✔ You can trade them like stocks. That means you can buy and sell shares in them at any time during the trading day instead of waiting until the market closes, as with non-exchange traded traditional mutual funds.
✔ ETFs offer listed options. That means you can apply all option strategies to sectors of the stock market by trading options on the underlying ETF. This often lets you make index bets without using index options with expiration and last day of trading may cause you some extra steps.
✔ There are ETFs based on commodity indexes. These let you participate in commodity markets without trading futures. When you add the extra dimension of options being available, you have a nice array of different strategies available.
ETFs are an excellent trading vehicle category, for all those reasons and more. You can design entire diversified portfolios with ETFs and then use options to hedge individual positions or the entire portfolio. Chapter 13 gives you all the details.
You can participate in rising or falling markets through stocks and ETFs, assuming that you are comfortable with both owning these securities and selling them short. But what do you do in a sideways market, except maybe sitting it out or collecting a few dividends? You can craft option strategies for sideways markets whether you have any underlying positions or not. Chapter 16 tells you all about this great set of strategies.
Reducing your directional bias and making money in flat markets
Directional bias refers to the connection of profits to the direction of prices. To make money when you are long, you need prices to rise. And to make money when you’re short, you need falling prices. When you use option combination strategies, you design trades that let you make money when the underlying stock moves up or down. Consider this:
✔ You can set up strategies that let you profit if the underlying rises or falls, depending on your trade setup. Chapters 14 and 15 tell you all about these trades.
✔ Options let you set up strategies that can make money in sideways markets.
Controlling your emotions
Perhaps the most difficult part of trading any market is the emotional responses that can be triggered by price movements in things you own, or wish you owned. Let’s face it, we are all emotional. It’s part of being human. The problem is that emotional trading is usually the path to big losses. That’s why we have rules and why you design an anticipatory trading plan, in order to control the emotion that goes along with trading.
A good trading plan has these key characteristics:
✔ Access to the proper equipment: Make sure you have all the technology you need: computers, mobile devices, and backup systems along with a quiet place to work.
✔ Knowledge of time commitment: Think about whether you will day trade or be a longer time position trader. If you can’t devote a couple or three hours at a time to monitor a position, day trading is not for you.
✔ Access to good information: Put together a good list of websites and a reliable real-time quote-charting service.
✔ Flawless trade execution: Pick an online broker that has some scale and can execute your trades in a timely fashion without leaving you in the cold.
✔ An excellent educational component: Work on your analytical skills, technical and fundamental, every day. You need to be a crack chartist and hone your decision-making skills.
Each chapter is this book reveals new information that is intended to make it easier to appreciate and execute the end game, the successful trading of options. Chapter 2 is all about the different types of options.
Chapter 2
Introducing Options
In This Chapter
There are many forms of options, but this book spends most of its time on listed stock options and listed index options, both of which trade on exchanges. These two distinct types of options function in two ways. First, they can be used to manage your risk by limiting your losses. And they offer you the opportunity for profits when used with the right strategy.
As silly as it may sound, to make the most out of options trading, it’s imperative that you really understand what options are and know the risks and potential rewards associated with them. That’s why this chapter details the information on the individual components of an option and how to recognize them in the market.
By learning the basics of options contracts and then being able to compare them to other derivatives, you will be able to get a good working understanding of these securities and how to best use them both for risk reduction and for speculative gains. The next few sections are all about the basic concepts that will get you to a comfortable point in trading options and then lead to a good understanding of the risks and rewards associated with options trading.
Grasping option basics
A financial option is a contractual agreement between two parties. Although some option contracts are over the counter, meaning they are between two parties without going through an exchange, this book is about standardized contracts known as listed options that trade on exchanges. Option contracts give the owner rights and the seller obligations. Here are the key definitions and details:
✔ Call option: A call option gives the owner (seller) the right (obligation) to buy (sell) a specific number of shares of the underlying stock at a specific price by a predetermined date. A call option gives you the opportunity to profit from price gains in the underlying stock at a fraction of the cost of owning the stock.
✔ Put option: Put options give the owner (seller) the right (obligation) to sell (buy) a specific number of shares of the underlying stock at a specific price by a specific date. If you own put options on a stock that you own, and the price of the stock is falling, the put option is gaining in value, thus offsetting the losses on the stock and giving you an opportunity to make decisions about your stock ownership without panicking.
✔ Rights of the owner of an options contract: A call option gives the owner the right to buy a specific number of shares of stock at a predetermined price. A put option gives its owner the right to sell a specific number of shares of stock at a predetermined price.
✔ Obligations of an options seller: Sellers of call options have the obligation to sell a specific number of shares of the underlying stock at a predetermined price. Sellers of put options have the obligation to buy a specific amount of stock at a predetermined price.
