Chapter 1 Introduction – The Options Trading Primer

CHAPTER 1

Introduction

A Brief History of Options

Options date all the way back to ancient Greece, when olive oil options were traded. And options were also extremely popular during the “tulip bulb mania” of seventeenth century Holland. During that time, tulip wholesalers sold call options to hedge their risks against a poor harvest, while tulip growers hedged their investments in bulbs, fertilizer, and fuel by buying put options.

The price of tulip bulbs continued to rise, leading to a secondary unregulated options market that was available to the general public. And the Dutch investors were ecstatic while the party lasted. But, as often happens, the Dutch economy suffered a major decline in 1638. Thousands of Dutchmen who had invested all of their financial holdings in tulip options suffered massive financial losses. They lost everything, because they were unable to meet their financial obligations. That event gave options trading a bad reputation.

The use of options to hedge (minimize) losses still prevails today among financial institutions and individual investors alike, because put options increase in value when the price of the underlying stock drops in value. So you have read about two kinds of options: call options and put options. Either type of option can be bought or sold, providing, as you will soon learn, tremendous flexibility to those who buy and sell options on a regular basis.

Today options are much safer, because they are heavily regulated. Government-enforced brokerage rules limit investment levels to prevent the possibility of colossal investor losses. And books like this one explain the dos and don’ts of option trading. Of course, uneducated option traders who do not understand how options work enter trades that experienced option traders avoid. This is also true of stock, futures, and foreign exchange traders. There simply isn’t any investment vehicle that doesn’t carry risk. Even the most experienced and successful market traders have bad days.

Unregulated options trading in the United States began in the 1890s. The volume of option trading in the United States had increased substantially by the 1920s. But the options market was essentially unregulated and attracted some unscrupulous individuals. Some compared options trading to the “wild west,” because the lack of regulatory oversight and the practices of unscrupulous characters added substantial risk to options trading. Uneducated option traders made risky investments and lost fortunes. But some options traders became highly successful, while others fell victim to both their limited understanding of how options work and the unscrupulous practices by some market makers (those who match buy and sell orders) who were suspected of skimming the option transactions that passed through their shops.

In 1973, the Chicago Board of Options Exchange (CBOE) was formed to create and oversee the options market. Today there are nearly 7,000 optionable stocks, exchange-traded funds (ETFs), financial indexes, and futures. And options are highly regulated by the U.S. Securities and Exchange Commission (SEC). The Options Clearing Corporation (OCC) also contributes to the stability and security of options trading by closing, or clearing, all expired options contracts that are subject to assignment by fulfilling the obligations that exist between options buyers and sellers. In addition, there are strict SEC rules that govern options trading. These rules ensure that options traders have sufficient financial equity in their trading (or brokerage margin) accounts to settle their options trades. Furthermore, only those option traders who can demonstrate their options knowledge through either several years of trading experience or by satisfactorily passing an options test are permitted to trade high-risk option strategies such as selling “uncovered calls,” which is described in some detail in this book.

The dynamics of buying and selling calls and puts are described throughout this book. Chapter 5 includes a series of essential option trading rules. Follow these rules and you will increase your probability of achieving more successful trade outcomes than losses. These trading rules are also included in substantial detail in each of the option trade examples included in the Hands-On Option Trading Activities contained in Chapter 6.

Once you finish that chapter, you should be ready to try out several rules-based option trades. Trade them in simulation first. Manage them in simulation. And check your win–loss ratio. If you’re not batting at least 700, don’t risk your money until you are. Some traders will even exceed 800. But what about the few losses? If you never lose a trade, you’re probably not trading. The market is a random universe. You’re never going to be right 100 percent of the time.

Why We Trade Options

There are many reasons for new and experienced investors alike to be drawn to options trading, several of which are provided here. These reasons are responsible for the increasing popularity and explosive growth in the volume of options trading.

Options Trading Growth

Option trading volume increased by 22 percent in the year 2018—faster than all other trading venues combined. Once you finish this book, you should understand why options trading has become so popular and why people just like you want to learn how to earn steady incomes by becoming competent, high-frequency options traders.

Financial Leverage

Done properly, options can provide much larger financial returns than buying the underlying equity, that is, the stock, ETF, financial index, etc. Investing a few hundred dollars trading options can control stock worth several thousand dollars. This is financial leverage! For example, the synthetic long stock strategy detailed in Chapter 6 cost $275 when filled and can return tens of thousands of dollars in profit. This is also true of other option strategies. Several examples of the financial leverage available in options trades are detailed within this book.

Option Strategies for Every Market Condition

There are options strategies that fit nearly every market condition. Traders can buy or sell a call or a put depending on the trader’s bullish or bearish bias. And there are strategies that combine two or more puts or calls. Traders buy one or more calls when buying volume (or current volatility) is relatively low and the market is rallying, because call options increase in value as the price of the underlying increases. They buy puts when buying volume (or current volatility) is relatively low and when the market is dropping. Hence, puts increase in value when the market is dropping. When the market is dropping, option traders sell calls and sell puts when the market is rallying. This book explains both how this works and how it is done.

Traders combine bought and sold options in a variety of ways. Combining bought (long) and sold (short) options are frequently used to limit the maximum amount of money that can be lost. Strategies that combine long and short (bought and sold) options are referred to as “defined risk” trades.

These generalizations show the flexibility of put and call options. And we choose the options based on our bullish, neutral, or bearish bias that is based on what we see on our price charts. (More about price charts in Chapter 3.)

Statistically Predictable Trade Outcomes

Options include mathematically calculated values, including statistical probabilities for success. Success corresponds to knowing the odds of where the price of the underlying equity, such as a stock, is likely to be upon the expiration of the option contract. (Every option is a contractual agreement between an option buyer and seller. Every option contract expires at market close on a specific date. More about this later.) Option traders study probability statistics to determine the likely outcomes of their trades. This is how so many educated option traders earn steady incomes. It’s also why option trading volumes are increasing throughout the world.

We use these statistical probabilities in our option trading. The options math makes this reasonably easy. Even with this information based on probabilities, it’s always possible to encounter a loss. In fact, if you become an active options trader, you will lose from time to time, even when you follow all of your rules that are statistically valid.

Consider the blackjack card game for a moment. A score of 21 always wins. You are at the gaming table and are dealt 18. Your personal rules tell you 18 is likely to be a winning hand based on statistical probabilities. The dealer gives 3 to the player to your right. That’s the card you need to hit 21! But no worries, the odds are still in your favor because you’re holding 18. The dealer draws a 10 off the stack, turns his cards face up, and shows a 20—a Queen and a 10. He taps his cards and picks up your chips. You lost! But your process was right and statistically sound. The dealer got lucky. This happens even when your rules are valid.

So even though we follow statistically valid rules and succeed eight out of ten times, random events happen, just as in a blackjack hand. Stick to your rules! Using them will return many more wins than losses, in spite of the randomness of the market.