t trade|smart

university TM
Lesson 1 Foundation
Anatomy of a Trade! 6

Step 1 ~ Line Drawing! 6

Step 2 ~ Moving Averages! 8

Step 3 ~ Chart Patterns ! 10

Step 4 ~ Candlestick Patterns ! 13

Step 5 ~ Indicators! 17

Step 6 ~ Entries & Exits! 20

Step 7 ~ Choose Your Strategy! 20

Lesson 2 Option Basics

Options Defined! 22

The Options Chain! 24

Option Pricing! 26

Open Interest! 31

Short to Mid-Term Trading with Options! 32

Buying Out of The Money Options ! 33

Lesson 3 Selling Options

Option Selling Defined! 35

Why Sell Options?! 36

Which Option to Sell?! 37

Covered vs. Uncovered! 38

The Two Most Common Option Writes! 38

Trade Setups! 45
Lesson 4 Hedge Strategies
Hedging 101! 47

Hedge Vehicles! 47

Hedging with Options! 47

Lesson 5 Spread Trading

Spreads Defined! 53

Vertical Spreads! 54

Debit Spreads! 54

Credit Spreads ! 56

Unwinding a Spread! 57

Timing a Spread! 57

Lesson 6 Sideways Trading

Sideways Markets! 59

Iron Condor! 61

Butterfly Spread! 62

Lesson 7 Volatility Trading

Volatility ! 64

Volatility Concerns When Trading! 65

Straddle! 67

Strangle! 69

Straddle/Strangle Trading Criteria! 70

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 Exiting the Trade! 70

Lesson 8 Option LEAPs

LEAP Acronym! 72

Leaps Instead of Stock! 77

Spreads WIth LEAPs ! 78

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Advanced Option Strategies

LESSON 1
FOUNDATION
Anatomy of a Trade
Line Drawing
Moving Averages
Chart Patterns
Candlestick Patterns
Indicators
Determine Entry/Exits
Applying the Right Strategy

Step 1 ~ Line Drawing

Starting point of Technical Analysis
Process of connecting similar peaks and similar valleys
Two Words:
• Support
• Resistance
CE: The
RESISTAN
p o i nt where a
price
SUPPORT: The price fi nd s mo
re
s to ck n
point where a stock g p r e ssure tha
sellin d
finds more buying
g p r e s sure, an
buyin e
pressure than selling
e ll e rs drive th
the s ).
pressure, and the l o w e r (bearish
price
buyers drive the price
higher (bullish).

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TREND LINE:
A support or
resistance line
that defines the
direction and
angle of a trend

UP-TREND:
A stock that is
moving in a
predictable pattern
while making
higher highs and
higher lows.

DOWN-TREND:
A stock that is
moving in a
predictable pattern
while making
lower highs and
lower lows.

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 Quick Tip
trade
Smart traders
, not
to pivot po ints
thro ug h them.

All horizontal and angled (trend) lines become a future “pivot point” and price target.

Pivot Point: Price point of support & resistance where a stock determines to either
move up or down.

Step 2 ~ Moving Averages

Created by plotting the “average” price of the
stock over a given number of periods (hours,
days, weeks, months)
Very useful in determining trend structure
during a trend
Not very useful when stock is moving sideways

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Moving Averages: Three Main Uses
Help determine the trend
Gives buy/sell indication with Moving Average Cross
Average can serve as a “floating trend line”

Moving Averages: Angles

The stronger the angle, the stronger
the trend.
No angle or a weak angle indicates a sideways MOVING AVERAGE
move (Averages Not Useful) SETTINGS
• 10 Day Exponential
• 20 Day Exponential
• 50 Day Exponential

Fast Pace Fast Pace

Pointing - 4:00 Pointing - 1:00

No Trend
Pointing - 3:00

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Step 3 ~ Chart Patterns
“Shorter term” Line Drawing
Form shapes we call “patterns”
Three Classifications:
• Reversal
• Continuation
• Consolidation

Reversal Patterns

Continuation Patterns

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 Continuation Patterns

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 Consolidation Patterns

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 Step 4 ~ Candlestick Patterns
Traditional Japanese Indicator
Combine with western technical analysis to provide
strong signals
Can provide early indication of reversal
Each time period reflects a story of market sentiment
Works on all time periods (intra-day, daily, weekly, monthly)
Candle is made up of Open, High, Low, Close information
Contain a “body” and the “wicks”

Single Line Candles

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 Doji Variations

Single Line Candles

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 Two Line Patterns

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 Multi-Line Patterns

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Step 5 ~ Indicators
“Gauges” that help us measure strength of market
Help to confirm analysis or alert of impending change
Not the starting point of Analysis
Should be used to supplement the rest of your trading knowledge

Indicators We Use
Moving Averages
Oscillators
• Stochastics
• RSI
• MACD
Bollinger Bands
Trend Indicators
• ADX
• Parabolic

Moving Averages
Trading above or below the averages?
Averages crossing?
Averages working as good support or resistance?
Good strong angle?

MOVING AVERAGE MOVING AVERAGE

SETTINGS SETTINGS
• 10 Day Exponential • 100 Day Simple
• 20 Day Exponential • 200 Day Simple
• 50 Day Exponential
(Long Term)
(Short Term)

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Stochastics
Are the two lines crossing?
STOCHASTICS
Overbought or Oversold? SETTINGS
Fast line crossing down through 80% line? • %K = 13
Fast line crossing up through 20% line?
Divergence? • %D = 5
• Smoothing Period = 7

RSI
Overbought or Oversold? RSI SETTINGS
Line crossing down through 70% line?
• RSI = 9
Line crossing up through 30% line?
Divergence? • Overbought Line = 70%
• Oversold Line = 30%

MACD
Are the two lines crossing? MACD SETTINGS
Moving above/below zero line?
Divergence? • Fast Line = 12
• Slow Line = 26
• Avg Line = 9

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Bollinger Bands
Are we in a BB Squeeze? BOLLINGER BAND
Are we in a BB Trend?
Are we seeing a BB reversal? SETTINGS
Bands:
• Average = 20
• Standard Deviation = 2
Average:
• Simple 20 Period

ADX
Average Directional Index
Trend (up or down) gaining strength ADX SETTINGS
when ADX line is moving up Bars Used = 7
Down near 20, ready for trend
Up over 50, trend needs to slow down

Parabolic
Are the dots supporting the trend? PARABOLIC SETTINGS
Acceleration Factor: 0.2
Max Accel. Factor: 0.02

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Step 6 ~ Entries & Exits
Determine what happens IF the stock goes up.
Determine what happens IF the stock goes down.
What is your target?
Where will you set your stop? Tip
Document it! Qu i c k
users
r ade
o o d t
t r aders
“G t
grea
sto p s;
a rg ets.”
t
r ad e to
t

Step 7 ~ Choose Your Strategy

Strategy is “how” you play your trade setup.
Most trade setups can actually work with several
different strategies.
Your first decision: Pick a Direction!
• Up (Bullish)
• Down (Bearish)
• Sideways (Neutral)

Picking a Direction
If things look UP, pick a BULLISH strategy:
• Stock: Buy Long
• Options:You have many choices.
If things look DOWN, pick a BEARISH strategy:
• Stock: Sell Short
• Options:You have many choices.
If things look SIDEWAYS, you need options.

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Advanced Option Strategies

LESSON 2
OPTION BASICS
Options Defined
The buyer of an option receives the right but not the CALL OPTION
obligation to buy or sell a specific stock, at a specific price, The right to BUY
on or before a specific date.

Breakdown
Buyer - You
Right but not the obligation - You are in control PUT OPTION
Buy or Sell - Call (right to buy) or Put (right to sell) The right to SELL
Specific Stock - The “underlying stock”
Specific Price - The “Strike Price”
Specific Date - The “Expiration Date”

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 Peter holds 10 April $120 Example 1
Call Options for IBM. Based on
our definition what benefit • Right but not the obligation
does Peter have with these • To buy IBM
options? • For $120/share
• On or before expiration in April (3rd Friday)

Jon owns 500 shares of Example 2

AMZN which is currently
trading for $130/share. He Answer: Put Option
wants to hold it but is afraid it • Jon has the right but not the obligation
will go down. Jon wants to • To sell AMZN for $130
make sure he can sell AMZN • On or before expiration date (April)
for $130/share. What Option
could he buy?
Option Contracts
• Options trade in Contracts of 100 shares.
• 1 Contract holds 100 shares of stock.
• How many contracts will Jon need to
accomplish this trade?




Answer: 5 Contracts

DE is currently trading for Example 3

$55/share, and Jose believes it
will soon be trading much Answer: Call Option
higher. Jose would like to buy • Jose has the right but not the obligation
1000 shares, but he wants to • To Buy DE for $55
wait and make sure DE is really • On or before expiration date (April)
going higher. He also wants • How many contracts will be needed?
the ability to buy for $55.



Answer: 10 Contracts
What is his best choice?

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The Options Chain
A list that contains all of the important information related
to all of the listed options for a given underlying security.

old

new
Option Symbols

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Option Chain Examples

Angie believes the overall Example 1

market is going down and
wants to hedge her tech
positions by purchasing several (1 contract = 100 shares)
put options of the QQQQ
ETF. After doing all of her
$1.01x100 = $101/contract
research she decides to buy 25 x 25 contracts
contracts of the February $45
strike price. Based on the
option chain, how much would $2,525 + Commissions
this cost her if she were to
make the purchase today?

Chris believes based on a Example 2

recent chart pattern break
that the overall market is
moving to new highs in the (1 contract = 100 shares)
next couple of months. He $4.34x100 = $434/contract
wishes to capitalize on this
move by purchasing call x 10 contracts
options of the QQQQ ETF.
He decides he wants to buy 10
contracts of the $42 strike $4,340 + Commissions
price for February. How much
will this cost him?

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Option Pricing
Primarily made up of two values:
Intrinsic Value
Time Value (Premium)

Intrinsic Value: The “Built-In” Value

Difference in Stock Price & Strike Price
Calls - Lower Strike Prices will have higher intrinsic value
Puts - Higher Strike Prices will have higher intrinsic value

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 AXP is trading for $37/share. Intrinsic Value Example 1
You buy a $35 call option.
How much intrinsic value do
you have?

HAL is trading for $31/share. Intrinsic Value Example 2

You buy a $35 put option.
How much intrinsic value do
you have?

Intrinsic Value = In The Money

No Intrinsic Value = Out of The Money

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Intrinsic Value (continued)
An option will always be at least worth its intrinsic value.
Intrinsic value does not disappear with time.
An option’s real worth at expiration is its intrinsic value.

In The Money
Option has intrinsic value

At The Money
Strike is at the current stock price

Out of the Money

Option has no intrinsic value

Example of ITM Pricing

Theoretical Call Pricing for AMZN trading at $138.50
Option Intrinsic
Strike Price Time Value
Price Value

$115 $26.25 $23.50 $2.75

$120 $22.25 $18.50 $3.75

$125 $18.55 $13.50 $5.05

$130 $15.15 $8.50 $6.65

$135 $12.15 $3.50 $8.65

$140 $9.60 $0 $9.60

$150 $7.40 $0 $7.40

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Time Value
The “Premium” Value
Composed of many variables (changing conditions)
Can change rapidly
Disappears with time (closer to expiration)
Will be worth nothing at expiration
Time Value Factors
Time to expiration
Volatility
Interest Rate
Dividends
“The Greeks”
Set of numbers that help predict future value of option
Five letters are represented:
• Delta • Theta • Rho
• Gamma • Vega

Greek Definitions
Delta - Change in price to option relative to 1-point change in price of stock
Gamma - Change in Delta relative to 1-point change in stock
Theta - Change in price to option relative to 1-day passing of time
Vega - Change in price to option relative to 1-point change in volatility
Rho - Option’s relationship to the assumed interest rate

Stock Option Delta

Delta Price Price
Increases Increases • IBM is trading for $130
• The $130 Call is trading for $2.25/share
0.40 $1 $0.40 • The Delta is 0.56
• IBM moves up to $131
0.60 $1 $0.60 $2.25
+ $0.56
0.75 $1 $0.75
$2.81
0.99 $1 $0.99

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 Stock
Delta Gamma
Gamma Price
Increases
Increases • IBM is trading for $130
• The $130 call has a Delta of .56
0.02 $1 0.02 • The Gamma is 0.08
• IBM moves up to $131
0.04 $1 0.04
Delta: 0.56
0.08 $1 0.08 + 0.08

0.10 $1 0.10 0.64

One Day Option Theta

Theta • IBM is trading for $130
Passes Price
• The $130 call is $2.25 and has a
-0.02 1 -0.02 Theta of 0.05
• 1 day later stock is $130
-0.12 1 -0.12 • Call option is now worth?
$2.25
-0.20 1 -0.20 - 0.05

-0.32 1 -0.32 $2.20

Volatility Option Vega

Vega • IBM is trading for $130
Change Price
• The $130 call is $2.25 and has a
-0.05 1 point -0.05 Vega of 0.12
• 1 day later volatility moves down 1
-0.12 1 point -0.12 point but the price of the stock stays
the same $2.25
-0.20 1 point -0.20 - 0.12
-0.32 1 point -0.32 $2.13

Delta is the most You see the price’s direct If you’re In The Money, the
important factor. connection to the underlying other “less predictable” factors
stock’s price movement will not hurt you very much.

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Open Interest
The measure of the number of open contracts that have been
issued and are currently “open” on a given option.

The more Open Interest (OI), the more liquidity there is.
An option with low OI is not a good option to buy (it’s always okay to sell).
Options with low OI will often have higher Bid/Ask Spreads.
Strike prices with high OI help reveal where the masses are hedging their
positions.

Open
Date Scenario
Interest

1/2 Person A sells 5 contracts to Person B 5

1/3 Person C sells 1 contract to Person D 6

1/4 Person B closes 3 of his contracts from A 3

1/5 Person E sells 2 contracts to Person F 5

1/6 Person B closes his last 2 positions 3

1/9 Person F closes both positions 1

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Short to Mid-Term Trading with Options
Use options instead of stocks to make quick profits on
short and intermediate level trends.
Capitalize on greater leverage.
Control large amounts of stock with less capital.

Example 1
Stock Option
Buy AMZN Stock @ $110 Buy AMZN $110 Call @ $12
Sell AMZN Stock @ $141 Sell AMZN $110 Call @ $33
(Trade 1,000 Shares) (Trade 1,000 Shares)
$141,000 $33,000
- $110,000 - $12,000

Profit = $31,000 Profit = $21,000

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In The Money Options
Have more “built in value”
Gain intrinsic value quicker
Hold better Delta value
Hold value longer
Have less variation in price Option Price Behavior
Are not as affected by volatility-based factors
Are the ideal choice for short- to mid-term trades

Which Option Should You Buy?

If you’re buying options in place of stock for short-term gains:
Buy 1-2 Strike Prices IN The Money
Look for a Delta of .70 -.90 (certainly not below .50)
Look for Open Interest of at least 500 (1000+ is better)
Buy at least 2-3 weeks more time than you need
Avoid At The Money options unless Delta Rule applies (because of increased
premium charge)

Buying Out of The Money Options

Much more risky (no intrinsic value)
Buy 1-2 Strike Prices Out of The Money
Delta will be bad
Open Interest of at least 500 (1000+ is better)
Buy at least 4-6 weeks more time than you need
Avoid At The Money options (because of increased premium charge)

The of
n ce
a
o rt me
imp on Ti
i
Opt ue!
!
Val

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Advanced Option Strategies

LESSON 3
SELLING OPTIONS
Option Selling Defined
The seller of an Thanks for Thanks for The buyer of an option
buying
option sells the right but the option receives the right but not
not the obligation to buy the obligation to buy or
or sell a specific stock, at sell a specific stock, at a
a specific price, on or specific price, on or
before a specific date. before a specific date.

The seller
sells his rights. He is
OBLIGATED.

Options can be
Call Put Both buying &
played 4 ways
selling are valid
strategies; they
Buy Bullish Bearish
just play opposite
directions.
Sell Bearish Bullish

Call Call Put Put

Buyers Sellers Buyers Sellers

Make
Money
When
Stock
Moves

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Why Sell Options?
Buyers pay a “premium” for their options.
Sellers collect that “premium.”
Most options expire worthless (75%).
If 75% of bought options expire worthless, then only 25%
of sold options are ever paid out.
Your “odds of being right” are higher when selling options.
You sell options for the “premium”
If you’re selling OTM options, you have a 66% chance of being correct.
You get paid up front (timing is not as critical).
You want time to disappear quickly so you can keep your premium.
Works with a trending or sideways/neutral market condition.

RIMM is trading at $66/share Example 1a

Profit
after a good earnings report.
Samson is convinced RIMM will In The Money
move higher and decides to
speculate a bit by purchasing a
$75 call option. What must occur
for Samson to make money with
his $75 call on RIMM?

Julian recognizes that RIMM will Example 1b

most likely not be trading above Profit
$75/share in a few weeks. But
he’s not sure if RIMM will be In The Money
trading lower. So he decides to (Samson owns $75 Call)
sell the $75 call (to Samson). The
day of the transaction, $1.29/share
is deposited into Julian’s account.
He simply waits until expiration
to see if his expectation was
correct. What must RIMM do for
Julian to keep all his profit?

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Option Selling Example 1 Scenarios
Samson will make money if and only if RIMM trades ITM above $75/share before
expiration. Odds of winning? (1/3)

Julian will make money if RIMM goes down, if it goes sideways, or if it goes up but does
not close above $75. Odds of winning? (2/3)

Which Option to Sell?

You want to collect the highest premium
You want the least chance of being exercised
With time value disappearing quickly
• At The Money or Out of The Money
• At or beyond recent resistance (call) or support (put)
• Less than 3 weeks to expiration (ideal)

Example 2
After appropriate analysis, Paul has decided GOOG looks to be going higher...and if not,
it will likely trade sideways. He decides to sell some put options. GOOG is currently
trading at $620/share with good upward momentum. Which option may be a good one
to sell?

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 Example 3
Jackson has concluded, based on her technical analysis of POT, that the stock will
most likely stall if not go down completely. She would like to sell call options and
collect a profit from the premium. With POT selling at $111/share, which option may
be a good choice for her to sell?

Covered vs. Uncovered 4

When you sell an option for stock you Calls Puts
choices
hold in your portfolio, you are “covered.”
When you sell an option for stock you do Covered Covered Covered
not hold in your portfolio, you are Calls Puts
“uncovered” (also known as naked).
Uncovered positions require additional Uncovered Uncovered Uncovered
Calls Puts
margin to place the trade.

The Two Most Common Option Writes

The Covered Call
The Naked Put

Covered Call
Created when you own the underlying stock and write a call option against it
Great for “neutral” or sideways moving stocks
Collect a premium for the stock you own
Can be used to “dollar cost average” down
Can be done in your IRA
You still collect any dividends paid on the underlying stock.
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 Covered Call Scenario 1
Alexis has owned HAL for many years, and she she originally bought it for $21/share.
Recently, however, the stock seems to have stagnated. She wishes to bring in some
money on the 2000 shares she owns. What are some choices?

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 Covered Call Scenario 2
Harvey has noticed the implied volatility for RMBS is always high, yet the stock itself
does not seem to be very volatile. For years RMBS has traded between
$15-$25/share with only occasional spikes above or below that range. Harvey
believes it would be okay to own this stock for the purpose of writing covered calls.
He does not mind holding the stock, and he also does not mind if he gets exercised
and is forced to sell. What are the scenarios for Harvey if he does this“buy/write”
transaction?

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Harvey decides to buy 1000 shares of RMBS as a place to park some money for a while.
He also chooses to write (sell) 10 call contracts against the 1000 shares for the $27
strike price expiring January 2010. What is Harvey’s cost basis today?

Buy 1000 Shares RMBS @ $24.75 Total Investment $24,750

for an Investment of $24,750 - Total premium $1,410

Sells 10 contracts of $27 strike @ $1.41 Cost Basis $23,340

premium, bringing in a total of $1,410

Let’s assume RMBS trades up just a little bit and closes at $25.50 by expiration day in
January. Harvey keeps his $1,410 in premium, and he’s also the owner of 1000 shares of
a $25.50 stock with a cost basis of only $23.34/share. In February Harvey decides to do
the same thing again, but this time he decides to sell the $28 strike price instead. What
happens to his cost basis?

Sells 10 contracts of $28 strike @ $1.50 Previous Cost Basis $23,340

premium, bringing in a total of $1,500 - February premium $1,500
(Theoretical premium)
Cost Basis $21,840

Harvey is pleased with what is now nearly $3000 in premiums he has received by writing
covered calls on RMBS. In February the stock again closes slightly up, this time at $26.
Harvey decided for a third time to write a covered call for all 1000 shares, again at the
$28 strike price but for the March expiration.

Sells 10 contracts of $28 strike @ $1.50 Previous Cost Basis $21,840

premium, bringing in a total of $1,500 - March premium $1,500
(Theoretical premium)
Cost Basis $20,340

RMBS closed at the end of session for March at $28.14, and Harvey was exercised and
forced to sell his RMBS stock for $28/share. His position was liquidated for an even
$28,000. What was Harvey’s total gain during the last 3 months?

Sells RMBS for $28,000 Sell RMBS for $28,000

- Total Cost Basis $20,340 - Original Cost Basis $24,750
Total Profit $7,660 Total Profit $3,250

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When to Use the Covered Call
If stock is moving bullish, sideways, or down slowly
If you want to own the underlying stock
If you want to bring in 5-10%/month on your stock
If you like receiving a monthly dividend (or rent!)

The Naked Put

Created by selling a put without being short the underlying stock
A bullish/neutral strategy
Can be used to enter a long stock trade at a discount
Should only be executed if you do not mind owning the underlying stock (one
day you will get put the stock!)
Requires Substantial Margin:
• Either 20 or 25% of underlying stock (depending on broker)
• PLUS - total premium received
• MINUS - the amount the option is out of the money
Alternately, you could do a “cash secured” naked put for 100% of the value of
the underlying security.

Naked Put Scenario 1

Lorie takes a quick look at one of her favorite stocks, SNDK, and sees that she
missed a great breakout move. She’s tempted to buy 1000 shares at the current
trading price of $30.13, but is afraid the trade may have moved too far and needs to
pull back. She decides to sell a $28 put instead.

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 Naked Put Scenario 1 (continued)
Upon taking a glance at the option prices, Lorie decides to sell 10 contracts of
SNDK, January 2010 Puts. She brings in $0.71/share for a total of $710. What are
the potential outcomes for Lorie?

SNDK does seem to exhaust itself and fails to make any new highs. By expiration day
SNDK is trading for $28.22/share, just above the $28 strike price Lorie sold.
What happens?

Sells SNDK Puts @ $0.71

Total Premium $710

Lorie is obligated to buy SNDK for

$28/share if required.

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 Naked Put Scenario 2
After watching the covered call trade her friend Harvey did with RMBS, Lorie wanted
a piece of the action as well. However, after looking at the chart for RMBS, she was
concerned that the stock may pull back in a few days. Instead of buying the stock for
$24.75/share, Lorie decides to sell a $22.50 put instead. How much does she make?

Sure enough two weeks later RMBS has

Sells 10 RMBS Puts @ $1.12 traded down and closed on expiration day
Total Premium $1,120 at $22.13, just below the $22.50 strike price
Lorie sold. But Lorie is not upset. She
Lorie is obligated to buy RMBS for wanted to own RMBS anyway, and she now
$22.50/share if required. will be purchasing the stock for only $22.50,
a few dollars less than her friend Harvey.
But she also made $1,120 in the process!

Buy RMBS for $22,500 The next day after expiration Lorie decides
- Original premium $1,120 she’s happy owning RMBS for a total cost
Total Cost Basis $21,380 basis of $21,380. Not to be outdone by her
friend Harvey, Lorie turns around and writes
Now that Lorie owns RMBS, how can she a covered call for the $25 strike price,
continue to make money with it? bringing in an additional $1.48/share.

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 When to Sell Naked Puts
Stock is neutral/bullish
You want to pull some money up front rather than hold the stock
You do not mind owning the stock
You have an exit strategy if you get put the stock (e.g., Covered Call)

NEVER Sell Naked Puts If You Do

Not Want the Underlying Stock

Trade Setups
The ideal candidates for Covered Call
“buy/writes” and “Naked Puts” are:
• Stocks less than $40/share
• Relatively predictable range
• Fairly high Implied Volatility
You should be able to bring in 5-10%/
month writing this type of option.

otes
N

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Advanced Option Strategies

LESSON 4
HEDGE STRATEGIES
Hedging 101
Definition
1. A fancy word for insuring an investment
2. The act of purchasing one investment to offset
the potential loss of another investment
Options were originally created as a “hedge.”
Investors needed them to provide insurance for an investment.
A “call” is a hedge against a short stock trade gone bad.
A “put” is a hedge against a long stock trade gone bad.
Today a relatively small percentage of option open interest is actually a
hedged position.
Like insurance, a “hedge” has a cost associated with it.
• When buying options = “The premium”
• When using offsetting investments = Lost profit potential

Hedge Vehicles
Inverse ETF (Index or sector based)
Index Futures
Enter an opposing position (very common in Forex)
Commodities
Buying options (calls & puts)
Combined options strategies

Options as Hedges
Create a leveraged hedge with limited downside risk but unlimited protection
Can be used with indexes for broad market hedge or on individual trades

Hedging with Options

Most comparable to an insurance policy
Involves:
• Premium
• Deductible (maybe)
• Time element
• Transfer of Risk

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Insurance

Typical Homeowner’s Policy Stock Option “Insurance”

Home Value: $250,000 Stock Value: $250,000
Deductible: $15,000 Strike Price: $235/share (x1000)
Premium: $1680/year ($140/mo) Premium: $0.56/share ($560)
Time: 1 Year Time: 1 Month
Transfer of risk: To State Farm Transfer of risk: To Option Seller

The Bottom Line Deal: The Bottom Line Deal:

• You pay State Farm $1400/year and • You pay option seller $560/month
hope your house does not burn down. • Option Seller agrees to pay you
• State Farm agrees to pay you $235,000 $235/share if the stock goes down
if your house burns down. below $235

Popular Option Hedge Strategies

Protective Put
Protective Call
Covered Call (believe it or not!)

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 Protective Put Scenario
Bill owns 1000 shares of AAPL that he has
collected through the years, with an average
cost basis of only $59/share. Due to poor
iPod sales, Bill is concerned AAPL may take a
short-term hit, but he wants to hold his stock
for the long run. However, Bill’s fear has got
the best of him, and he wants to make sure
he can at least lock in the majority of his
profits at $190/share. So Bill buys a protective
put for $4.55 and hopes for the best. He has
two months until his option expires.

Protective Put Scenario Possibilities

A put you buy for the intention of Stock continues higher:
protection. • Bill continues to profit with AAPL.
• Put option expires worthless.
Usually buy OTM Stocks falls dramatically:
The further OTM the cheaper, • Bill can sell his stock for $190,
but higher “deductible” accepting the $19 hit as
The closer to ATM the more a “deductible.”
costly, but lower “deductible” • Bill can sell the put and keep his
AAPL stock (offsetting draw down).

Scenario Outcome:

AAPL received bad news, and the stock dropped to $164/share. Bill can either sell
his stock for $190/share or sell his option, which is now worth roughly $26/share.
Since Bill is ultimately bullish on AAPL, he chooses to sell the option for $26/share
and continue holding AAPL. He still owns the stock, but he offset (hedged) his losses
by using a put as protection.

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 Protective Call Scenario
Based on his analysis, Dave believes BIDU is
about to fall dramatically and sells 1000
shares short @ $415/share with a downside
target below $300/share. However, Dave
recognizes BIDU can move fast and wants to
protect himself against a potential unlimited
bullish move. Because he’s short he will
eventually have to buy BIDU for a fair market
price. Dave buys a $425 call option as
protection. If BIDU goes up dramatically,
Dave now has the right to buy the stock (to
cover his position) for $425/share, thus
minimizing his loss.

Protective Call Scenario Possibilities:

A call you buy for the intention of Stock continues lower:
protection. • Dave holds his short position
• Call option expires worthless
Usually buy OTM Stock rises dramatically:
The further OTM the cheaper, • Dave can cover his short position
but higher “deductible” for $425, accepting the $10 hit as
The closer to ATM the more a “deductible.”
costly, but lower “deductible” • Bill can sell the call and keep his
BIDU short position.

Scenario Outcome:

Dave was very wrong. BIDU took off and only 2 weeks later was trading at nearly
$500/share. Dave was very happy to own the calls at $425/share. He gladly exercised
the options, buying all 1000 shares to cover at $425. He accepted the $10/share
difference and chalked it up to a loss, happy to have dodged the big one because he
hedged his position by purchasing calls.

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 Protective Call Scenario
Lucy bought PBR several months ago in her
IRA. She likes the stock and holds 2000
shares of it at $33/share. However, price
action makes her a little concerned that the
recent bullish move may be done for a few
weeks, if not months. Currently trading at
$47/share, Lucy would be okay selling here,
but she’d really like to sell for more and
would love to hold the stock. She decides to
write a covered call. But interestingly, she
writes an ITM call at a $40 strike price for a
premium of $7.50/share. Why?

Covered Call as Hedge Scenario Possibilities:

A Covered Call brings money in Stock continues lower and closes
to your account (buying puts below strike price:
takes money out). • Hold stock
If you write OTM calls, you will • Option expires worthless but
only make the premium. you keep the premium
If you write ITM calls, you will Stock closes above strike price:
make difference between stock • Lucy could be assigned the stock
and strike plus the premium. and be happy to close it out for
the small profit she made.
• Lucy could buy back her option
and hold the stock.

Scenario Outcome:

Three weeks later PBR is trading at $41/share, just a dollar above the strike price
Lucy sold. She’s afraid she will be called out and forced to sell for $41. She would be
okay with that, but she really wants to hold her stock. So Lucy buys the $40 call
option back the day before expiration for $1.15. This releases her obligation to sell
for $40, and she pockets the difference in premium. Lucy has hedged her position by
making some quick money on the downside while preserving her core asset.

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Advanced Option Strategies

LESSON 5
SPREAD TRADING
Spreads Defined
Combining two or more options into a single strategy
to further enhance either profit, protection, or both
The difference between two or more prices from
different sides, or legs, of a trade

Spread Facts
Spreads are not nearly as difficult as you might think.
You can create very flexible trading scenarios.
They have Limited Risk/Limited Reward scenarios (mostly).
Spread are considered the “Bread & Butter” strategies of professional traders.
Many hedge funds are based on spreads.

Spread Terms
Credit: Spread that results in a net credit (income) to your
account at execution
Debit: Spread that results in a net debit (expense) to your
account at execution
Bull Spread: Will profit if the underlying stock rises
Bear Spread: Will profit if the underlying stock falls
Vertical Spread: Same expiration month
Calendar Spread: Different expiration month
Ratio Spread: Different number of options that are sold vs. bought

Various Spreads
Vertical Spread
Iron Condor
Front Spread
Back Spread
Combination
Butterfly Spread
Calendar Spread
Diagonal Spread


(plus variations...)

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Vertical Spreads
A vertical spread consists of all calls or all puts and involves the simultaneous
purchase and sale of options with the same expiration date but different strike
prices.
A vertical spread can be either a credit or debit spread.

Vertical Spread Breakdown

Type Name Direction

• The result is a “net debit” to Call Debit Bull Call

your account. (It takes money Bullish
Spread Spread
from your account.)
• Profits by buying options Put Debit Bear Put
Bearish
• A trending strategy Spread Spread

• The result is a “net credit” to Call Credit Bear Call

Bearish
your account. (It puts money Spread Spread
into your account.)
• Profits by selling options Put Credit Bull Put
Bullish
• A neutral or trending strategy Spread Spread

Debit Spreads
Bull Call Spread: A vertical debit spread created by
purchasing a call option and simultaneously selling a call
option one strike price higher, creating a net debit.
Bear Put Spread: A vertical debit spread created by
purchasing a put option and simultaneously selling a put
option one strike price lower, creating a net debit.

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 Bull Call Spread Scenario Action
Pete has been watching IBM for three
months and expects it to continue rising.
He wants to buy some $130 call options,
but the cost for the ATM call is $6. Pete
would like to offset the cost of this option
a little bit, so he decides to sell a $140 call y $ 1 30 c for $6.00
Bu
option 2 strike prices higher for $1.50. ll $ 1 4 0 c for $1.50
S e
= $4.50
Maximum Profit: $10 (spread) - $4.50 (debit) = $5.50 Net Debit
Maximum Risk: $4.50 (premium out - premium in)
Margin Requirement: $4.50 (net debit)
Direction: Bullish
Can only make money if underlying stock goes up
Maximum profit at or above the strike price of call sold
Maximum Loss = Net Debit
Break Even = Strike Price (call sold) + Net Debit

Bear Put Spread Scenario Action

Lucy has been watching PBR and believes
it will soon fall. She wants to buy some
$45 puts for $4.00. However she’s wishes
to lower her cost basis a bit so she
decides to also sell an equal number of
$40 puts, one strike price lower for $1.65.
for $4.00
Buy $45p r $1.65
fo
Maximum Profit: $5 (spread) - $2.35 (debit) = $2.65 Sell $40p
= $2.35
Maximum Risk: $2.35 (premium out - premium in) Net Debit
Margin Requirement: $2.35 (net debit)
Direction: Bearish
Can only make money if underlying stock goes down
Maximum profit at or below the strike price of put sold
Maximum Loss = Net Debit
Break Even = Strike Price (put sold) - Net Debit
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Debit Spreads - The Bottom Line
Debit spreads have the same risk profile as simply buying a long call or a long
put but with a limit to the profit.
With a debit spread, you may lower your cost basis a little from the sell of an
option, but you also incur additional commissions.
The likelihood of reaching maximum profit is 1/3, the same likelihood associated
with straight call or put buying.

Credit Spreads
Bear Call Spread: A vertical credit spread created by
selling a call option and simultaneously buying a call
option one strike price higher, creating a net credit.
Bull Put Spread: A vertical credit spread created by
selling a put option and simultaneously buying a put
option one strike price lower, creating a net credit.

Bull Put Spread Scenario Action

Paul very much enjoys trading GOOG
but has been disappointed lately at the
stagnation of the stock price. He would
like to sell some puts for the $590 strike
price bringing in $5.60/share, but he’s
concerned about the margin for $5.60
Sell $590p r $3.60
requirements of being naked. So he fo
Buy $580p
chooses to spend $3.60/share and also
it = $2.00
buy his own puts for protection at $580. Net Cred

Maximum Profit: $2.00 (net credit)

Maximum Risk: $10 (spread) - $2.00 (credit) = $8.00
Margin Requirement: $8.00 (risk)
Direction: Bullish/Neutral
Can make money if the stock goes up, sideways, or down to the sold put price
Maximum Profit = Net Credit
Maximum Loss = Spread - Net Credit
Break Even = Strike Price (put sold) - Net Credit
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 Bear Call Spread Scenario Action
Josiah is confident AZO will continue
trading downward but feels the trend is
not fast enough to buy puts. He wants to
sell some call options but is concerned
about being in an uncovered position. So
he sells a $165 call for $0.85 and buys a ll $ 16 5 c for $0.85
S e
$170 call for $0.30. Now, in the event y $ 1 7 0c for $0.30
B u
AZO trades up quickly, he is protected it = $0.55
from the risk of being uncovered. Net Cred

Maximum Profit: $0.55 (Net Credit)

Maximum Risk: $5 (spread) - $0.55 (credit) = $4.45
Margin Requirement: $4.45 (risk)
Direction: Bearish/Neutral
Can make money if the stock goes down, sideways, or up to the sold call price
Maximum Profit = Net Credit
Maximum Loss = Spread - Net Credit
Break Even = Strike Price (call sold) - Net Credit

Unwinding a Spread
You can always undo any option you sell by purchasing it back.
When you sell an option you are “short,” so simply
buying it back will close it.
It will most likely cost you more than you received.
Once you buy it back, you are free from all obligations.
What’s left is a regular long (bought) option position.

Timing a Spread
Ultimately, a spread breaks down to its most basic elements.
• A debit spread breaks down to buying an option.
• A credit spread breaks down to selling an option.
Normal buying and selling rules should be followed.

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Advanced Option Strategies

LESSON 6
SIDEWAYS TRADING
Sideways Markets
Occurs when a stock fails to make either
higher highs or lower lows (no trend)
Represents period of price consolidation
Can be very short or can last a long time
Can be very frustrating if you’re hoping to trade a trend
There is only one way to make money with options in a sideways market...
• Sell, Sell, Sell!
• When you sell options, you bring money in and let time decay work
in your favor.
Any selling strategy could
work for a sideways
market (theoretically).
COMMONALITIES
• Selling Puts • RECEIVE MONEY AT TIME OF TRANSACTION
• Selling Calls • USE TIME EROSION TO YOUR ADVANTAGE
• Bull Put Spread
• Bear Call Spread • MAKE MONEY IN 2 OUT OF 3 DIRECTIONS
• Covered Calls • LIKE “SELLING STOCK INSURANCE”

Selling Puts

• Stock can go up, sideways, or down just a little

• Risk of being put the stock (i.e., you have to buy)
• High risk, limited reward

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 Selling Calls

• Stock can go down, sideways, or up just a little

• Risk of being called out of the stock
(i.e., you have to sell)
• Unlimited risk, limited reward

Bear Call Spread

• Stock can go down, sideways, or up just a little

• Risk of being called out of the stock
(i.e., you have to sell)
• Lower risk by buying insurance
• Limited risk, limited reward

Bull Put Spread

• Stock can go up, sideways, or down just a little

• Risk of being put the stock
(i.e., you have to buy)
• Lower risk by buying insurance
• Limited risk, limited reward

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Iron Condor

Iron Condor

• Stock can go sideways, up, or down a little

• One side will always be 100% profitable
• Limited risk, limited reward

Why do an Iron Condor instead of a straight credit spread?

• One side will make money • No additional margin required
• It doesn’t cost any more • It’s like free money!

Iron Condor Scenario Action

BIDU has hit resistance at $450, and support at
$375 continues to hold. So Pedro wants to enter an Net Credit $0.80
IRON CONDOR to profit from this sideways move. + Net Credit $1.25
He starts by entering a Bull Put Spread using the
strike prices $380/$370, receiving a net credit of Total Credit $2.05
$0.80. Then Pedro adds the Bear Call Spread using
the strike prices $450/$460, pulling in an additional
$1.15 net credit.

• Maximum profit if BIDU stays

between $450 & $380
• If BIDU breaks out, close that leg
of the trade by buying back your
sold option.
• By doing an Iron Condor you
increased your ROI from 12% to 20%.

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Which Option to Sell?
Sell outside trading range.
Do front month (less than 4 weeks to expiration).
Ideal time to write is 3 weeks before expiration.

Butterfly Spread

Butterfly Spread

• In order to achieve maximum profit, the

underlying stock must close At The Money
in the middle of the butterfly (body).
• Low risk, limited reward, complicated
setup, and unpredictable

Long Call
Butterfly Short Call
Butterfly

Short Put
Long Put Butterfly
Butterfly

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Advanced Option Strategies

LESSON 7
VOLATILITY TRADING
Volatility
The great unknown factor
Apart from time passage, nothing else affects an option’s price more.
Very difficult to quantify
A relative number
Reflects the amount that a stock or option is expected to move

Two Types of Volatility

Historical Volatility: Based on the underlying stock
Implied Volatility: The volatility component implicit in an option price

Measuring Volatility
Two ways to measure expected implied volatility
moves in your option:
The relationship to Historical Volatility
The relationship to itself
The general rule:
• If Implied Volatility is substantially
higher than its usual relationship to
Historical Volatility, then volatility is high.
• If Implied Volatility is substantially higher than its usual relationship to itself,
then volatility is high.
High volatility leads to a much higher option which can mean two things:
• Option prices may be unfairly inflated.
• It may be more profitable to sell options.
Ultimately, volatility is a very theoretical attempt to price all unknown factors
into an option.

Importance of Volatility
If you have a good idea (or approximate) If IV is:
that an option’s volatility could likely change
rapidly, it should affect your decision of You Buy Options Sell Options
which strategy to implement should:

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Volatility Concerns When Trading
When Buying Options:
• It’s ideal to buy when volatility is rising but still low.
• Sometimes high IV should keep you out of a trade
When Selling Options: It’s ideal to sell when volatility is high and falling.

Volatility Scenario
Jim has been watching AAPL for several months and
is ready to enter a trade based on the recent • He’s bullish on the
breakout. He wishes to buy some calls but in the stock.
option chain he notices calls are very expensive. He • He would rather
takes a quick look at the Implied Volatility and “receive” too much
realizes AAPL is currently trading with an IV of 63, money in a sale than
nearly twice its normal average. Concerned he pay too much money
would be paying too much for calls, Jim decides to in a purchase.
sell puts instead. Why?

How does the IV traditionally compare?

How does it currently stock up?

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Possible Volatility Trade Setups
Buying Options: When a pattern break is obviously set up (wedge, flag, Bollinger
Squeeze, etc.) and IV is low...
Selling Options:
• Selling is usually beneficial when IV is high.
• Be sure to sell OTM and choose a strike that is out of the range of likely
assignment.

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Straddle
Involves buying both a Call and a Put of the same strike price
Designed to take advantage of a rapid rise in price
Even better when combined with rise in volatility
Ideal surrounding earnings announcement

Straddle Scenario 1 Action

Elza has been anxiously anticipating
upcoming earnings for RIMM and even
heard a rumor of a new and improved
Blackberry. She really wants to buy call
options but knows better than to trade
over earnings. Determined to place
some type of trade, Elza decides to buy a
$65 call. But just in case she’s wrong, she Call $6.30
also buys a $65 put. Now no matter Put $5.60
which direction RIMM trades following
.90
earnings, she can potentially make money. Cost: $11

Straddle Results
Cash Out: $16.45
After earnings RIMM did report great - Total Cost: $11.90
numbers, and the next day the stock
Profit: $4.55
gapped up $11 to $76.50. The $6 call
Elza purchased now had $11 Intrinsic
Value plus some additional Premium
Value. To make things better, the large
gap increased volatility from 42.3 up to
61, further enhancing Elza’s position. She
closed her $65 calls for $16.45 each.
After taking out the initial cost, her final
profit was $4.55, a gain of nearly 40%
overnight.

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 Straddle Scenario 2
Action
Teddy is very excited to try his new
straddle strategy over the upcoming
.50
earnings for GOOG. He enters the Call $13 0
.2
trade by purchasing both a call and a put Put $10
for the $600 strike price. This is an
3.70
expensive trade as it cost him $13.50 for Cost: $2
the call and $10.20 for the put, but he’s
confident things will work out fine.

Straddle Result
Cash Out: $19.75
GOOG’s earnings were incredible! Teddy - Total Cost: $23.70
can’t wait for the next morning when the
market opens to see the sure profit he Profit: - $3.95
expects from his straddle. First thing in
the morning GOOG gaps up $14 putting
Teddy’s calls $13 in the money. His calls
are now worth $16.50 while his puts
have dropped to $3.25. The combined
value of his positions is only $19.75 and
Teddy can’t figure out why he lost money
on this trade.

What Happened?
Later, upon revisiting the Implied Volatility, Teddy realized GOOG had an implied volatility
of 42 before earnings, and it dropped to 26 after earnings. The loss of Implied Volatility
caused the option prices to drop and made this trade a loser for Teddy.

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Volatility Considerations
Straddles are great, until they aren’t...
Failure to recognize inflated volatility will make this trade difficult...if not
impossible.
If you can enter a straddle with low Implied Volatility, you can potentially make
an explosive move as the volatility moves in on top of the news.
Compare IV to its own history as a reference.

Strangle
Involves buying both a Call and a Put
Just like a straddle except the strangle buys equally spaced Out of The Money
Calls and Puts
Should only be used for a large volatility break or a news trade
A rapid increase in volatility can make this trade extra profitable.

Strangle Scenario 3 Action

Glancing through his charts, Chris
discovered AXP had begun trading in a
Bollinger Band Squeeze, a pattern he
recognized to have typically low volatility.
He knows AXP is announcing earnings in
two days, so Chris decides to enter a
trade. He could do a straddle, but
instead decides to lower his cost a tad
and enter a strangle instead. He buys
both a $42.50 call for $0.45 and a $37.50 Call $0.45
put for $0.30. Since the options are Put $0.30
cheap, he buys 40 contracts, or 4000 5
shares. Cost: $0.7

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 Strangle Result
After a poor earnings AXP falls drastically
down to $35. Not only does this
represent a huge move for the stock, but Cash Out: $3.25
it also triggered the break out of the - Total Cost: $0.75
Bollinger Squeeze. Now his Put is ITM, Profit: $2.50
and Implied Volatility also shot up. The Put
Chris paid $0.30 for is now trading for
$3.15, and to his amazement, the Call still
had $0.10 of value because of the
volatility boost. At the end of the day,
Chris profited $2.50 in two days. With his
4000 shares, that’s a gain of nearly
$10,000.

Straddle/Strangle Trading Criteria

The stock needs to have low volatility. High volatility will make your trade
subject to volatility contraction.
The stock needs to have news or another major announcement coming.
If an additional pattern helps confirm the future move, it is better (e.g., chart
pattern, Bollinger Squeeze, etc.)
Less expensive is usually better

Exiting the Trade

Exit the next morning after the major move is done.
Close your losing leg ASAP, and take the money that is left.
Let your winning leg ride until you see early reversal signals (or alternately, take
full profit first thing in the morning).

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Advanced Option Strategies

LESSON 8
OPTION LEAPS
LEAP Acronym
An Option with more than a year to expiration
Long-term
Allows you to control a stock (for a long time!) Equity
Works just like any other option
Can allow some very creative strategies Antici-
Pation

Things to Remember
Anything you can do with a short term option, you can do with a LEAP
The more time you have until expiration, the slower your time value will erode
12 months or more is a long time to have control of a stock.....
(hmmm what could you do....?)

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Time Value with LEAPs

Jan 2012 Jan 2011 Jul 2010

Apr 2010 Feb 2010 Jan 2010

Month Theta Delta

Jan 2012 -.02 .66

Jan 2011 -.03 .63
Jul 2010 -.05 .61
Apr 2010 -.06 .60
Feb 2010 -.09 .61
Jan 2010 -.12 .67

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 LEAP Scenario 1
Steve has been watching IBM for months as the price has nearly double in less than a
year. Recently IBM has yet again broken new resistance and looks to be on a clear
path higher. Steve wants to buy it for a long time, but the cost of the shares could be
prohibitive at $130/share. So Steve looks at buying a $130 call option with an
expiration of Jan, 2012, for only $18.75/share. He buys 10 contracts for control over
1000 shares.

The next day Steve is excited as IBM

breaks out even more bullish. In 1 day
he’s already $2 ITM. The next year
should be fun!

Based on these Greeks how will Steve’s

IBM option react in the future?

Just 1 month later let’s assume IBM has exploded and is trading at $150/share.
Based on this option chain is there any way to know what the value of Steve’s $130
option would be?

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 LEAP Scenario 2
After Steve has seen the price rise so quickly for IBM he gets concerned that he may
lose all his money. He decides to buy some insurance with $140 puts paying $9.50
for Jan 2012. What is his risk?

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 LEAP Scenario 3
Now that Steve has a perfectly hedged position until 2012 he wants to have some fun
and really pull some profits. He believes IBM is ripe for some consolidation and $160
will be the top for a while. So Steve sells a $160 Call set to expire in Feb 2010
(front month) for $1.05/share.

Now that he’s hedged and can not really lose money Steve continues to sell both
calls and puts, Front month, as IBM rises and falls, bringing in monthly income
leveraging not just his money with LEAPs, but also his control of the stock.

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 LEAP Scenario 4
After 20 months Steve has raked in over $25,000 selling options against his hedge
position. In that time IBM has risen to $200/share, making Steve’s original $130 call
worth over $75/share. (he never sold because he always sold OTM calls against it)
Now steve is ready to close the trade and bid farewell to his 2- year cash cow.

What Happened?
First Steve controlled IBM with a 2 year option (used a LEAP instead of stock)
Next Steve Hedged his position with a 2 year Put Option (used a LEAP as a
insurance)
Then Steve wrote spreads against his options (diagonal or calendar spread)
Finally Steve sold his option for a nice Capital gain (leverage)

Leaps Instead of Stock

When you buy a LEAP you have control of a stock for an
extended period of time without putting up the full
amount of money
(usually between 15-25% of strike value for ATM LEAPs)
You can use the LEAP similar to uses of Stock
• Capital gains
• As leverage to write options

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Ideal Candidates
A stock you want to work with
Use regular analysis to enter a logical trend position
Buy At The Money if you intend to use the position to write options against
Buy Out Of The Money if you wish to purely speculate
(but only 1-2 strike prices)
At least 100 Open Interest (500+ is better)

Spreads WIth LEAPs

Calendar Spread: Buy and sell the same
number of options with the same strike price but
different months for expiration

Diagonal Spread: Buy and sell options with the different strike prices and
different months for expiration

The Ultimate Covered Call?

You can do them with Calls or Puts
The Same concept as a covered call but with leverage
Allows you to do a covered put (in function) without the unlimited risk
association

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