 index reached the 1,500 level in 2000, declined to below 800, and did not reach 1,500 again until 2007, only to substantially decline again. Even worse, the NASDAQ Composite reached the 5,000 level in 2000, plunged all the way down to nearly the 1,000 level, and has had great difficulty getting back to its old highs. The emerging markets have produced outstanding returns in some years, but they are inconsistent, and there are significant risks involved.

To understand options, you need to think a little outside the box because an option is unlike other investments. Trading options can be a way to diversify your income in a manner that is uncorrelated to other investments. Option strategies come in all shapes and sizes. Option strategies can be used to generate income, manage risk, speculate, and hedge in rising, declining, and sideways markets. Buying an option can be an attractive strategy because you can have limited risk with high profit potential, whereas selling (writing) an option can be attractive because you may have the odds on your side. Many traders are familiar with buying, in which the object is to buy low and sell high. Option selling works contrary to how trading is viewed by many people. The goal of option selling is the same as that of traditional trading but in reverse order: When selling an option, the goal is to sell high and buy low. If you are a novice trader, at first you may be confused about what it means to write (sell) an option because it involves selling first and buying later. Because markets can trend sideways for many years, selling options can provide a unique tool to potentially profit in sideways markets. The fact that option selling can work is demonstrated by the large number of institutional investors and professionals who sell options to enhance returns.

DEVELOPING A GAME PLAN

You may be under the impression that buying an option is the best strategy because you have a defined risk and can quickly make a lot of money; or you may have heard that selling an option is best because you have the odds on your side. So which is it? The answer is that sometimes buying an option is best and, at other times, selling is best, depending on what you are trying to accomplish and your views of the underlying stock and market.

Many option traders may be attracted to buying options because they are familiar with buying stocks (or other assets, such as a home), and they are attracted to limited risk and the possibility of large profits. Buying a call can be a good place to start when learning how to trade options. However, remember that consistent profits are possible by selling options, without having to pick the home run along the way. One advantage of selling an option is that close is sometimes good enough—in comparison to buying, where you need to be more precise in timing and direction. Ideally, you should develop strategies for both buying and selling options.

Selecting the best underlying instrument is one of the most important trading decisions you will make. In general, I have found that a broad-based index, such as the S&P 500 index, can be a good candidate for option selling: An option sale is a bet against volatility, and an index is typically less volatile than an individual stock. On the other hand, I find that stocks can be a good candidate for buying options because stocks can be very volatile.

Treat Option Trading Like a Business

If you were running a business, you would put together a business plan that encompasses trading strategies and details of how to operate the business and control expenses. The same perspective and focus should be developed when trading options. Developing a plan and working hard are essential to your success. Remember that the definition of luck is “preparation meets opportunity.” The more knowledge you have, the greater your chances of success.

You cannot always play the offensive if you want to win. Playing the defense is important if you want to trade successfully over the long run. As a result, before trading options, you should have an understanding of risks. You should have a thorough understanding of risk management strategies, have access to specialized option software and trading platforms (free or low-cost software are accessible), learn strategies that maximize your probabilities of success and can limit losses, and appreciate the importance of education. You should keep expenses low; maximum interest income credited to your account; and open accounts to trade options on stocks, ETFs, indexes, and futures. You should try to utilize their strengths when trading options. It is important to protect your investment capital. Manage risk by observing the following tips:

• If selling options, establish positions with probabilities of success of at least 75 percent.

• Trade limited-risk strategies.

• Have an exit strategy with defined profit and loss objectives.

• Have the courage to exit a position at a loss to protect capital.

• Use stop losses to automatically exit positions.

• Do not overtrade or feel compelled to be in the market at all times.

• Use technical analysis to time when and where to establish positions.

• Trade liquid options.

• Control expenses.

• Keep your losses small.

• Have a plan.

• Do not get greedy.

Create a Plan

Before engaging in any option transaction, you should determine your maximum profit, maximum loss, break-even point, and probabilities of success. You should develop a clear view of the direction, timing, and magnitude of the underlying stock and have strategies readily available to place yourself in a position to maximize your return and limit your losses. Unfortunately, some option positions are doomed from the start because they are poor trades from a risk-reward perspective and have little chance of success.

Before you get started, you should open brokerage accounts to take advantage of margin, and you should understand how option trading can be affected, depending on whether an account is a taxable account versus an individual retirement account (IRA) or a futures account. You should also understand how to maximize interest income and minimize commissions and taxes. You should practice option strategies using a practice (simulated) account until you become proficient at what you plan to trade.

Discipline and decisiveness are factors critical to your success, and you should not allow your emotions to control your investment decisions. To trade successfully, it is important that you develop guidelines on when to buy and when to sell. Buying and selling options, like other investments, can be an emotional roller coaster, if you let it become one. You should trade when you are levelheaded and calm, using a systematic approach determined beforehand.

Establish Goals

Which option strategies are best for you depends in part on the amount of your capital; your risk tolerance; and your confidence in determining the direction, timing, and magnitude of various moves in the marketplace. For example, if you are confident in your ability to predict direction, timing, and magnitude, then you may want to buy a call or put, depending on the direction. If you are uncomfortable with being so precise, you may want to sell options.

An option can, in some cases, be sold for what can appear to be a small premium, but when returns are calculated on an annualized basis, the returns can be outstanding. The object is to repeat the selling cycle monthly or quarterly to enhance returns throughout the year. Because you have the short-term odds on your side, you may be tempted to generate large profits by selling a large number of options; however, you should resist the urge because it usually means excessive risk. Remember the Wall Street adage: Bulls make money, bears make money, and pigs get slaughtered.

Ideally, you should exit a position with predetermined profit or loss objectives; for instance, if you buy an option, a rule of thumb may be to exit a position if a loss reaches 50 percent of the amount paid to establish a trade. If you sell an option, a guideline may be to close out a position if you have a profit of 70 percent of the maximum possible profit in a position.

One of the main risks that many option buyers and sellers encounter is that they trade too many contracts: thus, when things go wrong, the leverage of options works against them. If, in addition, they engage in low-probability trades, they are setting the stage for financial failure. Overtrading and establishing excessive positions should be avoided. Risk increases where too many options are bought (or sold), as leverage cuts both ways. In the world of options, each option you add affects the mathematical probabilities of the others you already own or have sold to establish a position.

Develop an Edge

The average investor finds it difficult to compete with big mutual funds that spend millions of dollars on research. However, the small investor can have an edge over big funds because he can enter and exit the market as opportunities develop and not be hindered by requirements to be invested at all times. Confidence and discipline are key components of developing your edge, and it is important to remember that always following the crowd can be hazardous to your wealth.

Protect Capital

It is important to protect your investment capital. A popular risk and money management strategy is to let profits run and keep losses small. You simply cannot let your losses run too high. As the old saying goes: An ounce of prevention is worth a pound of cure. If you lose a certain level of capital, it becomes more difficult to ever get back to where you ...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Preface
• Acknowledgements
• PART ONE - Learning the Fundamentals
• PART TWO - The Four Basic Option Strategies
• PART THREE - Spread Strategies
• PART FOUR - Comparing Underlying Instruments
• PART FIVE - Advanced Topics
• APPENDIX A - Strategies at a Glance—ETFs
• APPENDIX B - Strategies at a Glance—Indexes
• APPENDIX C - Strategies at a Glance—Stock Index Futures
• Glossary
• About the Author
• Index
• Wiley End User License Agreement