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• Puts and Calls• Equity Options• IndexOptions• Strategies• LEAPS ®• Time DecayVIRGINIA B. MORRIS©2013 by Lightbulb Press, Inc. All Rights Reserved.

The Options Industry Council (OIC) is pleased to introduceAn Investor’s Guide to Trading Options, a primer on options investing.The guide clarifies options basics, explains the options marketplace,and describes a range of strategies for trading options.An Investor’s Guide helps fulfill OIC’s ongoing mission to educatethe investing public and the brokers who serve them about the benefitsand risks of exchange listed options. We believe that education is thekey to sound and intelligent options investing, and that the tremendousgrowth of the options market in recent years can be attributed, at leastin part, to the value of this education.Formed in 1992 by the nation’s options exchanges and The OptionsClearing Corporation, OIC is your options education resource.We are always available to answer your questions and to expandyour options knowledge. To contact OIC, please visit our websiteat www.OptionsEducation.org or phone Investor Services at1-888-OPTIONS.The Options Industry Council©2013 by Lightbulb Press, Inc. All Rights Reserved.

The information in this guide is provided for educational purposes. Neither The OptionsIndustry Council (OIC) nor Lightbulb Press is an investment adviser and none of theinformation herein should be interpreted as advice.For purposes of illustration, commission and transaction costs, tax considerations, andthe costs involved in margin accounts have been omitted from the examples in this book.These factors will affect a strategy’s potential outcome, so always check with your brokerand/or tax adviser before engaging in options transactions.The prices used in calculating the examples used throughout this guide are for illustrativepurposes and are not intended to represent official exchange quotes.The options strategies described in this book are possibilities, not recommendations. Nostrategy is a guaranteed success, and you are responsible for doing adequate research andmaking your own investment choices. Please note: All equity options examples represent astandard contract size of 100 shares.Options are not suitable for all investors. Individuals should not enter into option transactionsuntil they have read and understood the risk disclosure document Characteristics and Risks ofStandardized Options. Copies of this document may be obtained from your broker, from anyexchange on which options are traded, or by contacting The Options Clearing Corporation, OneNorth Wacker Dr., Suite 500 Chicago, IL 60606 (888-678-4667). It must be noted that, despite theefforts of each exchange to provide liquid markets, under certain conditions it may be difficultor impossible to liquidate an option position. Please refer to the disclosure document for furtherdiscussion on this matter.Lightbulb PressProject TeamDesign Director Kara W. WilsonEditor Mavis WrightProduction and Illustration Thomas F. TrojanSPECIAL THANKS TOBess Newman, Gary KreissmanARTWORK CREDITSThe image on page 30 ©2003 Lightbulb Press and its licensors. All rights reserved.©2004, 2005, 2009, 2011, 2013 by Lightbulb Press, Inc. all rights reserved.www.lightbulbpress.comTel. 212-485-8800ISBN: 978-0-974038-62-9No 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, exceptfor brief quotes used in a review. While great care was taken in the preparation of this book, the authorand publisher disclaim any legal responsibility for any errors or omissions, and they disclaim any liabilityfor losses or damages incurred through the use of the information in the book. This publication is designedto provide accurate and authoritative information in regard to the subject matter covered. It is sold withthe 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 isrequired, the services of a competent professional person should be sought.©2013 by Lightbulb Press, Inc. All Rights Reserved.

the basicsWhat Is an Option?An option is a contract to buy or sell aspecific financial product officially knownas the option’s underlying instrument orunderlying interest. For equity options,the underlying instrument is a stock,exchange-traded fund (ETF), or similarproduct. The contract itself is very precise.It establishes a specific price, called thestrike price, at which the contract maybe exercised, or acted on. And it hasan expiration date. When an optionexpires, it no longer has value and nolonger exists.Options come in two varieties, callsand puts, and you can buy or sell eithertype. You make those choices—whether tobuy or sell and whether to choose a call ora put—based on what you want to achieveas an options investor.Types of OptionsContractsCallsBuying and sellingIf you buy a call, you have the right to buythe underlying instrument at the strikeprice on or before the expiration date. Ifyou buy a put, you have the right to sellthe underlying instrument on or beforeexpiration. In either case, as the optionholder, you also have the right to sell theoption to another buyer during its term orto let it expire worthless.The situation is different if you write,or sell, an option, since selling obligatesyou to fulfill your side of the contract ifthe holder wishes to exercise. If you sell acall, you’re obligated to sell the underlyinginterest at the strike price, if you’reassigned. If you sell a put, you’re obligatedto buy the underlying interest, if assigned.As a writer, you have no control overwhether or not a contract is exercised,and you need to recognize that exerciseis always possible at any time until theexpiration date. But just as the buyer cansell an option back into the market ratherthan exercising it, as a writer you canpurchase an offsettingcontractand end yourobligation tomeet the termsof the contract.At a premiumWhen you buy an option, the purchaseprice is called the premium. If you sell,the premium is the amount you receive.The premium isn’t fixed and changesconstantly—so the premium you paytoday is likely to be higher or lower thanthe premium yesterday or tomorrow.What those changing prices reflect isthe give and take between what buyersare willing to pay and what sellers arewilling to accept for the option. The pointat which there’s agreement becomes theprice for that transaction, and then theprocess begins again.If you buy options, you start out withwhat’s known as a net debit. That meansyou’ve spent money you might neverrecover if you don’t sell your option at aprofit or exercise it. And if you do makemoney on a transaction, you must subtractthe cost of the premium from any incomeyou realize to find your net profit.As a seller, on the other hand, youbegin with a net credit because you col-What’s a financial product?The word product is more likely to conjure up images ofvegetables or running shoes than stocks or stock indexes.Similarly, instrument might suggest a trombone or ascalpel rather than a debt security or a currency. But bothterms are used to refer to the broad range ofinvestment vehicles.5©2013 by Lightbulb Press, Inc. All Rights Reserved.

An options contractgives the buyer rights andcommits the seller toan obligation.Putsthe basicsHOLDERWRITERRule ofThumbFor options expiring inthe same month, themore in-the-money anoption is, the higherits premium.lect the premium. If the option is neverexercised, you keep the money. If theoption is exercised, you still get to keepthe premium, but are obligated to buy orsell the underlying stock if you’re assigned.The value of optionsWhat a particular options contract isworth to a buyer or seller is measured byhow likely it is to meet their expectations.In the language of options, that’s determinedby whether or not the optionis, or is likely to be, in-the-money orout-of-the-money at expiration. A calloption is in-the-money if the currentmarket value of the underlying stock isabove the exercise price of the option,and out-of-the-money if the stock isbelow the exercise price. A put option isin-the-money if the current market valueof the underlying stock is below theexercise price and out-of-the-money if itis above it. If an option is not in-the-moneyat expiration, the option is assumed tobe worthless.An option’s premium has two parts: anintrinsic value and a time value. Intrinsicvalue is the amount by which the option isin-the-money. Time value is the differencebetween whatever the intrinsic value isand what the premium is. The longer theamount of time for market conditions towork to your benefit, the greater thetime value.©2013 by Lightbulb Press, Inc. All Rights Reserved.Finding valuesShare market price– Exercise price= Intrinsic valuePremium– Intrinsic value= Time valueFor example$25– $20= $ 5$ 6– $ 5= $ 1Options pricesSeveral factors, including supply anddemand in the market where the optionis traded, affect the price of an option, asis the case with an individual stock. What’shappening in the overall investment marketsand the economy at large are two ofthe broad influences. The identity of theunderlying instrument, how it traditionallybehaves, and what it is doing at themoment are more specific ones. Itsvolatility is also an important factor, asinvestors attempt to gauge how likely itis that an option will move in-the-money.Old and newAmerican-style options can beexercised any time up until expirationwhile European-style options can beexercised only at the expiration date.Both styles are traded on US exchanges.All equity options are American style.6

the basicsHow Does OptionsTrading Work?You should know whetheryou’re opening or closing, buyingor purchasing, writing or selling.Options trading can seem complicated, in part becauseit relies on a certain terminology and system ofstandardization. But there’s an established processthat works smoothly anytime a trade is initiated.BUYERSELLEROPEN AND CLOSEWhen you buy or write a new contract, you’reestablishing an open position. That means thatyou’ve created one side of a contract and will bematched anonymously with a buyer or seller on theother side of the transaction. If you already hold anoption or have written one, but want to get out ofthe contract, you can close your position, whichmeans either selling the same option you bought,or buying the same option contract you sold.There are some other options termsto know:• An options buyer purchases a contractto open or close a position• An options holder buys a contract toopen a long positionSTANDARDIZED TERMSEvery option contract is defined bycertain terms, or characteristics. Mostlisted options’ terms are standardized,so that options that are listed on oneor more exchanges are fungible, orinterchangeable. The standardizedterms include:Contract size: For equityoptions, the amount ofunderlying interest isgenerally set at 100 shares of stock.Expiration month: Everyoption has a predeterminedexpiration and lasttrading date.Exercise price: This is theprice per share at which 100shares of the underlying securitycan be bought or sold at the timeof exercise.Type of delivery: Most equityoptions are physical deliverycontracts, which means thatshares of stock must changehands at the time of exercise.Most index options are cash7©2013 by Lightbulb Press, Inc. All Rights Reserved.• An options seller sells a contract toopen or to close a position• An options writer sells a contractto open a short positionAll options transactions, whetheropening or closing, must go through abrokerage firm, so you’ll incur transactionfees and commissions. It’s important toaccount for the impact of these chargeswhen calculating the potential profit orloss of an options strategy.settled, which means thein-the-money holder receivesa certain amount of cashupon exercise.Style: Options that can be exercisedat any point before expiration areAmerican style. Options thatcan be exercised only onthe day of expiration areEuropean style.Contract adjustments: Inresponse to a stock split,merger, or other corporateaction, an adjustment

the basicsLEAPS ®Long-term Equity AnticiPationSecurities SM , or LEAPS, are an importantpart of the options market. Standardoptions have expiration dates up toone year away. LEAPS, however, havelonger expiration dates, which may be upto three years away. LEAPS are traded justlike regular options, and each exchangedecides the securities on which to listLEAPS, depending on the amount ofmarket interest. About 17% of all listedoptions are LEAPS.LEAPS allow investors more flexibility,since there is much more time for theoption to move in-the-money. At any giventime, you can buy LEAPS that expire inthe January that is two years away or theJanuary that is three years away.EXERCISE AND ASSIGNMENTMost options that expire in a given monthusually expire on the Saturday after thethird Friday of the month. That means thelast day to trade expiring equity optionsis the third Friday of the month. If youplan on exercising your options, be sureto check with your brokerage firm aboutits cut-off times. Firms may establish earlydeadlines to allow themselves enough timeto process exercise orders.When you notify your brokerage firmthat you’d like to exercise your option:panel makes contract adjustments on acase-by-case basis. The panel consists oftwo representatives from each exchangeon which the affected contracts trade andone representative of OCC.An options class refers to all thecalls or all the puts on a given underlyingsecurity. Within a class of options,contracts share some of the same terms,such as contract size and exercise style.An options series is all contracts thathave identical terms, including expirationOptions ClassQUADRUPLEWITCHING DAYIn the last month of eachquarter—on the third Fridayof March, June, September, andDecember—the markets typicallyexperience high trading volume due to thesimultaneous expiration of stock options,stock index options, stock index futures,and single stock futures. This day is knownas quadruple witching day—upone witch since the introduction of singlestock futures.Your brokerage firm ensures the1exercise notice is sent to The OptionsClearing Corporation (OCC), the guarantorof all listed options contracts.OCC assigns fulfillment of your2contract to one of its member firmsthat has a writer of the series of optionyou hold.If the brokerage firm has more3than one eligible writer, the firmallocates the assignment using anexchange-approved method.The writer who is assigned must4deliver or receive shares of theunderlying instrument—or cash, if it isa cash-settled option.exercising optionsOCC employs administrative procedures thatprovide for the exercise of certain optionsthat are in-the-money by specified amountsat expiration on behalf of the holder of theoptions unless OCC is instructed otherwise.Individual brokerage firms often have theirown policies, too, and might automaticallysubmit exercise instructions to OCC for anyoptions that are in-the-money by a certainamount. You should check with your brokeragefirm to learn whether these proceduresapply to any of your long positions. Thisprocess is also referred to as “exerciseby exception.”month and strike price. For example, allXYZ calls are part of the same class, whileall XYZ February 90 calls are part of thesame series.Options Series©2013 by Lightbulb Press, Inc. All Rights Reserved.

On Which SecuritiesAre Options Offered?You can buy or sell options on stocks, indexes,and an orchestra’s worth of other instruments.In 1973, the first year that options were listed, investors couldwrite or purchase calls on 16 different stocks. Puts weren’tavailable until 1977. Today the field of option choices haswidened considerably—in 2012, investors could buy orwrite calls and puts on over 3,900different stocks and stock indexes.The most common options, and theones that individual investors are mostlikely to trade, are those on specificequities, typically the stocks of large,widely held companies. It’s generallyquite easy to find current informationabout those companies, makingit possible for investors to makeinformed decisions about how theprice of the underlying stock is likely toperform over a period of months—somethingthat’s essential to options investing.These options may also be multiply listed,or traded on more than one exchange.TO LIST OR NOT TO LISTOptions aren’t listed on every stock, andeach exchange doesn’t list every availableoption. The Securities and ExchangeCommission (SEC) regulates thestandards for the options selectionprocess, and beyond that, exchangescan make independent decisions. Thereare some rules, though.On every options exchange, a stockon which options are offered must:• Be listed and traded on theNational Market System for at leastthree months• Have a specified minimum number ofshareholders and shares outstanding• Have a specified minimum averagetrading price during an establishedperiod of timethe basicsADRSingleEquityIn addition to thoseminimum qualifications,stocks are chosen basedon the stock’s volatilityand volume of trading,the company’s historyand management, andperceived demand foroptions. This subjectivecomponent to thedecision-makingprocess explainsin part why someexchanges may chooseto list an option whileothers do not.In general, optionsare available on themost well-known,publicly traded companies, since those arethe stocks that are most likely to interestoptions investors. Although companies arenot responsible for options being listedon their stocks, most companies welcomeIt’s important to understand the differencebetween equity options and employee stockoptions.* Unlike listed options, which are standardizedcontracts, employee stock options areindividual arrangements between an employerand an employee. Usually, stockoptions grant the employeethe right to purchase thatcompany’s shares at apredetermined price after a certain date.Employee stock options cannot be traded onthe secondary market. Employers usually grantstock options as part of compensation packages,hoping to provide an incentive foremployees to work hard, sincethey’ll share in any companysuccess that is expressed ina higher stock price.*This guide does not cover features of employee stock option programs.©2013 by Lightbulb Press, Inc. All Rights Reserved.

ForeignCurrencythe basicsINDEXING THE MARKETIndex options, which were introducedin 1983, are also popular with individualinvestors. The underlying instrument is anindex instead of a single equity. Becausethey track the prices of many componentstocks, equity indexes can reveal a movementtrend for broad or narrow sectorsof the stock market. The S&P 500 indextracks 500 large-cap US stocks, for example,while the Dow Jones Utility Average,an index of 15 utility companies, is usedto gauge the strength or weakness inthat industry.Unlike options on stock, index optionsare cash settled, which means that uponexercise, the writer is obligated to givethe holder a certain amount of cash. Thetotal settlement is usually $100 times theamount the option is in-the-money.A 90 call on theDJIA at 9300DJX is 933x $ 100You receive $300Stock Indexthe listing of options, since historically astock’s trading volume tends to rise after anew options class is issued on that stock.For example, if you exercised a 90 callon the DJIA when the index is at 9300and DJX is at 93, you’d receive $300(or 3 x $100), before fees and commission.Index options can be more expensive thanstock options, but they may offer moreleverage and less volatility.off the listIt’s possible for exchanges to decide todelist options, or remove them from thetrading market. If the trading volume foran option remains low for a long period oftime, an exchange may decide that a lackof investor interest in that option makes itnot worth listing. In addition, exchangesmust delist options if they fail to meetcertain criteria.In general, options that have alreadybeen listed on a particular stock at thetime that option is delisted may be tradeduntil they expire. No new expirationmonths will be added on that class.OTHER OPTIONSWhile the most popular options are those offered onindividual stocks, ETFs, and stock indexes, contracts arealso available on limited partnership interests, AmericanDepository Receipts (ADRs), American Depository Shares(ADSs), government debt securities, and foreign currencies.Many debt security and currency options transactionsare initiated by institutional investors. Morerecently, retail investors have begun to tradecash-settled foreign currency options.An index reflects changes in a specificfinancial market, in a number of relatedmarkets, or in an economy as a whole. Eachindex—and there are a large number ofthem—measures a market, sector of themarket, or economy. Each is tracked froma specific starting point, which might be asrecent as the previous trading day or manyyears in the past.growth spurtThe total number of options tradesthat takes place each year has grown dramatically,as have the variety of availableoptions. On the first day of trading, therewere 911 transactions on the 16 listed securities.Today, an average dailyvolume might be close to onemillion on a single exchange.In 1973, 1.1 millioncontracts changed hands.In 2009, the year’s totalvolume was more than threebillion contracts on the sevenexchanges that were operating.In 2010, that number increasedto 3.9 billion contracts.©2013 by Lightbulb Press, Inc. All Rights Reserved.10

Where Are Options Listed?Transactions in listed options take place on exchangesthrough open outcry or electronic matching.If you’ve been trading stocks for sometime, you’re already familiar with thebasic procedures that govern optionstrading. Individual investors who wish tobuy or sell options place orders throughtheir brokerage firms. Where an ordergoes from that point depends on both thebrokerage firm’s policy and the exchangeor exchanges on which the options contractis traded.a job for a specialistTraders acting as specialists lead theauctions for each options class, and are incharge of maintaining a fair and orderlymarket, which means that contracts areeasily obtainable, and every investor hasaccess to the best possible market price.Each exchange has a particular structureof specialists, who may sometimes beknown as designated primary market makers(DPMs), lead market makers (LMMs),competitive market makers (CMMs), orprimary market makers (PMMs). Othertraders, sometimes known as agents, tradeoptions for their clients, sometimes buyingfrom and selling to the specialists.electronic TRADINGNew technology has supplemented orreplaced the traditional open outcrysystem on some exchanges. Instead oftraders gathering in a pit or on a floor,BUYthe basicstransactions are executed electronically,with no physical interaction betweentraders. Auction prices are tracked andlisted on computers, and orders may befilled within a matter of seconds.Some options exchanges are totallyelectronic, and many use a hybrid ofopen outcry and electronic trading. Themajority of the orders that come to thoseexchanges are filled by an automaticexecution computer that matches therequest with a buyer or seller at thecurrent market price. Transactionsrequesting an away-from-the-marketprice, or one that is higher or lowerthan the current market price, are heldin an electronic limit order book. Oncetrading reaches the requested price,those orders are the first to be handled.Proponents of electronic tradingargue that the anonymous nature of thetransactions means that all customers—whether represented by an experiencedbroker or not—have equal footing,which makes the market fairer. Theyalso point out that since the costs ofrunning an electronic exchange arelower, the transaction fees for tradesmay also be lower.STANDARD OF EXCHANGEListed options are traded on regulatedexchanges, which must adhere to SECrules designed to make trading fair forall investors. Nearly all equity options aremultiply listed, which means they’re availablefor purchase and sale on multipleexchanges. Contract terms and pricingare standardized so that the contractsare fungible, or interchangeable.Youmight give anorder to purchasean optionthat is executedon one exchange,and later give anorder to sell thesame option thatis executed on adifferent exchange.11©2013 by Lightbulb Press, Inc. All Rights Reserved.

the basicscrying outIn the early years of options trading, thefloors of exchanges operated as open outcryauctions. Buyers and sellers negotiated directlywith each other, using shouts and hand signalsto determine prices in a seemingly chaotic—but in reality, very structured—process. Openoutcry is similar to the auction system usedfor stock trading, but relies on a more freneticnegotiating atmosphere.Today, however, nearly all options transactionstake place electronically, and only rareorders above a certain size or those with specialcontingencies attached are passed on tobrokers working on the floor of theexchange. The manner in which atrade is filled is invisible to theinvestor, regardless of whether ithappens electronically or through openoutcry. In either case, when a trade hasbeen successfully completed, investorsare notified by their brokerage firms.options EXCHANGESBefore 1973, options trading was unregulated and options traded over the counter(OTC). The Chicago Board Options Exchange was the first to open, and the list hasexpanded regularly over the years. It currently stands at eleven:• BATS Options Exchange• BOX Options Exchange• C2 Options Exchange, Inc.• Chicago Board Options Exchange(CBOE)• International Securities Exchange(ISE)• MIAX Options Exchange• NASDAQ OMX BX• NASDAQ OMX PHLX• NASDAQ Options Market• NYSE Amex Options• NYSE Arca Optionsintroducing more playersThese organizations all have a role to playin options trading:OCC is theactual buyer and sellerof all listed options contracts,which means that every matched tradeis guaranteed by OCC, eliminating anycounterparty credit risk.The Options Industry Council (OIC)is a group sponsored by the optionsexchanges and OCC. OIC provideseducation for investors about thebenefits and risks of trading options.The Securities and ExchangeCommission (SEC) is a US federalagency that governs the securitiesindustry, including the options industry.The SEC protects investors by enforcingUS securities laws and regulating marketsand exchanges.CLEARING THE WAYOne of the innovations that made tradinglisted options workable from the startwas establishing a central clearinghouseto act as issuer and guarantor for allthe options contracts in themarketplace. That clearinghouse,which became TheOptions Clearing Corporationin 1975, has approximately 130member firms who clear tradesfor the brokerage firms, marketmakers, and customers who buyand sell options.Because of OCC, investors whoopen and close positions, trade contractsin the secondary market, or choose toexercise can be confident that theirmatched trades will be settled on the dayfollowing the trade, that premiums willbe collected and paid, and that exercisenotices will be assigned according toestablished procedures.Like the options exchanges,OCC has streamlined the clearingprocess—evolving from runnerswho made the rounds of memberfirms twice a day to a totally electronicenvironment.12©2013 by Lightbulb Press, Inc. All Rights Reserved.

What Are the Benefits?Whether you’re hedging, seeking income, or speculating,you can put options to work for your portfolio.Although options may not be appropriatefor everyone, they’re among the mostflexible of investment choices. Dependingon the contract, options can protect orenhance the portfolios of many differentkinds of investors in rising, falling, andneutral markets.REDUCING YOUR RISKFor many investors, options are usefulas tools of risk management, acting asa way to protect your portfolio againsta drop in stock prices. For example, ifInvestor A is concerned that the price ofhis shares in XYZ Corporation is about todrop, he can purchase puts that give himthe right to sell his stock at the strikeprice, no matter how low the marketprice drops before expiration.At the cost of the option’s premium,Investor A has protectedhimself against losses below thestrike price. This type of optionpractice is also known ashedging. While hedging withoptions may help you managerisk, it’s important tothe basicsremember that all investments carry somerisk, and returns are never guaranteed.Investors who use options to managerisk look for ways to limit potential loss.They may choose to purchase options,since loss is limited to the price paid forthe premium. In return, they gain theright to buy or sell the underlying securityat an acceptable price for them. They canalso profit from a rise in the value of theoption’s premium, if they choose to sell itback to the market rather than exerciseit. Since writers of options are sometimesforced into buying or selling stock at anunfavorable price, the risk associated withcertain short positions may be higher.Conservative.Investors with aconservative attitude canuse options to hedge their portfolios,or provide some protection againstpossible drops in value. Options writingcan also be used as a conservativestrategy to bolster income. Forexample, say you would like to own100 shares of XYZ Corporation nowtrading at $56, and are willing to pay$50 a share. You write an XYZ 50 put,and pocket the premium. If pricesfall and the option is exercised, you’llbuy the shares at $50 each. If pricesrise, your option will expire unexercised.If you still decide to buy XYZshares, the higher cost will be offsetby the premium you received.Bearish. Investorswho anticipate a marketdownturn can purchase puts onstock to profit from falling prices or toprotect portfolios—regardless of whetherthey hold the stock on which the putis purchased.RULE OF THUMBIf you buy a call, you have a bullishoutlook, and anticipate that the value ofthe underlying security will rise. If you buy aput you are bearish, and think the valueof the underlying security will fall.MODEST PROFITSMost strategies that options investors use have limitedrisk but also limited profit potential. For this reason,options strategies are not get-rich-quick schemes.Transactions generally require less capital thanequivalent stock transactions, and therefore returnsmaller dollar figures—but a potentially greaterpercentage of the investment—than equivalentstock transactions.13©2013 by Lightbulb Press, Inc. All Rights Reserved.

the basicsA LITTLE DOES A LOTOptions allow holders to benefit from movementsin a stock’s price at a fraction of the cost of owningthat stock. For example: Investors A and B thinkthat stock in company XYZ, which is currentlytrading at $100, will rise in thenext few months. Investor AInvestor Ainvests instock$spends $10,000 on thepurchase of 100 shares.But Investor B doesn’t havemuch money to invest.Instead of buying 100shares of stock, she purchases one XYZ call optionat a strike price of $115. The premium for theoption is $2 a share, or $200 a contract, sinceeach contract covers 100 shares. If the priceof XYZ shares rises to $120, the value of heroption might rise to $5 or higher, and InvestorB can sell it for $500, making a $300 profitor a 150% return on her investment.Investor A, who bought 100 XYZ sharesat $100, could make $2,000, butonly realize a 20% return onher investment.Investor B investsin options $Both invest in XYZ at $100 a shareCall option with $115 strikeAmount invested = $10,000Premium = $2 per share100 shares = 1 contractNumber of shares purchased = 100Contract price = $200She purchases 1 contractand now has a stake in 100 sharesXYZ stock price rises to $120Her 100 shares are worth $12,000Profit = $2,000, or 20%Premium rises to $5 a shareNew contract price = $500She sells her option for a profitof $300, or 150%Long-term. Investors can protect longtermunrealized gains in a stock bypurchasing puts that give them the rightto sell it at a price that’s acceptable tothem on or before a particular date. Forthe cost of the premium,a minimum profit canbe locked in. If thestock price rises, theoption will expireworthless, but thecost of the premiummay be offset bygains to the valueof the stock.SPECULATIVECLIMBEven those investors who use options inspeculative strategies, such as writing uncoveredcalls, don’t usually realize dramatic returns. Thepotential profit is limited to the premium receivedfor the contract, and the potential loss is oftenunlimited. While leverage means the percentagereturns can be significant, here, too, the amount ofcash changing hands is smaller than with equivalentstock transactions.Bullish. Investors who anticipate a marketupturn can purchase calls on stock toparticipate in gains in that stock’sprice—at a fraction of the cost ofowning that stock. Long calls canalso be used to lock in a purchaseprice for a particular stock duringa bull market, without takingon the risk of price declinethat comes withstock ownership.Aggressive.Investors withan aggressive outlookuse options to leveragea position in the marketwhen they believe theyknow the future direction of astock. Options holders and writerscan speculate on market movementwithout committing large amounts ofcapital. Since options offer leverageto investors, it’s possible to achieve agreater percentage return on a givenrise or fall than one could throughstock ownership. But this strategycan be a risky one, since losses maybe larger, and since it is possible tolose the entire amount invested.©2013 by Lightbulb Press, Inc. All Rights Reserved.14

What Are the Risks?The risks of options need to be weighed against theirpotential returns.Many options strategies are designedto minimize risk by hedging existingportfolios. While options can act assafety nets, they’re not risk free. Sincetransactions usually open and close inthe short term, gains can be realizedvery quickly. This means that losses canmount quickly as well. It’s importantto understand all the risks associatedwith holding, writing, and trading optionsbefore you include them in yourinvestment portfolio.RISKING YOUR PRINCIPALLike other securities—including stocks,bonds, and mutual funds—options carryno guarantees, and you must be aware thatit’s possible to lose all of the principal youinvest, and sometimes more. As an optionsthe basicsholder, you risk the entire amount ofthe premium you pay. But as an optionswriter, you take on a much higher levelof risk. For example, if you write anuncovered call, you face unlimitedpotential loss, since there is no cap onhow high a stock price can rise.However, since initial optionsinvestments usually require less capitalthan equivalent stock positions, yourpotential cash losses as an optionsinvestor are usually smaller than ifyou’d bought the underlying stock orsold the stock short. The exception tothis general rule occurs when you useoptions to provide leverage: Percentagereturns are often high, but it’s importantto remember that percentage losses canbe high as well.understanding premiumThe value of an equity option is composed of two separate factors. The first, intrinsic value,is equal to the amount that the option is in-the-money. Contracts that are at-the-money orout-of-the-money have no intrinsic value. So if you exercised an at-the-money option you wouldn’tmake money, and you’d lose money if you exercised an out-of-the-money option. Neither would beworth the cost of exercise transaction fees. But all unexercised contracts still have time value,which is the perceived—and often changing—dollar value of the time left until expiration. Thelonger the time until expiration, the higher the time value, since there is a greater chance that theunderlying stock price will move and the option will become in-the-money.Premium = intrinsic value + time valueThe entire premium of an at-the-money or out-of-the-money option is its time value, since itsintrinsic value is zero. In contrast, the entire premium of an in-the-money option at expiration isits intrinsic value, since the time value is zero.15©2013 by Lightbulb Press, Inc. All Rights Reserved.

the basicsHow Do You Get Started?It takes forethought and planning to begin investingsuccessfully in options.Since there are so many availableoptions—and so many ways to tradethem—you might not know where tobegin. But getting started is easier thanyou think, once you determine your goals.KNOW WHAT YOU WANT…Before you begin trading options it’scritical to have a clear idea of what youhope to accomplish. Options can play avariety of roles in different portfolios,and picking a goal narrows the field ofappropriate strategies you might choose.For example, you might decide you wantmore income from the stocks you own. Ormaybe you hope to protect the value ofyour portfolio from a market downturn.No one objective is better than another,just as no one options strategy is betterthan another—it depends on your goals.AND HOW TO GET ITOnce you’ve decided upon an objective,you can begin to examine optionsstrategies to find one or more that canhelp you reach that goal. For example, ifyou want more income from the stocksyou own, you might investigate strategiessuch as writing covered calls. Or, if you’retrying to protect your stocks from amarket downturn, you might thinkabout purchasing puts, or options on anindex that tracks the type of stocks inyour portfolio.MORE THAN JUST A BROKEROnce you’re ready to invest in options,you need to choose a brokerage firm. Yourfirm may offer helpful advice as well asexecute your trades. Some firms go furtherby working with clients to ensure that1. Open anAccount2. Find Your Level ofOptions Trading3. Pick YourObjective1 2 3 4 5WritingcoveredoptionsBuyingcalls,puts,straddlesDebitspreads,cashsecuredputsCreditspreadsWritingnakedoptions,straddlesIn both visible and invisible ways, TheOptions Industry Council (OIC) andThe Options Clearing Corporation(OCC) play a part as any investor preparesto trade options for the first time. OICprovides educational material on optionstrading as well as information aboutindividual options, contract adjustments,and changes in federal regulations. OCCprotects investors by guaranteeing everytransaction, which means that call holders,for example, don’t have to worry that thewriter might not fulfill the obligation.options trading fits into their individualfinancial plans. They also advise clientsabout potential objectives and strategies,and outline the risks and benefits ofvarious transactions.Some options investors choose discountfirms that charge lower commissions,but don’t offer personalized advisingservices. But others, including bothinexperienced and veteran investors,prefer to consult their brokers beforeopening or closing out a position.17©2013 by Lightbulb Press, Inc. All Rights Reserved.

the basicsKey Terms and DefinitionsLearn the language of the options world.While many of the terms used to describebuying and selling options are the sameterms used to describe other investments,some are unique to options. Masteringthe new language may take a little time,but it’s essential to understanding optionsstrategies you’re considering.IT’S GREEK TO METhe terms that estimate changes in theprices of options as various marketfactors—such as stock price and timeto expiration—change are named afterGreek letters, and are collectively knownas the Greeks. Many investors use theGreeks to compare options and find anoption that fits a particular strategy. It’simportant to remember, though, thatthe Greeks are based on mathematicalformulas. While they can be used toassess possible future prices, there’sno guarantee that they’ll hold true.GREEKS ON STOCKSWhen used to describe stocks, thesemeasurements compare the stock’sperformance to a benchmark index.Beta. A measure of how a stock’svolatility changes in relation to the overallmarket. A beta may help you determinehow closely a stock in your portfoliotracks the movement of an index, if you’reconsidering hedging with index options. Abeta of 1.5 means a stock gains 1.5 pointsfor every point the index gains—and loses1.5 points for every point the index loses.Alpha. A measure of how a stockperforms in relation to a benchmark,independent of its beta. A positive alphameans that the stock outperformed whatthe beta predicted, and a negative alphameans the stock didn’t perform aswell as predicted.A VOLATILE SITUATIONVolatility is an important componentof an option’s price. There are two kindsof volatility: historic and implied. Historicvolatility is a measure of how much theunderlying stock price has moved in thepast. The higher the historic volatility,the more the stock price has changed overtime. You can use historic volatility as anindication of how much the stock pricemay fluctuate in the future, but there’sno guarantee that past performance willbe repeated.Implied volatility is the percentageof volatility that justifies an option’smarket price. Investors may use impliedvolatility to predict how volatile theunderlying asset will be, but like anyprediction, it may or may not hold true.Volatility is a key element in the timevalue portion of an option’s premium. Ingeneral, the higher the volatility—eitherhistoric or implied—the higher theoption’s premium will be. That’s becauseinvestors assume there’s a greaterlikelihood of the stock price movingbefore expiration, putting the optionin-the-money.OTHERMEASUREMENTSOpen interest. The number ofopen positions for a particularoptions series. High open interest meansthat there are many open positions on aparticular option, but it is not necessarilya sign of bullishness or bearishness.Volume. The number of contracts—bothopening and closingtransactions—traded overa certain period. A highdaily volume means manyinvestors opened or closedpositions on a given day.Liquidity. The more buyers and sellersin the market, the greater theliquidity for a particular optionsseries. Higher liquidity maymean that there is a demandfor a particular option, whichmight increase the premiumif there are lots of buyers, ordecrease the premium if thereare lots of sellers.19©2013 by Lightbulb Press, Inc. All Rights Reserved.

the basicsGREEKS ON OPTIONSWhen used to describe options, the Greeksusually compare the movement of anoption’s theoretical price or volatility asthe underlying stock changes in price orvolatility, or as expiration nears.Delta. A measure of how much an optionprice changes when the underlying stockprice changes. The delta of an optionvaries over the life of that option, dependingon the underlying stock price and theamount of time left until expiration.Like most of the Greeks, delta isexpressed as a decimal between 0 and +1or 0 and –1. For example, a call delta of0.5 means that for every dollar increasein the stock price, the call premiumincreases 50 cents. A delta between 0and –1 refers to a put option, since putpremiums fall as stock price increases. Soa delta of –0.5 would mean that for everydollar increase in the stock price, the putpremium would be expected to drop by50 cents.Theta. The rate at which premium decaysper unit of time as expiration nears. Astime decays, options prices can decreaserapidly if they’re out-of-the-money. Ifthey’re in-the-money near expiration,options price changes tend to mirrorthose of the underlying stock.Rho. An estimate of how much the priceof an option—its premium—changeswhen the interest rate changes. Forexample, higher interest rates may meanthat call prices rise and put prices decline.Vega. An estimate of how much anoption price changes when the volatilityassumption changes. In general, greatervolatility means a higher option premium.Vega is also sometimes referred to askappa, omega, or tau.GREEKS ON GREEKSSome Greeks work as secondary measurements,showing how a particular Greekchanges as the option changes in priceor volatility.Gamma. A measure of how much thedelta changes when the price of theunderlying stock changes. You mightthink of gamma as the delta of anoption’s delta.HEDGINGIf you hedge an investment, youprotect yourself against losses, usuallywith another investment that requiresadditional capital. With options, you mighthedge your long stock position by writinga call or purchasing a put on that stock.Hedging is often compared to buyinginsurance on an investment, since youspend some money protecting yourselfagainst the unexpected.LEVERAGEWhen you leverage an investment, youuse a small amount of money to controlan investment that’s worth much more.Stock investors have leverage whenthey trade on margin, committing onlya percentage of the capital needed andborrowing the rest. As an options investor,you have leverage when you purchase acall, for example, and profit from a changein the underlying stock’s price at a lowercost than if you owned the stock. Leveragealso means that profits or losses may behigher, when calculated as a percentageof your original investment.©2013 by Lightbulb Press, Inc. All Rights Reserved.20

INVESTING STRATEGIESIntroduction toOptions StrategiesPlanning, commitment, and research will prepare youfor investing in options.Before you buy or sell options you need astrategy, and before you choose an optionsstrategy, you need to understand how youwant options to work in your portfolio. Aparticular strategy is successful only ifit performs in a way that helps you meetyour investment goals. If you hope toincrease the income you receive fromyour stocks, for example, you’ll choose adifferent strategy from an investor whowants to lock in a purchase price for astock she’d like to own.One of the benefits ofoptions is the flexibility theyoffer—they can complementportfolios in many differentways. So it’s worth taking thetime to identify a goal thatsuits you and your financialplan. Once you’ve chosen agoal, you’ll have narrowedthe range of strategies touse. As with any type ofinvestment, only some of thestrategies will be appropriatefor your objective.SIMPLE ANDNOT-SO-SIMPLESome options strategies, suchas writing covered calls, arerelatively simple to understandand execute. There aremore complicated strategies,however, such as spreadsand collars, that requiretwo opening transactions.These strategies are oftenused to further limit the riskassociated with options, butthey may also limit potentialreturn. When you limit risk,there is usually a trade-off.Simple options strategiesare usually the way to begininvesting with options. Bymastering simple strategies,you’ll prepare yourself foradvanced options trading.In general, the more complicatedoptions strategiesare appropriate only forexperienced investors.CallbuyingCallwritingPutbuyingPutwritingSpreadsCollarsAN OVERVIEW OF STRATEGIESIt’s helpful to have an overview of theimplications of various options strategies.Once you understand the basics, you’llbe ready to learn more about how eachstrategy can work for you—and what thepotential risks are.PossibleobjectiveProfit fromincrease in priceof the underlyingsecurity, orlock in a goodpurchase priceProfit from thepremium received,or lower net costof purchasinga stockProfit fromdecrease in priceof the underlyingsecurity, orprotect againstlosses on stockalready heldProfit fromthe premiumreceived, orlower netpurchase priceProfit from thedifference invalues of theoptions writtenand purchasedProtect unrealizedprofitsYour marketforecastNeutral tobullishNeutral tobearish,thoughcovered callwriting maybe bullishNeutral tobearishNeutral tobullish, thoughcash-securedputs maybe bearishBullish orbearish,depending onthe particularspreadNeutral orbullish21©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESMAKE A COMMITMENTOnce you’ve decided on an appropriateoptions strategy, it’s important to stayfocused. That might seem obvious, but thefast pace of the options market and thecomplicated nature of certain transactionsmake it difficult for some inexperiencedinvestors to stick to their plan. If itseems that the market or underlyingsecurity isn’t moving in the directionyou predicted, it’s possible that you’llminimize your losses by exiting early. Butit’s also possible that you’ll miss out on afuture beneficial change in direction.That’s why many experts recommendthat you designate an exit strategy or cutoffpoint ahead of time, and hold firm. Forexample, if you plan to sell a covered call,PotentialriskLimited to thepremium paidUnlimited fornaked callwriting, limitedfor coveredcall writingLimited to thepremium paidSubstantial, asthe stock priceapproaches zeroLimitedLimited©2013 by Lightbulb Press, Inc. All Rights Reserved.?PotentialreturnTheoreticallyunlimitedLimited tothe premiumreceivedSubstantial, asthe stock priceapproaches zeroLimited tothe premiumreceivedLimitedLimitedyou might decide that if the option moves20% in-the-money before expiration, theloss you’d face if the option were exercisedand assigned to you is unacceptable. Butif it moves only 10% in-the-money, you’dbe confident that there remains enoughchance of it moving out-of-the-money tomake it worth the potential loss.A WORD TO THE WISEBy learning some of the most common mistakesthat options investors make, you’llhave a better chance of avoiding them.Overleveraging. One of the benefitsof options is the potential they offer forleverage. By investing a small amount, youcan earn a significantpercentage return. It’svery important, however,to remember thatleverage has a potentialdownside too: A smalldecline in value can meana large percentage loss. Investors whoaren’t aware of the risks of leverage arein danger of overleveraging, and mightface bigger losses than they expected.Lack of understanding. Anothermistake some options traders make isnot fully understanding what they’veagreed to. An option is acontract, and its termsmust be met uponexercise. It’s importantto understand that ifyou write a covered call,for example, there isa very real chance thatyour stock will be called away fromyou. It’s also important to understand howan option is likely to behave as expirationnears, and to understand that once anoption expires, it has no value.Not doing research. A serious mistakethat some options investors make is notresearching the underlying instrument.Options are derivatives,and their valuedepends on the pricebehavior of anotherfinancial product—astock, in the case ofequity options. Youhave to researchavailable options data, and be confident inyour reasons for thinking that a particularstock will move in a certain directionbefore a certain date. You should also bealert to any pending corporate actionssuch as splits and mergers.22

INVESTING STRATEGIESACCEPTING RISKNo matter how well you’ve researched the equity on whichyou buy or write an option, there’s no guarantee that yourtrade will be successful. Some advisers recommend that you considerthe probability of the success of a particular trade. Probability is ameasurement of the odds that you’ll achieve the goal behind youroptions strategy, which might be making a profit orpurchasing stock, for example.Probability is based on factors includingvolatility, since an out-of-the-money optionon an underlying instrument with highvolatility—or one that often changesin price—is more likely to movein-the-money. It’s important toestimate the probability of successbefore committing yourself to atrade. You’ll have more realisticexpectations and a bettersense of what you stand togain and to lose.MANAGING YOUR CASHHow you’re going to manage yourcapital is another important decisionto make before you trade options.• If you’ve already allocated all your investmentfunds to other types of securities,you’ll have to reallocate in order to freeup capital for options. Most expertsrecommend that you use options tocomplement a diversified investmentportfolio instead of dedicating yourentire trading capital to options.research SOURCES• Financial newspapers, websites, and magazinesprovide company news and market trends• Your broker or financial adviser canmake recommendations as well as provideprofessional research• Options newsletters often offer informationon particular equities and trading strategies• If you’re notvery experienced,you might considertrading options withrisk capital only, ormoney that you could tolerate losingentirely, particularly when purchasingsimple puts or calls.• You should also take into account theimpact that trading options on marginwill have on your cash allocation. Ifyou write an uncovered call, you’llhave to deposit a minimumpercentage of the value ofthe underlying shares intoa margin account withyour broker. This mightmean tying up fundsthat you would haveinvested elsewhere.24©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESCall BuyingYou can profit from an increase in a stock’s price bypurchasing a call.Buying calls is popular with optionsinvestors, novices and experts alike. Thestrategy is simple: You buy calls on a stockor other equity whose market price youthink will be higher than the strike priceplus the premium by the expiration date.Or, you buy a call whose premium youthink will increase enough to outpacetime decay. In either case, if your expectationis correct, you may be in a position torealize a positive return. If you’re wrong,you face the loss of your premium—generallymuch less than if you had purchasedshares and they lost value.INVESTOR OBJECTIVESCall buying may be appropriate for meetinga number of different objectives. Forexample, if you’d like to establish a priceat which you’ll buy shares at some point inthe future, you may buy call options on thestock without having to commit the fullinvestment capital now.Or, you might use a buy low/sell highstrategy, buying a call that you expect torise and hoping to sell it after it increasesin value. In that case, it’s key to pick a callthat will react as you expect, since notall calls move significantly even when theunderlying stock rises.CALLING FOR LEVERAGEOne major appeal of purchasing calls is the possibility of leveraging your investment, andrealizing a much higher percentage return than if you made the equivalent stock transaction.1Investor A buys 100 shares of company LMNstock at $10 each, investing a total of $1,000.2In the next year, the stockrises in value to $15.100 Sharesx $ 10 Per share= $ 1,000 InvestmentInvestor B, however, invests the same $1,000 in1 2options, buying 20 calls at a strike price of $12.50.Each call cost her $50, or 50 cents per share, since her contractcovers 100 shares.CALLS$50 (50¢ per share)$ 50 Per callx 20 Calls= $ 1,000 InvestmentStrike price$12.50When the stock goes upto $15, her options arein-the-money by $2.50.Therefore the value of hercalls rises from 50 cents atpurchase to at least $2.50 pershare, a $200 gain per contract.PERFECT TIMINGBuying calls can provide an advantageover several different time periods:Short term. Investors can profitif they sell an option formore than they paidfor it, for example ifthere is an increasein the stock’s pricebefore expiration.25©2013 by Lightbulb Press, Inc. All Rights Reserved.Medium term.Over a matter ofseveral months,investors can use calloptions to minimize the riskof owning stock in an uncertainmarket. Investors who want tolock in a purchase price for ayear or longer can buy LEAPS, orperiodically purchase new options.Long term.LEAPS allowinvestors topurchase callsat a strike pricethey’re comfortablewith, and accumulate thecapital to purchase thoseshares in the interveningtime until expiration.

INVESTING STRATEGIESSome experienced investors may purchase calls in order to hedge againstshort sales of stock they’ve made. Investors who sell short hope to profit froma decrease in the stock’s price. If the shares increase in value instead, theycan face heavy losses. Buying calls allows short sellers to protect themselvesagainst the unexpected increase, and limit their potential risk.EXERCISING YOUR CALLSMost call contracts are sold before expiration, allowing their holders torealize a profit if there are gains in the premium. If you’ve purchased acall with the intent of owning the underlying instrument, however,you can exercise your right at any time before expiration, subject tothe exercise cut-off policies of your brokerage firm.However, if you don’t resell and don’t exercise before expiration,you’ll face the loss of all of the premiumyou paid. If your call is out-of-the-money atexpiration, you most likely won’t exercise.If your option is at-the-money, transactionfees may make it not worth exercising.But if your option is in-the-money, youshould be careful not to let expirationpass without acting.3Investor A sells and makes $500, or a50% return on his initial investment.x $100 Shares15 Per share= $ 1,500 Sale priceCHOOSING A SECURITYIn general, purchasing calls indicates abullish sentiment, so you should consider astock or stock index whose price you think isset to rise. This might be a stock you feel willrise in the short term, allowing you to profitfrom an increase in premium. You mightalso look for a stock with long-term growthpotential that you’d like to own. Purchasingcalls allows you to lock in an acceptableprice, at the cost of the premium you pay.$1,500 Sale price– $1,000 Investment=$ 500 Profit or50% return3At expiration the 20 contracts are now worth$5,000, or $4,000 above what she invested, a400% return.CALLS$250 ($2.50 per share)$ 250 Per callx 20 Calls held= $ 5,000 Sale priceHowever, if the stock price falls atexpiration to $9, Investor A will lose$100, or 10% of his investment.Investor B will lose $1,000, or 100%of her investment.$5,000 Sale price– $1,000 Investment= $4,000 Profit or400% returnBETTER THAN MARGINFor certain investors, buying calls is anattractive alternative to buying stock onmargin. Calls offer the same leverage thatyou can get from buying on margin, butyou take on less potential risk.If you buy stock on margin, you mustmaintain a certain reserve of cash in yourmargin account to cover the possible lossin value of those stocks. If the stock pricedoes fall, you must add cash to meet the©2013 by Lightbulb Press, Inc. All Rights Reserved.margin requirement, liquidate a portionof your position, or face having yourbrokerage firm liquidate your assets.If you purchase calls, you have thesame benefit of low initial investmentas the margin trader, but if the value ofthe stock drops, the main risk you face isloss of the premium, an amount that’susually much smaller than the initialmargin requirement.26

INVESTING STRATEGIESCALCULATINGWhenever you buy a put, yourmaximum loss is limited to theamount you paid for the premium.That means calculating the potentialloss for a long put position is as simpleas adding any fees or commissions tothe premium you paid. You’ll realizethis loss if the option expiresunexercised or out-of-the-money.$RETURNIf you anticipate experiencinga loss and sell youroption before expiration,you may be able to makeback some of the premiumyou paid and reduce yourloss, though the market priceof the option will be less thanthe premium you paid.Purchasing toHold or Sell the OptionPurchasing toHedge a Stock PositionIf you purchase a put and later sell it, youcan calculate return by figuring the differencebetween what you paid and what you received.For example, say you purchase one LMN putfor $300, or $3 per share.A month later, the price of the underlyingequity falls, placing the put in-the-money. Yousell your option for $600, or $6 per share.Your return is $300, or 100% ofyour investment.$600 Sale price– $300 LMN put price= $300 or 100% returnIf the price of the stock has risen after a month,the put is out-of-the-money, and the premiumdrops to $200.You decide to cut your losses and sell the put.You’ve lost $100, or 33% of your investment.$300 LMN put price– $200 Sale price= $100 or 33% lossIf you purchased the put to hedge a stockposition, calculating your return meansfinding the difference between your totalinvestment—the price of the premium addedto the amount you paid for the shares—andwhat you would receive if you exercisedyour option.For example, if you purchased 100 LMN sharesat $40 each, you invested $4,000.If you purchased one LMN put with a strikeprice of $35 for $200, or $2 per share, you’veinvested $4,200 total in the transaction.If you exercise the option, you’ll receive $3,500,for a $700 loss on your $4,200 investment.$4,200 Total investment– $3,500 Receive at exercise= $ 700 LossA $700 loss might seem big, but keep in mindthat if the price of the stock falls below $35,you would face a potentially significant loss ifyou didn’t hold the put. By adding $200 to yourinvestment, you’ve guaranteed a selling price of$35, no matter how low the market price drops.©2013 by Lightbulb Press, Inc. All Rights Reserved.30

INVESTING STRATEGIESPut WritingYou can earn income or lock in apurchase price with a put.While writing puts can sometimes be arisky transaction, there may be room forthe strategy in more conservative portfolios.By writing puts on stocks you’d like to own,you can lock in a purchase price for a setnumber of shares. But if the stock priceincreases, you may still profit from thepremium you receive.INVESTOR OBJECTIVESInvestors who choose to write puts are oftenseeking additional income. If you have aneutral to bullish prediction for a certainstock or stock index, you can sell a put onthat underlying instrument, and you’ll bepaid a premium. If the underlying instrumentdoesn’t drop in price below the strike price,the option will most likely expire unexercised.The premium is your profit on the transaction.For example, say you think that the stockof LMN, currently trading at $52, won’t dropbelow $50 in the next few months.You could write one LMN put with a strikeprice of $45, set to expire in six months, andsell it for $200. If theprice of LMN rises,Write Put for Incomestays the same, oreven drops to $46,CALCULATINGRETURNIf you write a put andit expires unexercised,your return may seemsimple to calculate:Subtract any fees andcommissions from thepremium you received.But writing putsusually requires amargin account withyour brokerage firm,so you should include inyour calculations any investing capital thatwas held in that account, since it couldperhaps have been profitably investedelsewhere during the life of the option.For example, if you write the LMN 45put, you’d receive $200. But your brokeragefirm would require that premium,along with a percentage of the $4,500needed to purchase the shares, to be heldKeep the $200on reserve in your margin account.The capital is still yours, but it is tied upuntil the put expires or you close outyour position.If you write a put that is exercised,the premium you receive when you openthe position reduces the amount thatyou pay for the shares when you meetyour obligation to buy. In the case of the31©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESRISKY BUSINESSWriting options is generally consideredriskier than holding options.• With any put writing transaction,your maximum profit is limited to theamount of premiumyou receive.• If you decide toclose out yourposition beforeexpiration, youmight have to buyback your option at a higher pricethan what you received for selling it.• At exercise, the potential loss youface is substantial if the price of theunderlying instrument falls below thestrike price of the put.Due to the risks involved, and thecomplications of margin requirements,writing puts is an options strategythat may be most appropriate forexperienced investors.your option remains out-of-the-money.You’ll keep the $200.A more conservative use of put writingcombines the options strategy with stockownership. If you have a target price fora particular stock you’d like to own, youcould write put options at an acceptablestrike price. You’d receive the premiumat the opening of the transaction, and ifthe option is exercised before expiration,you’ll have to buy the shares. The premiumyou received, however, will reduce yournet price paid on those shares.Write Put to Own StockFor example, if the price of LMN stockdrops to $42, your short put with a strikeof $45 is in-the-money. If you are assigned,you’ll have to purchase the stock for$4,500. That amount is partially offsetby the $200 premium, so your total outlayis $4,300.You would pay a net price of $43 foreach share of LMN stock. If its pricerises in the future, you could realizesignificant gains.Or, you could close out your positionprior to assignment by purchasing thesame put. Since the option is nowin-the-money, however, its premiummay cost you more than you collectedwhen you sold the put.Buy back the put for $300 with aloss of $100, or purchase the stock.LMN 45 put, the $200 premium reduceswhat you pay for the stock from $4,500 to$4,300. If you plan to hold the shares youpurchase in your portfolio, then your costbasis is $43 per share plus commissions.If you don’t want to hold those shares,you can sell them in the stock market. Butif you sell them for less than $43 per share,you’ll have a loss.©2013 by Lightbulb Press, Inc. All Rights Reserved.CASH-SECUREDPUTSCash-secured puts may help protect againstthe risk you face in writing put options.At the time you write a put option contract,you place the cash needed to fulfill yourobligation to buy in reserve in your brokerageaccount or in a short-term, low-riskinvestment such as Treasury bills. That way,if the option is exercised, you expect to haveenough money to purchase the shares.Securing your put with cash also preventsyou from writing more contracts than youcan afford, since you’ll commit all the capitalyou’ll need up front.32

INVESTING STRATEGIESSpread StrategiesYou can limit your exposure using twoor more options on the same stock.A spread is an options strategy thatrequires two transactions, usuallyexecuted at the same time. You purchaseone option and write anotheroption on the same stock or index.Both options are identical exceptfor one element, such asstrike price or expirationdate. The most commonare vertical spreads, inwhich one option has ahigher strike price thanthe other. The differencebetween the higher strike price andthe lower strike price is also knownas the spread. Different spreadstrategies are appropriate fordifferent market forecasts.You use a bear spread if youanticipate a decline in the stock price.You use a bull spread if you anticipatean increase in the stock price.Each options transaction isknown as a leg of the overallstrategy, and most optionsspreads stand on two legs—though there are some strategieswith three or more legs.WHAT ARE THE BENEFITS?Many options investors use spreadsbecause they offer a double hedge,which means that both profit and lossare limited. Investors who are interestedin more aggressive options strategies thatmight expose them to significant potentiallosses can hedge those risks by makingthem one leg of a spread. The trade-off isthat the potential profit is limited as well.It might help to think of spreads as aform of self-defense. Just as you can openan options position to protect againstlosses in a stock position, you can open anoptions position to protect against lossesin another options position.Write40callHow youhedge withSpreadsIf stock LMN istrading at $45:Investor A sells a callwith a strike price of $40, andpurchases a call with a strike priceof $55. She receives $720 for the callshe sells, since it is in-the-money,and pays only $130 for the callshe purchases, since it isout-of-the-money. Her cashreceived, or net credit, sofar is $590.Investor B writes a 40 call onLMN, and receives $720. His netinvestment is the margin his brokeragefirm requires for a naked call.InvestorAPurchase55 callInvestorBCREDIT OR DEBIT?If, like Investor A, you receive moremoney for the option you write thanyou pay for the option you buy, you’veopened a credit spread. The differencebetween the two premiums is a credityou receive, and it will be deposited inyour brokerage account when you openthe position. In most cases, the goal ofa credit spread is to have both optionsexpire worthless, retaining your creditas profit from the transaction.If you pay more for your long optionthan you receive for your short option,you’re taking on a debit spread. You’llhave to pay your brokerage firm thedifference between the two premiumswhen you open the transaction.In most cases, the goal of a debitspread is to have the stock move beyondthe strike price of the short option so thatyou realize the maximumvalue of the spread.MORE TYPES OF SPREADSA calendar spread is the purchase of oneoption and writing of anotherwith a different expirationdate, rather than with adifferent strike price.This is usually aneutral strategy.A straddle is thepurchase or writing of botha call and a put on an underlyinginstrument with the same strike price and thesame expiration date. A buyer expects the underlyingstock to move significantly, but isn’t sure about thedirection. A seller, on the other hand, hopes that theunderlying price remains stable at the strike price.33©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESWrite40 callIf the stock price rises to$60 at expiration:Investor A’s short call isin-the-money, and she mustsell 100 LMN shares at $40 each.However, her long call isin-the-money as well, whichmeans she can buy those sameshares for $55 each. Her net lossfor each share is $15, or $1,500total. This is offset by the premiumshe received, reducing hermaximum potential loss to $910.If the stock price fallsbelow $40 at expiration:Both of Investor A’s options expireout-of-the-money, and she keepsthe $590 for the maximum profit.If the stock price rises to$60 at expiration:Investor B’s short call isin-the-money, and he must sell100 LMN shares at $40 each, fora total loss of $2,000 over theirmarket price. His credit offsets thisby $720, reducing his maximumpotential loss to $1,280.If the stock price fallsbelow $40 at expiration:Investor B’s option expiresout-of-the-money, and he keepshis entire $720.Credit spread:premium you receive > premium you payDebit spread:premium you receive < premium you payARE YOU QUALIFIED?Although spreads aren’t always speculativeor aggressive, they are complexstrategies that aren’t appropriate for allinvestors. Your brokerage firm may haveits own approval levels for debit spreadsand credit spreads, to ensure that you’refinancially qualified and have adequateinvesting experience. Additionally,managing spreads as expiration nearsrequires time and attention, so you shouldbe sure you want to take on the challenge.A strangle is the purchaseor writing of a call and a putwith the same expiration dateand different—but bothout-of-the-money—strikeprices. A strangle holder hopes for a large movein either direction, and a strangle writer hopesfor no significant move in either direction.©2013 by Lightbulb Press, Inc. All Rights Reserved.EXECUTIng a strategyThe first step in executing a1spread is choosing an underlyingsecurity on which to purchase and writethe options.Next, you’ll have to choose the2strike prices and expiration datesthat you think will be profitable. Thatmeans calculating how far you think astock will move in a particular direction,as well as how long it will take to do so.You should be sure to calculate the3maximum profit and maximum lossfor your strategy, as well as the circumstancesunder which you might experiencethem. Having realistic expectations isessential to smart options investing.Finally, you’ll have to make the4transactions through a marginaccount with your brokerage firm. Theminimum margin requirement for aspread is usually the difference betweenthe two strike prices times the numberof shares covered.34

INVESTING STRATEGIESUnderstanding SpreadsBulls and bears, calls and puts, and creditsand debits don’t have to be confusing.There are four commonvertical spread strategies:the bull put, the bull call,the bear put, and the bearcall. Each of these has onelong leg, or an option youbuy, and one short leg, oran option you write.Bull putCredit ordebit?CreditLong legPut at lowerstrikeShort legPut at higherstrikeMany brokerage firmspermit you to enter bothlegs of a transactionsimultaneously. Withothers, you must executeseparate transactions inan approved sequence.Bull callBear putBear callDebitDebitCreditCall at lowerstrikePut at higherstrikeCall at higherstrikeCall at higherstrikePut at lowerstrikeCall at lowerstrikeEXIT A SPREADWhen you exit a spread, both legs areusually closed out, rather than exercised,since buying and selling the underlyingstock means committing large amounts ofcapital to the strategy. Instead, you mightclose out the spread, by making an offsettingpurchase of the option you wrote, andan offsetting sale of the option you hadoriginally purchased.For example, if you were moderatelybullish on stock LMN, which is trading at$55, you might open a bull call spread.You could buy a 60 call for $350 and writea 65 call, receiving $150. Your net debit is$200, which is also your maximum loss ifthe stock price stays below $60.If the options stay out-of-the-money$350 Purchase of 60 call– $150 Receive on 65 call= $200 Net debitIf the price of the stock rises to $66at expiration, both options will be in-themoney,and it’s reasonable to assume theoption you wrote will be exercised. If that’sthe case, you can exercise your long calland purchase 100 LMN shares for $6,000,and then sell those shares for $6,500 tomeet your short 65 call assignment. Ifexercise andassignmentoccurred atexpiration, your firmwould probably netthe difference.You’d earn $500,and after subtracting theIf the options are in-the-money$6,500 Sell shares– $6,000 Purchase shares= $ 500 Proceeds– $ 200 Debit= $ 300 Profitdebit of $200, your profit would be $300.You would have invested $200 for that $300profit. Alternatively, at or near expiration,you could close out your short call bybuying it back for about $100 and sellingyour long call for about $600, leaving youwith a profit of about $300, after the initial$200 debit.You committed only $300 in cash (thedebit plus the cost of offsetting your shortcall), instead of the $6,000 necessary if youwere to exercise your long call. Either way,you have given up the opportunity to profitif the stock continues to rise.35©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESMarketforecastNeutral orbullishModeratelybullishModeratelybearishNeutral orbearishMax profitNet creditSpread times100, lessdebitSpread times100, lessdebitNet creditMax lossSpread times100, lesscreditNet debitNet debitSpread times100, lesscreditOFFSETYOURLOSSESearning incomeSpreads can also be used to create incomefrom stocks you hold.For example, say you bought 100 LMNshares at $50. Now the stock is trading at$30, and you don’t think it will rise much inthe near future.You’d like to receive income on your shares,but you don’t want to have them calledaway from you, incurring a loss for thetax year.You write a slightly out-of-the-moneycall at $32.50, receiving $250. Yousimultaneously buy a 35 call for $150.Your net credit is $100.If the options stayout-of-the-money$250 Receive on 32.50 call– $150 Purchase of 35 call= $100 Net creditIf the price of the stock stays below $32.50,you pocket the $100.If the stock price increases above $35, youcan close out both options positions at a lossof $250 (the amount of the spread times thenumber of shares covered), which is reducedto $150 after accounting for your credit.This loss is one you may be willing to acceptas your shares of LMN gain value.Offsetting yourspread position,or buying back thespread you sold,can be advantageous if the underlyingstock has moved against you. If you arebearish on LMN when it is trading at $55,you might open a bear call spread.You can purchase a 65 call for $150,and sell a 60 call, receiving $350. Yournet credit is $200, which is also theamount of your maximum profit, if LMNstays below $60 and both options expireout-of-the-money.If the options expireout-of-the-money$350 Receive on 60 call– $150 Purchase of 65 call= $200 Net creditIf your expectations were wrong andthe stock price rises to $66, both LMNoptions will be in-the-money. At or nearexpiration, you might sell your 65 call for©2013 by Lightbulb Press, Inc. All Rights Reserved.If the options are in-the-money100 Number of sharesx $ 2.50 Amount of the spread= $ 250 Loss– $ 100 Credit= $ 150 Net loss$100, and buy back the 60 call for $600.The loss of $500 would be partially offsetby the original $200 credit.If the stock is $66 at expiration, you canassume your short call will be assigned,obligating you to sell 100 LMN shares at$6,000. You’d exercise your long call, andbuy 100 LMN shares for $6,500. Your firmwould probably net the difference, creatinga $500 loss in your account that would bepartially offset by your original $200 credit.If the options are in-the-money$600 Buy back 60 call– $100 Sell 65 call= $500 Loss– $200 Credit= $300 Net loss36

INVESTING STRATEGIESCollar TransactionsYou can use a collar to rein in profits you haven’tyet realized, but you might have to give upfuture gains in return.A collar is a spread strategy designed to protect unrealized profits on stockyou already own. You purchase a protective put on your long stock position, andoffset the cost of that put by writing a call that is covered by your long stockposition. The collar spread is also known as a fence for the protection it provides.In most cases, both the long put and the shortcall are out-of-the-money. If the call you write is lessexpensive than the put you buy, you’ll pay more premiumthan you receive, andwill establish a debit collar.If the put you buy is lessRULE OFTHUMBCall and put optionsmove in opposition.Call options usually risein value as the underlyingmarket prices go up. Putoptions usually rise invalue as the market pricesgo down—but timedecay and a changein volatility alsohave an effect.expensive than the call youwrite, you’ll receive morepremium than you pay,and will establish acredit collar.INVESTOROBJECTIVESA collar is most oftenused as a protectivestrategy. If you hold astock that has madesignificant gains, youmight want to lock in thosegains, protecting your positionagainst a future drop in price. Writing a covered callcan fully or partially offset the cost of purchasing aprotective put. Just as with other spread strategies,the risk you face with a collar is limited—and, inreturn, so is the potential profit.For example, say you purchased 100 shares ofLMN at $15 two years ago, and its current market price is $30.100 Sharesx $ 15 Per share= $ 1,500 Original costIf you purchase a 25 put, you’ll havethe right to sell those shares at $25 beforeexpiration, locking in a $10 profit on eachshare, or a total of $1,000. Suppose thatput costs you $275, or $2.75 per share.Let’s say you also write a 35 call withthe same expiration month, and receive$250 in premium, or $2.50 per share.$275 Put price paid– $250 Call price received= $ 25 Net costIf the price of LMN rises above $35 atexpiration, your call most likely will beexercised. You’ll receive $3,500 for yourshares, or a $2,000 profit, but you’ll miss outon any further gains the stock may have.Since the put you purchased cost morethan the call you wrote, your net cost is$25—less than one tenth of the price ofthe protective put alone. It would cost youonly $25 to ensure that you could sell at a37©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESWhen executing a collar, it’s important todefine your range of return, or the strikeprices for both the put you purchase andthe call you write. The strike price of theprotective put should be high enough tolock in most of your unrealized profit. Thestrike price of the covered call should behigh enough to allow you to participate insome upward price movement, but not sofar out-of-the-money that the premium youreceive does little to offset the cost of yourprotective put.minimum profit of $10 per share, or $1,000per contract.In most cases, a collar works best if youhave a neutral to bearish market forecastfor a stock that has behaved bullishly inthe past, leaving you with unrealized gainsyou’d like to protect. Some investors usecollars as income-producing strategiesby selling them for a credit. While thatapproach can be profitable, it also requirestime and attention to manage the strategy.©2013 by Lightbulb Press, Inc. All Rights Reserved.YOUR OPTIONSAT EXPIRATIONDepending on the direction the stock moves,your choices at expiration of the legs ofyour collar vary:If the price of the stock risesabove the strike price of theshort call:If assigned, you can fulfill your short callobligation and sell your shares at the strikeprice. You’ll lock in profits over what youinitially paid for the stock, but you’ll missout on any gains above the strike price.Alternately, you could close out your positionby purchasing the same call you sold, quitepossibly at a higher price than what you paidfor it. This may be worth it if the difference inpremiums is less than the additional profit youanticipate you’ll realize from gains in the stock’svalue, or if one of your goals is to retain the stock.If the price of the stock remainsbetween both strikes:You can let your put expire unexercised, orsell it back, most likely for less than what youpaid, since its premium will have decreased fromtime decay. Your short call will probably expireunexercised, which means you keep the entirepremium. Depending on whether your collar wasa credit or debit spread, you’ll retain your initialcredit as a profit, or debit as a loss.If the price of the stock falls belowthe strike price of the long put:By exercising your put, you can sell your sharesat the strike price. Your short call will probablyexpire unexercised, and you keep all of theproceeds from the sale of the call.COMMISSIONS AND FEESAs with stock transactions, options tradesincur commissions and fees charged byyour brokerage firm to cover the cost ofexecuting a trade. You’ll pay fees whenopening a position as well as when exiting.The amount of these charges varies frombrokerage firm to brokerage firm, so youshould check with yours before executingany transaction. Be sure to account for feeswhen calculating the potential profit andloss you face.You should also keep in mind thatspread transactions that require two legsmean you may face double commissionsat entry. And it also helps to consider thatany strategy that ends with an unexercisedoption, such as a covered call, means—ifyou’re not assigned—you won’t pay anycommissions or fees at exit.38

INVESTING STRATEGIESExit StrategiesThe best time to plan your exit is before you’ve entered.You can exit an options strategy at anypoint before expiration, and you mayhave more than one alternative. But theexit strategy you choose and your timingin putting it into effect might mean thedifference between a profit and a loss, asmall profit and a bigger one, or a smallloss and a bigger one. Smart investingmeans establishing how you’ll exit if youroption is in-the-money, at-the-money, orout-of-the-money—before you openthe trade.consequences of selling or acquiring stockthrough the exercise of an option, since itmight affect your capital gains or lossesfor the year.If you’re an options holder, you’ll havemore flexibility when deciding how to exit,since you have the choice not to exercise.You might still close out your position byselling the option, rather than exercisingit. If the option’s premium has gone upsince you bought it, closing out wouldCLOSING UP SHOPSince you can close out your position,or buy back an option you sold, asan options writeryou’re almostnever forced tofulfill an obligationto buy or sell theunderlying instrument—assumingyou close outbefore expiration.Keep in mind,though, thatin-the-moneystock options areoften exercisedbefore expiration.If you write anoption, closing outis the only wayto make sure youwon’t be assigned.Depending on theoption’s premiumwhen you want tobuy it back, youmight pay lessthan you received,making a netprofit. But youmight also have topay more than youreceived, taking anet loss.If that loss isless than what youwould have facedwere the optionexercised, closingout might be thebest exit. Youshould also keepin mind the taxPUT CALLCHOICESFOROPTIONsHOLDERSIf you’re long anoption, the priceyou paid in premiummight reduce yourgains. For example,if you hold an LMN90 call that cost you$200, you’ll have tofactor in the $2 pershare you spent onthe option whendeciding how andwhen to exit:CHOICESFOROPTIONSWRITERSIf you’re short anoption, the premiumyou received willadd to your gainor reduce your loss.For example, if youwrote an LMN 90put that earnedyou $200, you canfactor in the $2 pershare you receivedfor the option:If the stock price isabove $92• Your option is in-the-money. Youcan exercise and buy shares for$90. You can then retain the stockor possibly sell it on the marketfor more than $92, offsetting the$200 you spent, and still makinga profit.• You can possibly sell the optionfor more than the $200 you paidfor it, making a profit. Investorswho purchase options for leverageoften choose this exit strategy.If the stock price isbelow $88• The option is in-the-money, andwill most likely be exercised,which means you’ll have to buy100 shares for more than theirmarket price, taking a loss.• You might buy the option backbefore it is exercised, paying morefor it than you received, andtaking a loss.39©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESmean making a profit. If the option’spremium has decreased, closing out wouldmean cutting your losses and offsetting atleast part of what you paid.IMPORTANCE OF TIMINGThe profit or loss you’ll face at exitdepends on whether your option isin-the-money, at-the-money, orout-of-the-money. Since the intrinsicvalue can change quickly, timing is veryimportant for the options investor. Justa one dollar change in the price of theunderlying stock might be the differencebetween a position that’s profitable tohold, and one that you’ll want to closeout. Especially as expiration nears, andtime value drops quickly, you shouldmonitor your positions in case they passyour predetermined point for exercise orfor closing out. Time decay may work foror against you as the option gets closerto expiration, depending on the status ofyour option.Another important timing factor isthe exercise cut-off your brokerage firmimposes before expiration. This meansyou can’t wait until the last minute todecide whether to exercise your optionor close out a position. Check with yourbroker ahead of time to determine thefirm’s trading and exercise deadlines.If the stock price is between$90 and $92• The option is in-the-money—orat-the-money, if the stock is exactly$90—but exercising it and then sellingthe shares won’t provide enough profitto offset the cost of the premium. If youwant to own the LMN shares, exercisingit allows you to purchase them, andyou might gain back your $200 in thefuture, if the stock rises.• You can sell the option, hoping to earnback some of the premium you paid.• You can let the option expire, losing$200. This may be the mostcostly exit, inthis case.If the stock price isbetween $88 and $90• The option is in-the-money—orat-the-money if the stock price isexactly $90—and might be exercisedat the discretion of the put holder. You’llhave to buy the shares at $90, but thepremium reduces your net price paidto $88 a share, so you could stillsell them on the market for asmall profit.• You could buy the option back,and you may or may not have topay as much as you received for it.• The option could expire unexercisedif it is at-the-money, in which casethe $200 would remain your profit.If the stock price is lessthan $90• The option is out-of-the-money,and exercising it would meanpurchasing shares at more thantheir market value. You’d losemoney on top of what you spenton the premium.• If there is any time value left,you can sell the option to partiallyoffset what you paid for it.If the stock price isabove $90• The option is out-of-the-money,and most likely will notbe exercised.You keep the$200 asyour profit.©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESRolling Up, Over, and OutIf you don’t want to exit,you can roll into anotheroptions series.If you’ve been successfully earning income bywriting covered calls and would like to extendthat strategy over time, or if your optionsstrategy hasn’t worked out as you planned butyou think your initial forecast still holds true,you might consider rolling your options.Rolling means first closing out an existingposition, either by buying back the option yousold, or selling the option you bought. Next,you open a new position identical to theold option but with a new strike price,new expiration date, or both. If youare long an option, and you rollwith enough time remainingbefore expiration, your oldoption will have some timepremium left, which meansit’s likely that you can earnback some of what you paid.But on the opposite side,if you write a covered call,rolling might reduce yourprofit from the initialtransaction. But youmight roll anyway, ifyou don’t want yourstock called awayfrom you.WHEN TO ROLLDeciding when to roll an optionsposition depends on several factors,including the costs involved, and yourmarket prediction.• As a covered call writer, youmight roll down or out to extendyour successful strategy andmaintain the income provided bythe premiums you receive• If you use long puts to hedge yourinvestment, rolling your optionsto ones with later expirations mayextend the protection you seek• You might also consider rolling ifa strategy you chose hasn’t beensuccessful, but you think thatyour prediction for a stock’smovement is applicable forthe coming monthsROLLING UPIf the new positionyou open has the sameexpiration date but a higherstrike price, you’re rolling up. Youmight roll up if you’ve written a coveredcall on a stock that has increased in price,and you’d like to maintain your shortoptions position—or continue to generateincome—without having your stock calledaway from you. Rolling up also appeals tocall holders who have a more bullishmarket forecast on the underlying stock.For example, say you think thatEFG, a stock that’s trading at $16,will increase in price in the nextfew months.You buy a call with a strike price of $15,for a premium of $200.As expiration nears, EFG has risen andis trading at $19. Your call is now worth$550. But you think EFG will continue torise, so you decide to roll your call up.$550 Received from sale oflong call– $200 Purchase of call= $350 ProfitYou purchase a new 20 call with a laterexpiration, paying $300. You earned $350by closing out the older call, a profit thatoffsets the cost of the new call, leaving youwith a net credit of $50 on the transaction.$350 Profit from existing call– $300 Purchase of new call= $50 Net profit of rolling up41©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESROLLINGDOWNIf the new position youopen has the same expirationbut a lower strike price, you’rerolling down. This strategy might appealto investors who’d like to receive incomefrom writing calls on a stock for whichthey have a long-term neutral prediction.For example, say you write acovered call on stock JKL.You predict it will be neutral or fallslightly below its current trading price of$74, so you write an 80 call, and receive$250 in premium. As expiration nears,the stock price has fallen to $72, and yourshort call is still out-of-the-money. Thatmeans it will likely expire unexercised,leaving you a $250 profit. But you thinkthe stock will remain neutral or fall in thenext few months, and would like to repeatyour profitable trade.You buy back the option you sold for$50, locking in a profit of $200. You thensell a 75 call and receive $150 in premium.$250 Received from long call– $50 Purchase of call= $200 Profit+ $150 Received from newlong call= $350 Total cash plus profitfrom rolling downWhen rolling down a covered call, it’simportant to keep an eye on the priceyou paid when you initially bought thestock. If the market price falls nearyour original cost, it may make sense toconsider closing out your position andselling the stock. But, if the price hasfallen below your initial cost but beginsto rise, you might have to scramble andbuy back your call.word to THE WISEWhile rolling may be used effectively toincrease your profits, it’s important to makesure that you base a decision to roll on yourresearch and market forecast. If you chosea strategy and the stock moved against you, it’spossible that rolling out—or up or down—could makethat strategy profitable. But if you roll out of frustrationwith an unsuccessful strategy, you’re just committingmore capital to a misguided trade. If you’re notconfident about what will come next, it mightbe better just to cut your losses and exitthe strategy.ROLLING OUTIf the new position you open has the samestrike but a later expiration date, you’rerolling out. If your options strategy hasn’tyet been successful but you think you needmore time for it to work, or if it has beensuccessful and you think it will continue tobe in the future, you might roll out.For example, say you purchased100 shares of LMN stock for$44 a share.At the same time, you purchased aprotective 40 LMN put to prevent lossesof more than $4 a share. You paid $100 forthe protection.As expiration nears, LMN is trading at$45, but you still think there’s a chance itwill fall below $40 in the coming months.You sell your out-of-the-money put for $50,earning back some of what you paid for it.You purchase a new 40 LMN put with alater expiration for $100, and extend yourdownside protection at a net cost of $150.– $ 100 Purchase put+ $ 50 Received from put= – $ 50– $ 100 Purchase of new put= – $ 150 Total cost©2013 by Lightbulb Press, Inc. All Rights Reserved.42

INVESTING STRATEGIESIndex OptionsYou can balance your portfolio by investing in options ona stock index, which tracks an entire market or sector.Index options are puts and calls on a stockindex, rather than on an individual stock.For many investors, the appeal of indexoptions is the exposure they provide tothe performance of a group of stocks.Holding the equivalent stock positionsof one index option—say the500 stocks in the S&P 500—wouldrequire much more capital andnumerous transactions.Another attraction is thatindex options can be flexible,fitting into the financial plans ofboth conservative and more aggressiveinvestors. If you’ve concentrated yourportfolio on large US companies, youmight sell options on an index thatcorrelates to your portfolio to hedge yourinvestments. Or, if you feel that thebiotech industry is headed for recordgains, you could purchase a call on theBiotech Industry Index.Most index options are European style,which means they can only be exercised atexpiration, not before.hedging your portfolioConservative investors may use indexoptions to hedge their portfolios. If yourportfolio drops in value, an index that correspondsto the movement of your portfoliowill drop as well. By purchasing a put onthat index, you’re entitled, at expiration,to an amount of cash proportionate to thedrop of the index below the strike price.For example, say you have $100,000invested in a portfolio that contains someof the larger stocks in the broad-basedXYZ Index, which is currently trading atabout 950. You’d like to protect yourself1,0501,000950900850800TIMEOUT-OF-THE-MONEYIN-THE-MONEYagainst a loss of more than 5%, or $5,000.You purchase a 900 put on the XYZ Index.In the next few months, your portfoliodrops in value by about 10%, to $90,000.Since XYZ has a similar makeup, it has alsodropped by a little more than 10%, to 850.Your put is now in-the-money by 50 points,and at expiration you receive $5,000 minusthe premium you paid for the put and anysales charges. Your overall loss is reducedto about $5,000, or 5%, which was yourpredetermined acceptable level. Keepin mind, though, that what you pay forthe put affectsyour return.If the indexdoesn’t drop beforeexpiration, youroption will remainout-of-the-money orat-the-money. Youcan decide whetherto extend yourhedge by buyinganother option witha later expiration,or rolling out.EXPIRATIONThe 900 putreduces thetotal loss by 5%43©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESusing leverageIndex options also appeal to investorsbecause of the leverage they provide.Investors can participate in moves fora fraction of the cost of purchasing theequivalent assortment of stocks. And evena small change can result in large percentagegains. The downside of leverage, ofcourse, is that if the market moves againstexpectations, the percentage loss can behigh, and might be all of your investment.The leverage of index options alsomeans that if you’re confident a certainsector is going to make gains, but youdon’t know which individual stock willrise, you can purchase an index call tobenefit from the broader market shift.what’s the risk?The risk of buying index options is thesame as the risk of buying stock options:It’s limited to the amountof premium you pay. Ifyou’re consideringbuying a put, it’simportant to weighthe cost of hedgingyour portfolio againstthe benefits of the hedge.Index options writers,however, face substantialpotential risk. Since the value of the indexmight drop suddenly, a put writer mightowe a lot of cash. The same risk applies toa call writer, if the index increases sharply.And index call writers usually can’t coverthemselves by holding the underlyinginstrument, as they can with individualstock options.margin considerationsThe margin requirements are differentfor writing index options than forwriting options on individualequities. In general, you initiallyneed to deposit the entire premium,and at least 15% of the contract’saggregate value, or the level ofthe index multiplied by $100, in yourmargin account. Since the aggregate©2013 by Lightbulb Press, Inc. All Rights Reserved.how much insurance?If you’re using index puts to hedge yourportfolio, you’ll have to calculate thenumber of contracts to purchase in orderto match the size of your portfolio.Determine the current aggregate1value of the index option:______ Current index valuex $100= Aggregate valueDivide the value of your portfolio2by the aggregate value.______ Your portfolio’s value÷ Aggregate valuefrom above=The result is the number of contractsthat will protect your entire portfolio.Once you’ve determined the numberof contracts that will cover your portfolio,you should calculate how much downsideprotection you want. The strike price youchoose should match that amount, so thatthe insurance will kick in if the index dropsthat far. For example, if you want to protectagainst a decline greater than 10% in yourportfolio, your strike price should be 90%of the current value of the index, whichwould be the value of the index if it drops10% from current value.value of an index option changes daily,the amount of the margin maintenancerequirement fluctuates, which meansyou’ll need to pay close attention to youraccount to avoid a margin call.If your goal is to hedge your portfolio withindex puts, the key is to find an index thatmirrors the movement of your portfolio.Otherwise, what happens to the index won’taccurately reflect what happens to yourportfolio, and you may not offset any ofits declining value. The first step is to findindexes that cover the same market or sectoras your portfolio. Once you’ve narrowedyour choices, you might use the past performanceof an index or judge its volatility tofind one that closely mirrors your portfolio’smovement. But unless yourportfolio exactly matches themakeup of an index—whichis very unlikely—you’llalways face the risk that itwon’t move the same wayyour portfolio does.44

INVESTING STRATEGIESTax ConsiderationsYou can’t ignore the tax implications of trading options.Capital gains you realize on investmentsyou sell—whether they’re stocks, bonds,or options—are taxable unless you ownthem in a tax-deferred account or they’reoffset by capital losses. The rate at whichthose gains are taxed depends on how longyou own the investment before you sell.The long-term capital gains rate appliesto investments you’ve held for longer thana year. Through 2008, that rate is 15% fortaxpayers whose regular bracket is 25%or higher. Taxpayers in the 10% or 15%tax bracket face only a 5% tax on theirlong-term gains.The short-term rate applies to investmentsheld less than a year. Any gains yourealize on those investments will be taxedat your regular income tax rate, which maybe significantly higher than the long-termgains rate. Most options transactions fallunder the short-term category.Any capital gains tax you pay is basedon your overall gains for the year, whichmeans that if you make a profit on oneshort-term investment, but lose money onanother short-term investment, you canuse that capital loss to offset all or part ofyour capital gain, reducing the amount oftax you’ll pay. The same is true for longtermgains and losses. And for options,the premium and transaction costs arefactored in to your gain or loss.TAXING INDEXESFor certain index options, the rules are alittle different. The IRS considers broadbasedindex options—such as the DJIAor the S&P 500—to be nonequity options,and you’ll have to report them on adifferent form when you complete yourtax return. All broad-based index optionsare subject to the 60/40 rule, whichmeans that 60% of your gain or loss istaxed at the long-term rate, and 40% is60/40taxed at the short-term rate.Additionally, if you have an openposition in a broad-based index option atthe year’s end, you’re required to mark tomarket, or calculate the option’s value asif you sold it on the last business day ofthe year. You then include that unrealizedgain or loss in your tax filings—even ifyou continue to hold the option into thenext tax year. When you do close out theWHAT’S THE TERM?For stocks, calculating whether you’ve heldan asset for more than a year or less than ayear is a simple matter of comparing thepurchase date to the sale date.For long options positions, therules are similar.If an option you hold expires or you closeit out, the amount of time you held the optiondetermines whether your gain or loss is shortterm or long term.For short positions, however, the matter is a bitmore complex.• If your short position expires unexercised, the premium you receive isa short-term gain, regardless of how long the position existed. Thispremium is taxable in the calendar year the option expires, whichmight not be the year you receive the premium. That means youmight have more than a year to enjoyyour profit without paying taxes on it.• If you close out your short position,your gain or loss is short term.• If you are assigned on your shortoption, the term of the gain or lossdepends on a number of items. Youshould consult your tax adviser andreview the Taxes and Investing bookletat www.888options.com.45©2013 by Lightbulb Press, Inc. All Rights Reserved.

INVESTING STRATEGIESFor more detailed information, youcan download a free booklet calledTaxes and Investing from OIC’s website,www.OptionsEducation.org.position, you’ll be taxed on any gain orloss realized from the beginning of the taxyear, not from the opening of the position.Options on market or sector indexesthat are narrow-based are not subjectto the 60/40 rule or the mark to marketrequirement. Instead, gains and losses arecalculated and taxed in the same way asequity options.KEEP GOOD RECORDSYou’re required to report all optionstransactions, whether you realize a gainor loss, to the IRS. When it comes timeto calculate your taxes, it will be easierif you have a written record of all thepositions you opened and closed over thepast year. That includes any confirmationsor receipts you receive that detail thepremium paid or received, transactioncosts, the date the position was opened,when and how it was closed, and any gainor loss produced. You should also holdonto any account statements you receivefrom your brokerage firm. Most expertsrecommend that you keep thesedocuments for three years after youfile, which is the normal time limit forthe IRS to audit your return.THE FORMS TO USESchedule D. The form on which youtally your capital gainsand losses, both shortterm and long termForm 6781. The formon which you report gainsor losses on straddles,options that are subjectto the 60/40 rule, orthe mark to marketrequirementWORKING WITH ATAX ADVISERMany options investors work with professionaltax advisers when calculating theirtax returns and when considering openingor closing options positions. Since exercisingan option often involves a transferof stock, options have tax consequencesnot only for your stock portfolio, but yourlarger financial situation as well.For example, a tax adviser can helpdetermine whether it might be beneficialto close out a covered call you wrote ifyou’d face a short-term gain on thatstock were it called away from you. Or shemight point out when you might be ableto use losses to offset capital gains. Whileyou don’t want to make investmentdecisions solely because of theirtax implications, neither doyou want to ignore the impacttaxes can have on yourbottom line.A tax adviser will also helpyou understand the IRSrules as they apply to youroptions positions, and Adviserwill be able to explainthe often complexrules thatapplytocertainoptions strategies,straddles in particular.If you’ve written covered calls, it’s important topay attention to how you report the transaction onyour tax return. You might sell a call in Novemberof one year, and buy it back in January of thenext. That means your sale date comes beforeyour buy date, which is the opposite of mostinvestments. If you get confused, you mightmake an error on your tax return, so be sureto keep good records and double-check theforms before you submit them.©2013 by Lightbulb Press, Inc. All Rights Reserved.

esearch and informationTrading OptionsWhen you’re choosing a brokerage firm, consider thetools and the expertise at your disposal.There have been some major changes inequity options investing since the mid-1990s. Thanks to the Internet, you haveeasier access to a wide range of timelyinformation that allows you to researchunderlying investments on which optionsare available, track real-time or near realtimeprices changes, and follow tradingactivity in contracts that interest you.You also have a broader selection ofbrokerage firms to handle your orders.They range from traditional full-servicefirms to discount firms that operateexclusively online. Some firms specializein options, while others offer optionsaccounts in addition to regular brokerageaccounts. If you choose an online firmor an online account with a traditionalfirm, you should ask how you’d trade if theInternet connection isn’t working. Manyfirms offer phone service, though it maycost more to trade that way.EXECUTING A TRADEDepending on the firm you use, you’ll find differences in the cost of trading and your access toprofessional advice. But whether you enter your options trading order yourself using your onlineaccount or you telephone your order to your broker, you put the same process in motion.1Initiate a trade2Confirmyour orderIn order to initiate a trade, you providethe details of your trade, which include:• The symbol of the option or theunderlying stock• Whether you’re buying to open, buyingto close, selling to open, or selling to close• Whether you want a put or callThe strike price• The expiration date• A specific buy or sell price, or a market order to buy orsell at the current market price• Whether you’d like to use a cash account or a margin account• With some brokers, you can request a multi-part transaction,such as a spreadThe next step isconfirming your orderbefore it is placed,double-checking theinformation displayedonline or repeatedback to you by yourbroker to make sureit’s correct.SPECIAL CONSIDERATIONSIf you’re just beginning to trade options,you may want to work with an experiencedinvestment adviser at a full-servicefirm who can advise you on the optionsstrategies or the specific contracts thatmay be most appropriate for you. Or, ifyou’d prefer to trade on your own, youmay want to choose an online firm.The first step is often to ask yourother professional advisers, friends,or colleagues who trade options forreferrals. You can check the OIC website,www.OptionsEducation.org, for a list offirms, and you can use the SEC’s EDGARdatabase (www.sec.gov/edgar.shtml) tosearch for information and regulatoryfilings on any firm. If you’ve alreadyopened an account with a brokerage firmbut you’re not satisfied with the toolsthey offer or the execution of your orders,shop around.You can find reviews of brokeragefirms in financial publications, and somefirms’ websites allow you trial access totheir account holder services. You mayalso want to compare the range ofservices offered by several firms. Forexample, some brokerage firms offer awide variety of educational information,and others have more experienceexecuting complex transactions.47©2013 by Lightbulb Press, Inc. All Rights Reserved.

esearch and informationCOMPARATIVE TOOLSIn order to be competitive, many brokeragefirms offer their customers advancedtools and technology to help themresearch and track securities and strategies.You might have access to some orall of the following tools through yourfirm’s website:Options calculator. If youenter the details of a particularoptions trade, thiselectronic tool can calculatethe potential profit and lossof adopting the strategy, aswell as your breakeven pointand any margin requirement.An options calculator can also be used todetermine the Greeks for a particularoption and the annualized returns forvarious strategies, which allows you tocompare options strategies with differenttime periods.Options screener. Youcan find specific optionsthat match a strategy, aparticular market forecast,or other condition. Forexample, if you were looking for optionswith a very high implied volatility, anoptions screener would providea list of options with the highestimplied volatility.Options chains. If you select aparticular stock or stock index, youcan see a chart of all put and callseries offered on it, the delayedor real-time premiums, and othercharacteristics such as volume andopen interest.Options information. You canresearch options, finding outabout underlying stocks and stockindexes, as well as price history,volatility, and other data.3 Receive4 Execution5confirmationMonitorstatusAfter submitting theorder, you shouldreceive a confirmationthat it has beenplaced—but notyet executed. Theremay be a lapse betweenwhen your order is placed andwhen your brokerage firm canfill it. Some firms’ websites offeran order status page, whereyou can view your executedorders and any current,pending orders.When your option order hasbeen executed—it may be amatter of minutes or severalhours, depending on the typeof order—you should receive anotification that will include theprice at which it was executed.Because most options are nottraded as heavily as most stocks,execution can take longer.You can monitor the statusof your options positionsthrough your brokeragefirm’s website.THE LANGUaGE OF ORDERSThere are ways to restrict an order youplace if you’d like it to be executed onlyat a certain price, for example, or withina specific period of time. A limit orderrestricts the transaction to the highestprice you’re willing to pay if you’re purchasing,or the lowest price you’re willingto accept if you’re selling. As with stockorders, if the market has passed yourbuy limit, your order will not be filled.The opposite of a limit order is a marketorder, which means you’re willing to paywhatever the market price is at the timeyour trade is entered.Most orders are day orders, whichmeans they will be automatically canceled©2013 by Lightbulb Press, Inc. All Rights Reserved.if they’re not filled by the end of thetrading day. Alternatively, you might placea good ‘til canceled order (GTC), whichmeans it is pending until your brokeragefirm fills the order, unless you cancel it.Some brokerage firms have 90-day limitson GTC orders, so check with yours fortheir policy.A stop-loss order is a request toautomatically close your options positionif its price moves beyond a certain predeterminedlevel. Stop-loss orders are oftenused on stock transactions to stem lossesif prices drop dramatically. Some brokeragefirms allow stop-loss orders on options.48

esearch and informationOptions Information SourcesThe smart approach is to prepare for trading byresearching your options.The key to smart investing is beingwell informed. As an options investor,this means you’ll want to research theunderlying stock for a particular optionsseries, as well as the options class andthe overall market. While this takes timeand requires effort on your part, the goodnews is that the information you needis readily available through a variety ofsources—and much of it is free.LOOK ONLINEToday, most options investors use theInternet as a source for at least someof their research. The Internet is easyto access for most people, much of theinformation is free, and news is almostalways up-to-date, since financial websitesare updated frequently. Even thoseinvestors who don’t give their buy andsell orders online can research optionsand underlying stocks on the Internet.• OIC’s website, www.OptionsEducation.org, and OCC’swebsite, www.theocc.com, bothprovide generaloptions education,plus industry-widevolume, openinterest, contractadjustments,SEC filings, andexpiration cycles,among other topics.• The websites of theoptions exchangesoffer informationon the options theylist as well as realtimeand delayedquotes, volume,and open interest.• Both online andtraditional fullservicebrokeragefirms offer theirclients websiteaccess to information about specificoptions and strategies, as well asanalysis and recommendations.COLLEAGUES AND FRIENDSDon’t neglect your personal connectionsand business contacts when researchinginvestments. Discussing options and financialmarkets with colleagues and friends letsyou compare other perspectives with yourown. Someone else’s investing experiencemight serve as a cautionary tale or introduceyou to a particular investment or a certainmarket sector that you might not haveinvestigated on your own. And if you knowpeople who have been investing longeror more successfully than you have, youmight be able to learn a lot from them.Don’t forget, though, that a tip froman acquaintance is never a substitute fordoing your own research. Ultimately,you’re responsible for all of yourinvestment choices.• A range of commercialsites areexclusively devotedto options information.Most of theseare accessible bypaid subscriptiononly, so you’ll haveto use your ownjudgment to decidewhether their educationand analysis isreliable and worthpaying for.• Many of theleading financialinformation sitesoffer substantialdata as well. Thesesites are usuallyfree, and includeMarketWatch(www.marketwatch.com) andYahoo! Finance(http://finance.yahoo.com).When using the Internet for research,it’s important to be discriminatingabout the reliability of a source, just asyou would when using any investmentresearch. You can find a list of reputable49©2013 by Lightbulb Press, Inc. All Rights Reserved.

esearch and informationoptions websites atwww.OptionsEducation.org.They might serve as goodstarting points foryour research.CHECK OUTTHE PAPER?Newspapers areanother resourceto consider, butthe informationthey offer may notbe as timely or ascomprehensive as thenews on the Internet.In the financial section of anewspaper, you may be able to finda summary of the previous day’s optionstrading—including volume, open interest,and premiums—for some of the mostpopular options.If you’re lookingfor informationabout a particularoption,it might behard to find, since the space devoted tooptions in a newspaper is increasinglylimited. But you can check online editionsfor recent articles. Financial newspapersare more likely than general newspapersto have options information.If you’re interested in learning aboutoptions but aren’t ready to start trading,a daily scan of a newspaper’s financialsection can be a good way to see howthe market moves, and familiarize yourselfwith the way options informationis presented.SUBSCRIBING TONEWSLETTERSFinancial newsletters are anotherpopular source of options information.Most options newsletters are paid servicesthat offer subscribers a periodic updateon options news, educational information,and specific recommendations on optionsand strategies. Some newsletters areprinted, while others are only availableonline or delivered by email. Newslettersare usually written by options expertswho offer their opinion and analysis—butwho can’t guarantee the success of anystrategy. Some newsletters are tailored tothe needs of specific groups of investors,so it’s important to look for one that suitsyou, as well as one you trust to deliveraccurate, reliable analysis.PUT ABROKER TO WORKIf you already work with a brokerage firm,you might be able to find options informationand analysis through their website oroffice, just as you might when researching astock purchase. If your brokerage firm specializesin trading options, they are likely tohave a greater wealth of resources for you.Even if the firm focuses primarily on stocks,you might be able to use their research onan option’s underlying instrument. But it’sa good idea to support that research withoptions-specific information.If you’re comfortable working withyour broker for research and analysison your other investments, it might makesense to do the same for options researchas well. You should check first, however, tofind out whether your broker has optionstrading experience.A DISCRIMINATING READERNewsletters and online columnsoften provide an analysis of optionsinformation and recommend specifictrades and strategies based onthat analysis. They can also be goodplaces to learn more about individualbenchmarks or indicators, andhow to use them as the basis forcreating strategies. If you subscribeto a newsletter or regularly read anonline options column—and youconsider it to be a trustworthysource of analysis—you can usetheir recommendations as a startingpoint. But you should always doyour own independent researchto see if the information you comeacross backs up any assertions orpredictions they’ve made.©2013 by Lightbulb Press, Inc. All Rights Reserved.50

esearch and informationApplying OptionsInformation and AnalysisOnce you do your research,put it to work for your portfolio.There’s a wealth of information about tradingoptions at your fingertips. But the sheeramount often seems overwhelming. So youneed to know how to use that information tocreate options strategies.USING BENCHMARKSBenchmarks are measurements that youcan use to judge the relative position of thesecurity you’re interested in, compared tothe market. One benchmark many optionsinvestors use is the CBOE Volatility Index,which is commonly known by its tickersymbol, VIX. In the same way that stockindexes are compilations of stock prices, VIXis a compilation of the implied volatilities ofS&P 500 index options. You can use VIX as abenchmark to measure how volatile investorsfeel the S&P 500 index—and by extension,the stock market—will be. In general, a higher volatility indicatesa bearish market sentiment, though there are exceptions. And keepin mind, that’s only how investors predict the market will behave.The actual market movement may or may not match predictions.pricing modelsAnother benchmark you can use to analyze options is an options pricingmodel that estimates the theoretical fair value for a given options position.In 1973, three mathematicians—Fischer Black, Myron Scholes, and RobertMerton—published their formula, known as the Black-Scholes model, forcalculating the premium of an option, accounting for the variety of factorsthat affect premium. You can find the actual formula on many optionswebsites, but what’s most important to know are the variablesthat go into the formula. These are the variables affecting anoption’s premium:©2013 by Lightbulb Press, Inc. All Rights Reserved.

esearch and informationWHAT’S THE INDICATION?Indicators are part of a technical analysistoolbox. A variety of different data andmeasurements can serve as indicatorsof larger market trends and movement.For example, the put/call ratiois an indicator used to measuremarket sentiment. The ratio issimply a comparison of thenumber of put contracts openedand the number of callcontracts opened.Since puts are usuallya sign of a bearish marketforecast, and calls are usually asign of a bullish forecast, when investorsbuy more puts than calls, it’s an indicationthat they anticipate a drop in a particularstock or the broader market. Many optionsinvestors tend to be contrarians, and view negativemarket sentiment as a buying opportunity.BE CONSISTENTWhatever benchmark, indicator, or analysis you rely on to shape youroptions strategies, it’s important that you determine which informationis important to you. If you choose one or two pieces of data as indicatorsor benchmarks, be consistent and stick with them over the long term.That way, you can easily track the small number you’ve chosen, rather thanbeing overwhelmed by trying to follow every piece of market data available.Consistency is also important when you’re evaluating your options positions. Say youbought an option because your research and calculations indicated it was undervalued,and you think its premium will go up. But you’ve recently looked at 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 inplace for evaluating whether to close the position, based on the samebenchmark or indicator that prompted you to open the position.If you’re consistent in how you evaluate positions, you’ll be moreconfident when deciding whether to hold a position, orexit and cut your losses.The Black-Scholes formula, thoughperhaps the best known, isn’t the only methodfor computing an option’s theoretical value. Equityoptions are typically priced usingeither the Cox-Ross-Rubensteinmodel, which was developedin 1979 for American-styleoptions that allow earlyexercise, or the Whaleymodel. Inputs to anyof these models can betweaked, or manuallyadjusted, to illustrate theimpact of stock movement,volatility changes, or other factors that mayinfluence an option’s actual value. For example,you could adjust the quantities of a potentialspread to see how that change would affect thedelta, gamma, and other Greeks.©2013 by Lightbulb Press, Inc. All Rights Reserved.The limitation of all pricing models is thatactual premiums are determined by marketforces, not by formula—no matter howsophisticated that formula might be. Marketinfluences can actually result in highly unexpectedprice behavior during the life of a givenoptions contract.But while no model can reliably predict whatoptions premiums will be available to you orother investors at some point in the future, someinvestors do use pricing models to anticipate anoption’s premium under certain future circumstances.For instance, you can calculate how anoption might react to an interest rate increase ora dividend distribution to help you better predictthe outcomes of your options strategies.52

esearch and informationReading Options ChartsOptions tables look a lot like stock tables, but there areimportant distinctions.If you research options in a newspaper,you’ll need to be familiar with optionscharts, which list information andstatistics from the previous trading day.The options information you’ll find innewspapers isn’t as comprehensive aswhat’s available online, since only themost active options are listed, butnewspapers may still be a good resourcefor an overall view of the market.NEWSPAPER OPTIONsTABLESA list of options beginning withthe closest expiration date andlowest strike price appears afterthe name of the underlyinginstrument. Often, the samemonth appears several timeswith different strike prices,but with the groupings byprice rather than date. Forexample, since JK Industrieshas options at 40 and 42.50,the 40s are listed first,followed by the 42.50s.Calls are listed separately fromputs. Some days only a call ora put will trade for a particularstock or index. In that case,an ellipsis (…) appears inthat column, as it does for theHatchery August 35 puts.The name of the underlyingstock is listed in bold. Somenames are easy to recognize.Other companies are referred toby abbreviations, sometimes thesame ones used in stock tablesand sometimes different ones.You can find the company’s nameusing an Internet search engine.The number in the first column belowthe option name is the most recentmarket price of the underlying stock.In this example, Xerxes traded at$80.79 at the end of the previoustrading day.Information about the most activelytraded options and LEAPS is givenseparately, often at the beginning orend of the options columns.Volume reports the numberof trades during the previoustrading day. The number isunofficial, but gives a senseof the activity in each option.Often, you’ll notice that tradingincreases as the expirationdate gets closer. But manyfactors contribute to tradingvolume, and expiration dateis just one influence.Last is the previous trading day’sclosing price for the option. In thiscase, the Sanchez 17.50 Septembercall closed at 90 cents, or $90 for anoption on 100 shares at $17.50.53©2013 by Lightbulb Press, Inc. All Rights Reserved.

esearch and informationPROFIT AND LOSS CHARTSAs you compare different optionsstrategies, you will probably encountera standard chart for each strategy, meantto help you visualize the potential profitor loss you’d face under different circum-stances, and the point at which you’dbreak even. These charts are available atoptions websites and through brokeragefirms. The following chart illustrates theprofit and loss a call holder faces.LONG CALL13524The vertical axis shows the scale of1profit and loss, measured in dollars.The center of this axis is a breakeven line,where your profit or loss is $0.The horizontal axis, shown in red,2shows the price of the underlyingstock: The farther to the right, the higherthe stock price.The blue arrow tracks the profit3or loss you’d realize at a particularstock price. If you pick a stock price onthe horizontal axis, and find the height ofthe arrow at that stock price, you’ll havean idea of your profit—or loss. In thiscase, the loss is steady, or flat, for allstock prices below the strike price. Theloss decreases as the stock price risesabove the strike price—but you don’trealize a profit until the stock pricemoves past the breakeven point.The strike price you choose4determines where the profit andloss line bends, since if the stock is belowthat price you’ll face a loss. Above thatprice your loss drops until you begin torealize a profit.Your breakeven point is the5stock price at which you’ll neitherlose money nor make a profit on theinvestment. With a long call, the breakevenpoint is to the right of—or higherthan—the option’s strike price. Sincethis strategy calls for spending money topurchase the option, you’ll have to earnback the premium before you can realizea profit. If this chart were for call writing,your breakeven point would be to theleft of—or lower than—the strike price,since premium received would partiallyoffset loss.USE ‘EM OR LOSE ‘EM?While it’s possible to graph a profit and losschart using the numbers from a specific purchaseor sale you’re considering, many investorsuse generic profit and loss charts to get anoverview of what will happen as the underlyingstock price increases or decreases. If you’dlike to be able to visualize your strategies, thistool might be helpful. You can find profitand loss charts for each of the basicoptions strategies on the OIC website,www.OptionsEducation.org. What a chart canhelp clarify is whether a strategy’s potentialfor gain or loss is limited, as it is with a spread,or unlimited, as with long or short calls.©2013 by Lightbulb Press, Inc. All Rights Reserved.54

esearch and informationOptions ChainsLearn how to translate the specialized options toolsyou can find online.Instead of options tables, many websitesoffer options chains or options strings.You select a particular underlying instrument,and can see a chain of all theoptions currently available, so that youcan compare the prices for calls and puts,different strike prices, and differentexpiration months.You can choose whether to displayall option strike prices, or only thosethat are in-the-money, at-the-money, orout-of-money, or any combination of thethree. You can also select the expirationmonths to be displayed and whether toinclude LEAPS or not.In addition to price information foreach contract that appears in the optionchain, you’ll find its theoretical value,implied volatility, and a calculation foreach of the Greeks.The uppermost area of the optionchain indicates the name ofthe underlying stock, its tickersymbol, and the primary exchangeon which the underlying stockis listed.Just below you’ll find informationabout the underlying stock,including its current marketprice, its net change up or down,the 52-week high and low, and thestock volume. Options statisticsinclude the average daily optionvolume for the option class aswell as the average open interest.You can find the month, day,and year of option expirationas well as the number of daysuntil expiration.You can find the symbologykey for each availableoption series.The option symbol column indicatesthe option symbol for calls and puts onthe underlying stock. For each strikeprice, the chain will display informationfor calls (C) and puts (P).Bid indicates what buyers arewilling to pay for the option, andask indicates which sellers arewilling to take for the option.Change is a measurement ofthe percentage change in theoption’s price for the day. Apositive number indicates aprice increase, while a negativenumber indicates a decrease.55©2013 by Lightbulb Press, Inc. All Rights Reserved.

esearch and informationBID AND ASKThe bid is the price that a buyer is willing to payfor an option, and the ask is the price that a selleris willing to accept. In general, the two prices areslightly different, and the gap between them isknown as the spread. So how does that affectindividual investors?When you buy or sell an option—or astock—you’re possibly buying from and sellingto a market maker. One role of market makers isto provide liquidity in the marketplace, making iteasier to buy or sell one or more options withoutchanging the market price. One way marketmakers can profit is by buying option contractsat the current bid price and selling them at thehigher ask price. Without a change in the underlyingstock price, they may make a profit from thespread of only a few cents per contract. But theymay trade in high volume every day, so the smallprofits can add up.As a rule of thumb, the more actively tradedan option is, the smaller the spread will be. Butthe bid and ask spread for any particular optioncontract may vary on the different exchangeswhere the contract is listed. So option brokersfocus on getting their customers the best executionprice among the various exchanges where theoption is traded.Volume is the current number ofcontracts traded for each option seriesduring the trading day. Some optionchains allow you to view only optionswith a certain daily volume.Implied volatility is thevolatility percentage thatproduces the best fit for eachoption series.Open interest indicates the totalnumber of open contracts outstanding.©2013 by Lightbulb Press, Inc. All Rights Reserved.56

esearch and informationOption Symbology andSourcesIn 2010, the options industry overhauledthe way it identifies exchange-listedoption contracts, creating a simpler, morestandardized symbology. The method itreplaced, which had been in use sinceexchange-trade options were introduced in1973, was confusing to both investors andoption professionals and commonly led tobookkeeping and order entry errors.OCC and the various US optionexchanges use the new symbology toidentify option contracts. Brokeragefirms use it to identify and track optionpositions in your account. And youmay see symbology keys on your tradeconfirmations and monthly statements.DECODING SYMBOLOGYWith the new methodology, an option series canbe identified and distinguished from all otherseries by its formal symbology key. Each of thesespecific keys contains the same four elements:• Option symbol. It is generally the sameas the ticker symbol of the underlying stock.• Expiration date. It is identified by itsexplicit year, month, and day.• Option type. Call contracts are identifiedwith “C” and put contracts are identifiedwith “P”.• Strike price. Strike prices are expressedto two decimal places representing dollarsand cents.Here’s an example of the four pieces ofinformation strung together to form a symbol key:XYZ is the option symbol that specifies theunderlying stock11 06 18 isthe contract’sexpiration dateof June 18, 2011C indicates theoption is acall contractThe option’sstrike priceis $50.00THE MORE THINGS CHANGEDepending on the source, you might findsymbology keys displayed in differentformats, but with the same four piecesof information identifying the sameoption contract.XYZ 11 06 18 C 50.00XYZ 11/06/18 C 50.00XYZ 110618C00050000XYZ 11/06/18 Call 50.00XYZ June 18 2011 C 50.00XYZ June 18 2011 Call 50.00PLACING OPTION ORDERSYou’re responsible for entering the correctorder information for the specific call orput you want to trade. But you may or maynot need to use the appropriate symbologykey. Many brokerage firms allow you toplace orders directly from option chainson their website, by simply clicking on thekey for the option contract you want tobuy or sell.But if you have any questions aboutthe symbology key or another other datayou’re entering, it’s important to checkwith your firm before placing your order.Getting the details right is ultimatelyyour responsibility.57©2013 by Lightbulb Press, Inc. All Rights Reserved.

esearch and informationINDUSTRY ORGANIZATIONSThe Options Industry Council (OIC) andOCCOne North Wacker Drive, Suite 500Chicago, IL 60606Email: options@theocc.comToll-free: 888-OPTIONS (888-678-4667)You can call OIC and OCC toll-freeto speak with experienced representatives.While they don’t provide investmentadvice, they can answer options-relatedquestions you might have—whether aboutthe basics of options trading or about aspecific, advanced strategy.OIC websitewww.OptionsEducation.orgLearn about options and strategies, findfree educational seminars near you, andget the latest news on options trading atthe OIC website.• Take online classes on options trading• OIC offers a printable online glossarydefining all of the terms commonlyused in options tradingOCC websitewww.theocc.comOn the OCC website, you can findeducational tools and volume information,as well as a database of all listed options.You can view an options symboldirectory, new listings, and contractadjustment memos.FINRAwww.finra.orgYou can find resources about a varietyof securities on the website of theFinancial Industry Regulatory Authority.• Find tips for protecting yourinvestments and avoiding fraud• Learn about the markets and othereducational topics• You can also use the FINRA websiteto check the background of abrokerage firm or brokeryou’re consideringSecurities and Exchange Commission(SEC)www.sec.govThe SEC is a government agency thatregulates the securities industry andprotects individual investors.You can also research individual companiesusing EDGAR, a database of themandatory corporate reports and filings.THE EXCHANGESThe websites for OIC’s participantexchanges offer directories of all theoptions they list, as well as the latesttrading data, delayed and real-timequotes, product specifications, and anexpiration calendar for those options.The exchanges also provide marketinformation for the stock, index, or otheroptions that they list, their official tradinghours and their trading technology.In addition most of these websites offereducational tools, the latest options news,explanations of basic options information,and details about a variety of optionsstrategies. You can also find profit andloss diagrams, stock charts, links todownloadable documents and brochures,glossaries of options terms, answers tocommonly asked questions, and links tooutside resources.BATS Options Exchange913-815-7000www.batstrading.comBOX Options Exchange866-768-5600www.bostonoptions.comC2 Options Exchange, Inc.312-786-5600www.c2exchange.comChicago Board Options Exchange(CBOE)312-786-5600www.cboe.comInternational Securities Exchange (ISE)212-943-2400www.ise.comMIAX Options Exchange609-897-7300www.miaxoptions.comNASDAQ OMX PHLX212-401-8700www.nasdaqomx.comNASDAQ Options Market212-401-8700www.nasdaq.comNYSE Amex Options212-306-1000www.nyse.comNYSE Arca Options312-960-1696www.nyse.com©2013 by Lightbulb Press, Inc. All Rights Reserved.58

esearch and informationStrategy ScreenerYou can screen for strategies based on your risktolerance and market forecast.As you consider whether to add equityoptions to your investment portfolio, youmight find it helpful to review these strategyscreeners. First, if you’ve identifiedan objective you’re trying to achieve—tohedge a stock position, for example, orreceive income—look at the correspondingtable. Next, choose the level of riskthat you’re willing to take. If you’re newto options, you’ll probably want to choosea low-risk strategy to begin with. Finally,find a forecast that fits your expectations,from very bearish to very bullish, either onan individual stock, or on the market as awhole. You’ll find a potential strategy thatfits your particular situation and forecast.These tables are far from comprehensive,but they can be helpful shortcutsto identifying an appropriate optionsstrategy. Once you’ve begun considering astrategy, you’ll have to do some researchon your own to match it with an underlyingsecurity that might work to meetyour objective.EXPIRATION CYCLESIf you’re considering opening an optionsposition on a particular stock, you’ll alwayshave the choice of contracts expiring infour different months. That’s the easy part.What can be a little more complicated isfiguring out which months those are.That’s because there are three factorsat work:Options are always available for the1current month and the followingone. So on January 1, you can buy or selloptions that expire in January and inFebruary on all stocks with listed options.On February 1, you can buy optionsexpiring in February and March for allstocks—and so on through the year.The two other months in which2options on a specific stock expireare determined by the expiration cycleto which the underlying stock is assigned.There are three cycles, beginning inJanuary, February, and March, eachincluding four months, one in eachcalendar quarter. Stocks are assignedrandomly to one of those cycles.So, on January 1, options on a stockassigned to the January cycle would beavailable in April and July, the next twomonths in the cycle, as well as Januaryand February. Those on a stock assignedto the February cycle would be availablein May and August in addition to Januaryand February. Stocks assigned to theMarch cycle would have options expiringin June and September.Due to an approved pilot program,some options may be available for tradingin additional months.59©2013 by Lightbulb Press, Inc. All Rights Reserved.Cycle 1(January)Cycle 2(February)Cycle 3(March)January February MarchApril May JuneJuly August SeptemberOctober November DecemberThe current month’s options expire3on the Saturday following the thirdFriday, and a new options series with anew expiration is added on the followingMonday. If, for example, January 20 werea Monday, new options series expiring inMarch would be added to the January andFebruary cycles, and a new series expiringin September would be added for stocksin the March cycle.If LEAPS are available on an optionsclass, there might be five expirationmonths trading at a given time, in additionto the LEAPS, since LEAPS convert intoregular options with a January expirationin the final year of the contract.If you’d like to find out the availableexpirations for an option class you’reconsidering, you can call 888-OPTIONS,or check on OIC’s website,www.OptionsEducation.org. You can alsocheck the third and fourth expirationmonths of an options chain, whichwill tell you the cycle to which theunderlying stock has been assigned.

esearch and informationspeculate orReceive incomeYour RiskTolerance YourExpectationPossibleStrategy *Low Very bullish Buy out-of-the-moneycallsLow Bullish Buy callsLow Moderately bullish Open bull call spreadLow Neutral or bullish Open bull put spreadLow Neutral or bearish Open bear call spreadLow Moderately bearish Open bear put spreadLow Bearish Buy putsLow Very bearish Buy out-of-the-moneyputsModerateNeutral to moderatelybullishWrite covered calls onstock you ownHigh Neutral to bullish Write naked putsExtremely high Neutral to bearish Write naked callsimprove yourpurchase priceor protectprofitsprofit froma market orsector moveLowNeutral to slightlybullishBuy calls to lock inpurchase priceLow Neutral to bullish Buy-write to reduceyour net price paidLowLowLowLowNeutral, long-termbullishNeutral to moderatelybearishVery bearish,long-term bullishBearish, long-termbullishWrite puts to reduceyour net price paidOpen a collar to lock inpotential gainsBuy putsBuy out-of-the-moneyputsLow Bullish Buy index callsLow Bearish Buy index putsExtremely high Neutral to bearish Write index callsExtremely high Neutral to bullish Write index puts* These strategies are described as possibilities, not recommendations. No strategy is guaranteed success, and you are responsible fordoing adequate research and making your own investment choices.©2013 by Lightbulb Press, Inc. All Rights Reserved.60

glossaryAmerican-style An option that you canexercise at any point before expiration.Equity options are American style.Ask The price that market makers orsellers will accept to sell an option.Assignment When an options holderexercises the contract, an options writeris chosen to fulfill the obligation.At-the-money When the price of theunderlying stock is the same as or closeto your option’s strike price.Black-Scholes formula A pricing modelthat calculates the theoretical value ofan option, based on factors includingvolatility and time until expiration.Breakeven point The stock price atwhich, if you exercise your option, youwould earn back your initial investment.Buyer If you purchase an optionscontract, regardless of whether you’reopening or closing a position, you’rea buyer.Buy-write You simultaneously purchaseshares of stock and write a call onthat stock.Bid The price that market makers orbuyers will accept to buy an option.Call If you buy a call, you hold the right topurchase a certain security at the strikeprice, on or before the expiration date.If you write a call, you face an obligationto sell a certain security at the strikeprice, on or before the expiration date,if the call is exercised.Cash-settled An option contract, usuallyan index option, that requires cash tochange hands at exercise. The exactamount of cash is calculated by a specificformula, using the option’s intrinsic value.Close If you buy or sell an option in orderto offset a position you previously opened,you’re closing.Collar You simultaneously purchase aprotective put and write a covered call.Also known as a fence.Covered call You write a call on stockyou hold. Also known as an overwrite.Day order An order you place topurchase an option that is canceled ifit is not filled before the end of thetrading day.Equity option A contract to buy or sellshares of a stock, an exchange-tradedfund (ETF), or other equity interest at acertain price before a certain time.European-style An options contractthat you can exercise only at expiration,not before.Exercise If you’re an options holder,exercise means you give an order toact on an option, and the options writermust transfer to you or receive from youthe shares of stock—or amount ofcash—covered by the option.Expiration date The date after whichan option is no longer valid, and you canno longer exercise it.Fungible Able to be bought and sold onmultiple exchanges or markets.Good ‘til canceled order (GTC) An orderyou place to purchase or sell an optionthat is valid until it is filled, you cancel it,or your brokerage firm’s time limit on GTCorders expires.Hedge An investment that’s intendedto limit or reduce potential losses onanother investment by returning a profitunder the opposite conditions.Holder If you purchase an option to opena position, you’re a holder.In-the-money When the strike price ofan option is below the market price for theunderlying stock, in the case of a call, andabove the underlying stock price, in thecase of a put.Intrinsic value The value of an optionif you exercised it at a given moment.Out-of-the-money and at-the-moneyoptions have no intrinsic value. Forin-the-money options, the intrinsic valueis the difference between the strike priceand the underlying stock price.Leg Each separate options position in astrategy that calls for you to hold multiplepositions at the same time, such as a spread.Leverage If you leverage, you use a smallamount of money to control an investmentof much larger value.Limit order An order you place topurchase or sell a security or financialinstrument, such as an option, only ata certain price or better.Long When you own a security or option.You might have a long position, or be long.Long-term Equity AnticiPationSecurities (LEAPS ® ) An option whoseexpiration date is between one and threeyears away.Market order An order to purchase orsell an option at its current market price.61©2013 by Lightbulb Press, Inc. All Rights Reserved.

glossaryMark to market This tax rule requiresyou to calculate the theoretical profityou’d earn on an asset if you sold it atthe end of the tax year. You owe tax onthat unrealized gain. This rule appliesto broad-based index options.Married put You simultaneouslypurchase shares of stock and a put onthat stock.Naked call You write a call on stockyou don’t hold.Open If you purchase or write an option,creating a new position on that option,you establish an open position.Open interest The number of contractsin existence in the market on a certainoption.Options chain A tool that lets you seeall the available options for an underlyingstock, including their prices and othertrading data.Options class All the calls or all theputs on an underlying security.Options series All the calls or puts onan underlying stock with identical terms,including expiration month and strike price.Out-of-the-money When a call’s strikeprice is above the underlying stock price,or a put’s strike price is below thestock price.Physical delivery An option that callsfor you to deliver if you’re the writer, orreceive if you’re the holder, 100 shares ofstock at exercise.Premium The price you pay if you’re anoptions buyer, or the amount you receiveif you’re an options writer.Protective put You purchase a put onstock you already own.Put If you buy a put, you hold the rightto sell a certain number of shares at thestrike price, on or before the expirationdate. If you write a put, you face anobligation to buy a certain number ofshares at the strike price, on or beforethe expiration date, if the put is exercised.Put/call ratio A ratio of the number ofputs traded compared to the number ofcalls traded for a particular options class.Rolling Extending your options strategyby closing an existing position and openinga new one on the same underlyinginstrument with a different expirationor strike price.Seller If you sell an option, whetheropening a new position or closing anexisting position, you’re a seller.Short When you have written an option.You may hold a short position, or be short.Specialist A trader who leads theauction for an options class or a set ofunderlying securities, and maintains afair and orderly market.Spread An options strategy that callsfor you to hold two or more simultaneouspositions. Spread may also refer tothe difference between an option’sbid-ask price.Stop-loss order An order you place topurchase an option or security that comeswith an order to sell if the price dropsbelow a certain limit in the future, orrises, if you’ve sold an option.Strike price The price at which youmay buy the underlying stock, if you holda call, or sell the underlying stock, if youhold a put.Terms The characteristics of your option,including strike price, exercise style, andexpiration date.Time decay The decline in value of youroption as the expiration date approaches.Time value The perceived and oftenchangingvalue of the time left until anoption’s expiration.Vertical spread You simultaneouslypurchase and write two or more optionswith different strike prices and the sameexpiration month.VIX The Volatility Index, or a compilationof volatility of several S&P 500 options.You might use VIX as a benchmark for themarket’s perception of volatility.Volatility How much an option pricefluctuates. Historical volatility is ameasure of past actual fluctuations.Implied volatility is a gauge of the market’sprediction for its future fluctuation.Volume The number of positions thatare traded, or opened and closed, duringa time period for a specific option.Wasting asset A security that losesvalue over time, and has no worth aftera certain date.Writer If you sell an option to open anew position, you’re a writer.©2013 by Lightbulb Press, Inc. All Rights Reserved.62

indexaAdjustment........................................................15Agreement form................................................17Alpha..................................................................18American Depository Receipts(ADRs)..........................................................9American Depository Shares(ADSs)...........................................................9American-style option.............................5, 6, 60Ask........................................................ 54-55, 60Assignment.................................................27, 60At-the-money.............................................. 25, 60Automatic exercise.............................................7Away-from-the-market price............................10bBATS Options Exchange............................11, 57Bear call/put................................................34-35Bearish investor..........................................12, 28Bear spread...................................................... 32Benchmarks................................................ 50-51Beta....................................................................18Bid......................................................... 54-55, 60Black, Fischer...................................................50Black-Scholes model............................ 50-51, 60BOX Options Exchange..............................11, 57Breakeven point......................................... 53, 60Brokerage firms................7, 10-11, 16-17, 26-27,31, 33-34, 39, 46-49Commissions and fees...........................6, 37Tools..................................................46-47, 49Bull call/put.................................................34-35Bullish investors...................................12, 25, 30Bull spread....................................................... 32Buy backs..........................................................38Buying/selling.....................................................4See also Trading optionsBuy-write....................................................27, 60cC2 Options Exchange.................................11, 57Calculating return..............................26, 29, 30Calculator, options........................................... 46Calendar spread............................................... 32Calls............................. 4-5, 7-8, 12-14, 16, 20-21,23-27, 33, 40-41, 45, 60Bear and Bull........................................34-35Buying.................................20-21, 24-25, 27Exiting...................................................38-39Index......................................................42-43Margin........................................................17Movement...................................................36Put ratio...............................................51, 61Writing..................................................26-27Capital gains....................................15, 38, 44-45Cash management............................................23Cash margin requirement................................27Cash-secured put............................................. 31Cash-settled option........................................6, 9CBOE Volatility Index.......................................50Charts and tables........................................52-53Chicago Board Options Exchange(CBOE)................................................. 11, 57Clearing.............................................................11Close position............................................... 6, 60Closing out. See ExitingCollar......................................... 20-21, 36-37, 60Commissions and fees................................. 6, 37Competitive market makers (CMMs).............10Conservative investors.....................................12Consistency...................................................... 51Contracts.................................................5, 11, 15Physical delivery...................................6, 61Covered call................................................ 26-2736-37, 40-41, 45, 60Cox-Ross-Rubenstein model............................51Credit, net........................................................4-5Credit collar.................................................36-37Credit spread................................................... 32dDay order....................................................47, 60Debit, net......................................................4, 34Debit spread............................................... 32, 37Delta..................................................................19Designated primary market makers(DPMs)........................................................10Discount brokerage firms................................16Dividend.......................................................26-27Double hedge....................................................32Dow Jones Utility Average.................................9Down Jones Industrial Average(DJIA).........................................................44eEarning income.....................................35, 37, 40Employee stock options.....................................8Equity options.........................................4-19, 60See also Stock options; Trading optionsEuropean-style options............................5-6, 60Exchange-traded funds (ETFs).....................4, 9Exercised option.................. 4, 6-7, 9, 25, 27, 60Exiting.................................27, 34, 37, 38-39, 40Expiration date............. 4, 6-7, 18, 31, 38, 42, 60Collar legs...................................................37Cycles......................................................... 58Exit strategies............................................39Options premium......................................17Rolling options...........................................40Spread management.................................33Theta measure............................................19Time decay............................................15, 19fFees. See Commissions and feesFence.................................................................36Financial product...............................................4FINRA................................................................57Foreign currencies.............................................9Form 6781..........................................................45Fundamental analyst........................................22Fungible....................................................... 6, 11gGamma...............................................................19Generalists........................................................10Go long/go short................................................15Good ‘til canceled order (GTC)................47, 60Greeks, the......................................18-19, 46, 5463©2013 by Lightbulb Press, Inc. All Rights Reserved.

indexhHedging............................... 12, 19, 25, 28-29, 40Index..................................................... 42-43Spreads...................................................... 32Historic volatility............................................. 18Holder..............................................................5, 6Exit strategies.......................................38-39Stockholder vs............................................15iImplied volatility....................................... 18, 55Income...................................................35, 37, 40Index options.............................6-7, 9, 18, 42-43Taxes.......................................................... 44Indicators..........................................................51Industry organizations.............................. 11, 57Instrument..........................................................4Interest rates....................................................19International Securities Exchange(ISE)................................................ 10-11, 57InternetBrokerage firms.........................................48Information........................47, 48-49, 53, 57Options chains......................................54-55Trading.......................................................46In-the-money.................................5-7, 18, 21, 27,33-35, 38-39, 60Intrinsic value.................................. 5, 14, 39, 60lLast price..........................................................52Lead market makers (LMMs)..........................10LEAPS ® .............................................7, 24, 52, 60Leg...................................................32, 34, 37, 60Leverage........................................ 19, 24, 43, 60Limit order.................................................47, 60Liquidity........................................................... 18Long...............................................................6, 15Long calls.........................................13, 24-25, 53Long puts................................................28-29, 40Long-Term Equity AnticiPationSecurities ® .......................................7, 24, 52Long-term gains................................................44Long-term investors.........................................13mMargin account................................17, 25-29, 33Index options............................................ 43Margin call........................................................17Market order..............................................47, 60Market price......................................................52Mark to market..........................................44, 61Married put................................................28, 61Medium-term call option.................................24Merton, Robert..................................................50MIAX Options Exchange............................11, 57Mistakes, common............................................21nNaked calls.................................................26, 61NASDAQ OMX BX.......................................11, 57NASDAQ OMX PHLX..................................11, 57NASDAQ Options Market...........................11, 57National Market System.....................................8Net credit........................................................ 4-5Net debit........................................................4, 34Net price paid...................................................31Newsletters...................................................... 49Newspapers...................................................... 49Options tables............................................ 52New York Stock Exchange (NYSE)....................8Nonequity options.............................................44NYSE Amex Options.............................. 8, 11, 57NYSE Arca Options.....................................11, 57oOnline resources. See InternetOpen position................................................6, 61Open interest.......................................18, 55, 61Open outcry auctions.......................................11Options basics............................................... 4-19See also Equity options; Stock options;Trading optionsOptions calculator........................................... 46Options chains (strings)...............47, 54-55, 61Options charts.............................................52-53Options class................................................ 7, 61Options order..............................................46-47Options Clearing Corporation, The(OCC).............................. 7, 11, 16-17, 48, 57Options series.............................................. 7, 61Options Industry Council, The(OIC)........................ 11, 16-17, 47-48, 53, 57Options prices.....................................................5Out-of-the money..................................19, 25-26,33-37, 39, 42, 61Overleveraging................................................. 21Overwrite.......................................................... 27pPhysical delivery.......................................... 6, 61Premium................................... 4-5, 14-15, 17-19,25-26, 28, 31, 33, 37-38, 61Prices.......................................................5, 31, 52Away-from-the-market..............................10Bid and ask.....................................54-55, 60Employee stock options...............................8Exercise..................................................6, 27Greeks.....................................................18-19Index.................................................9, 42-43Movement..................................15, 18-19, 22See also Stock price; Strike pricePrimary market makers (PMMs)....................10Principal............................................................14Probability........................................................ 23Profit and loss................................ 12, 19, 26, 31,33-35, 36, 38-39, 41Charts......................................................... 53Protective put.......................................28, 36, 61Put.................................................. 4-5, 13, 20-21,23, 28-31, 33, 40, 61Bear and Bull........................................34-35Buying..................................................28-29Cash-secured..............................................31Exit strategy..........................................38-39Index......................................................42-43Movement...................................................36Writing..................................................30-31Put/call ratio..............................................51, 61©2013 by Lightbulb Press, Inc. All Rights Reserved.64

indexqQuadruple witching day.....................................7Quarterly earnings report................................22rRange of return.................................................37Recordkeeping................................................. 45Regulated exchanges........................................11Research and information........21-22, 41, 46-61Application...........................................50-55Sources.....................................23, 48-49, 57Return rate..................................................13, 37Calculation.................................... 26, 29-30Rho.....................................................................19Risk capital...................................................... 23Risk management.......................................12, 24Risks.................................................14-15, 17, 20Acceptance of............................................. 23Index options............................................ 43Naked calls.................................................26Selling short...............................................28Spread strategies against...................32, 36Writing puts......................................... 30-31Risk tolerance.................................................. 59Rolling...................................................27, 40-41Down.......................................................... 41Out...................................................27, 41-42Up............................................................... 40sS&P 500 Index.....................................................9Schedule D (tax form).....................................45Scholes, Myron..................................................50Securities. See Shareholders; Stock optionsSecurities and Exchange Commission(SEC).................................................8, 11, 57Seller....................................................4, 6, 13, 61Selling short..................................................... 28Shareholders.....................................................15Capital gains calculation.........................44Put buying..................................................28Spreads..................................................32-37See also Stock optionsShorting stock.................................................. 28Short position.........................................6, 15, 61Short-term call options........................24, 26, 33Short-term gains.........................................15, 4460/40 rule.................................................... 44-45Specialist.....................................................10, 61Speculation.................................................13, 28Spread........................................ 20-21, 32-37, 61Stock exchanges................................... 10-11, 57Stock index.....................................7, 9, 18, 42-43Stock options.......................................8-9, 32-35Covered call...........................................26-27Equity vs. employee.....................................8Expiration date...........................................7Holder vs. shareholder..............................15Investment objectives...........................16-17Selection criteria............................22-23, 25Spreads..................................................32-35See also ShareholdersStock price................................ 18, 25, 36, 41, 52Exercised option........................................27Exit strategies.......................................38-39Expiration options....................................37Short selling...............................................28Stop-loss order...........................................47, 61Straddle............................................................ 32Strangle............................................................ 33Strategies.........................................20-45, 58-59Exit........................................................38-39Overview...............................................20-21Rolling..................................................40-42Screener..................................................... 58Spread...................................................32-37Strike price..................................4, 7, 12, 24, 27,32-33, 37, 40-41, 56, 61Symbols...................................................... 54, 56Greeks........................................18-19, 46, 54Symbology..........................................................56tTax adviser....................................................... 45Taxes................................................15, 38, 44-45Tax forms...........................................................45Technical analysis............................................22Theta..................................................................19Ticker symbol................................................... 54Time decay......................................15, 19, 36, 61Time value........................................ 5, 14, 17, 61Timing....................................................24, 38, 39Trading options.................................4-19, 46-59Covered calls.........................................26-27Execution of trade...............................46-47Exit strategies......................................38-39Fees and commissions......................... 6, 37Getting started.....................................16-17Information sources................ 23, 48-49, 57Key terms..............................................18-19Mistakes......................................................21Options order........................................46-47Risks...........................................14-15, 17, 20Spreads.................................20-21, 32-37, 61Taxes..........................................15, 38, 44-45uUncovered calls...........................................17, 26vValue....................................................... 5, 39, 60Benchmarks..........................................50-51Call vs. put movement..............................36Covered call writing..................................27Factors........................................................14Vega....................................................................19Vertical spread................................32, 34-35, 61VIX (Volatility Index)................................50, 61Volatility......................................... 18-19, 23, 50Volume............................................18, 52, 55, 61wWasting asset.............................................. 15, 61Websites........................................... 47-49, 53, 57Whaley model....................................................51Writer...............................................5-7, 14-16, 17Call......................20-21, 26-27, 36, 40-41, 45Closing out............................................38-39Exit strategies.......................................38-39Index options.............................................42Put..............................................20-21, 30-31Return calculation....................................2665©2013 by Lightbulb Press, Inc. All Rights Reserved.

An Investor’s Guide to Trading OptionsIntroduction toOptions StrategiesPlanning, commitment, and research will prepare youfor investing in options.Before you buy or sell options you need astrategy, and before you choose an optionsstrategy, you need to understand how youwant options to work in your portfolio. Aparticular strategy is successful only if itperforms in a way that helps you meetyour investment goals. If you hope toincrease the income you receive fromyour stocks, for example, you’ll choose adifferent strategy from an investor whowants to lock in a purchase price for astock she’d like to own.One of the benefits ofoptions is the flexibility theyoffer—they can complementportfolios in many differentways. So it’s worth taking thetime to identify a goal thatsuits you and your financialplan. Once you’ve chosen agoal, you’ll have narrowedthe range of strategies touse. As with any type ofinvestment, only some of thestrategies will be appropriatefor your objective.SIMPLE ANDNOT-SO-SIMPLESome options strategies, suchas writing covered calls, arerelatively simple to understandand execute. There aremore complicated strategies,however, such as spreadsand collars, that requiretwo opening transactions.These strategies are oftenused to further limit the riskassociated with options, butthey may also limit potentialreturn. When you limit risk,there is usually a trade-off.Simple options strategiesare usually the way to begininvesting with options. Bymastering simple strategies,you’ll prepare yourself foradvanced options trading.In general, the more complicatedoptions strategiesare appropriate only forexperienced investors.20INVESTING STRATEGIES INVESTING STRATEGIESCALLBUYINGCALLWRITINGAN OVERVIEW OF STRATEGIESIt’s helpful to have an overview of theimplications of various options strategies.Once you understand the basics, you’llbe ready to learn more about how eachstrategy can work for you—and what thepotential risks are.POSSIBLEOBJECTIVEProfit fromincrease in priceof the underlyingsecurity, orlock in a goodpurchase priceProfit from thepremium received,or lower net costof purchasinga stockPUTProfit fromBUYING decrease in priceof the underlyingsecurity, orprotect againstlosses on stockalready heldPUTProfit fromWRITING the premiumreceived, orlower netpurchase priceSPREADS Profit from thedifference invalues of theoptions writtenand purchasedCOLLARS Protect unrealizedprofitsYOUR MARKETFORECASTNeutral tobullishNeutral tobearish,thoughcovered callwriting maybe bullishNeutral tobearishNeutral tobullish, thoughcash-securedputs maybe bearishBullish orbearish,depending onthe particularspreadNeutral orbullishMAKE A COMMITMENTOnce you’ve decided on an appropriateoptions strategy, it’s important to stayfocused. That might seem obvious, but thefast pace of the options market and thecomplicated nature of certain transactionsmake it difficult for some inexperiencedinvestors to stick to their plan. If itseems that the market or underlyingsecurity isn’t moving in the directionyou predicted, it’s possible that you’llminimize your losses by exiting early. Butit’s also possible that you’ll miss out on afuture beneficial change in direction.That’s why many experts recommendthat you designate an exit strategy or cutoffpoint ahead of time, and hold firm. Forexample, if you plan to sell a covered call,POTENTIALRISKLimited to thepremium paidUnlimited fornaked callwriting, limitedfor coveredcall writingLimited to thepremium paidSubstantial, asthe stock priceapproaches zero?POTENTIALRETURNTheoreticallyunlimitedLimited tothe premiumreceivedSubstantial, asthe stock priceapproaches zeroLimited tothe premiumreceivedLimited LimitedLimited Limitedyou might decide that if the option moves20% in-the-money before expiration, theloss you’d face if the option were exercisedand assigned to you is unacceptable. Butif it moves only 10% in-the-money, you’dbe confident that there remains enoughchance of it moving out-of-the-money tomake it worth the potential loss.A WORD TO THE WISEBy learning some of the most commonmistakes that options investors make, you’llhave a better chance of avoiding them.Overleveraging. One of the benefitsof options is the potential they offer forleverage. By investing a small amount, youcan earn a significantpercentage return. It’svery important, however,to remember thatleverage has a potentialdownside too: A smalldecline in value can meana large percentage loss. Investors whoaren’t aware of the risks of leverage arein danger of overleveraging, and mightface bigger losses than they expected.Lack of understanding. Anothermistake some options traders make isnot fully understanding what they’veagreed to. An option is acontract, and its termsmust be met uponexercise. It’s importantto understand that ifyou write a covered call,for example, there isa very real chance thatyour stock will be called away fromyou. It’s also important to understand howan option is likely to behave as expirationnears, and to understand that once anoption expires, it has no value.Not doing research. A serious mistakethat some options investors make is notresearching the underlying instrument.Options are derivatives,and their valuedepends on the pricebehavior of anotherfinancial product—astock, in the case ofequity options. Youhave to researchavailable options data, and be confident inyour reasons for thinking that a particularstock will move in a certain directionbefore a certain date. You should also bealert to any pending corporate actionssuch as splits and mergers.21an investor’s GUIDE TO trading optionscovers everything from calls and puts to collars and rolling up,over, or out. It takes the mystery out of options contracts, explainsthe language of options trading, and lays out some popular optionsstrategies that may suit various portfolios and market forecasts.If you’re curious about options, this guide provides the answers toyour questions.Lightbulb Press, Inc.www.lightbulbpress.cominfo@lightbulbpress.comPhone: 212-485-8800©2013 by Lightbulb Press, Inc. All Rights Reserved.