Preface – The Options Trading Primer

Preface

Several years ago, I read an online article that offered a “secret trading method” that earned a weekly income each and every week without fail. The article stated that this secret method had been discovered by a Russian programmer who had been working for Wall Street financial institutions for twenty years. His name was Boris Kosilov, and the website included a narrated presentation conducted by Boris. He had been contacted by a wealth investment company to send fail-safe weekly trades each Monday morning. The trade setups, based on his secret method, would be revealed to company subscribers. As part of this trading program, Boris would send alerts to subscribers in case the market moved against a working trade that needed to be closed to prevent losses. Boris also recommended the use of a discount financial brokerage to minimize trading commissions.

The subscription cost was $750 per year. This fee would be refunded within 60 days if a subscriber was not completely satisfied. This seemed reasonable for a trading system that would take only a matter of minutes each week to use, especially if it produced a nice weekly income. And they would refund the subscription fees if the subscriber was not completely satisfied with the outcome. However, the termination refund required subscribers to provide their trading records.

I opened an account with a discount brokerage, paid my subscription, and anxiously awaited my first e-mail from Boris. It arrived on the following Monday morning about 30 minutes after the market opened. It included three option trades on three different financial indexes: the S&P 500, the Nasdaq 100, and the Russell 2000, symbols SPX, NDX, and RUT, respectively. The recommended trades sold 100-share call and put option contracts that were far above and below the current prices of these indexes. And all three indexes were unlikely to ever reach the recommended option prices, called strike prices. (You’ll learn all about option strike prices in Chapter 2 of this book.) The option contract values, called premium, ranged from 10 cents to 30 cents per share, or $10 to $30 for each 100-share option contract.

I received step-by-step instructions from Boris that showed me how to trade one or more options on my new trading platform. This entailed opening what is called an option chain. One by one, I entered the index symbols at the top of the option chain, clicked on the Bid columns at the recommended option prices, entered a quantity of one, for one contract, and clicked Send. My order filled within a matter of seconds. I repeated this process for the other two indexes—all filled quickly, and as I sold each option, referred to as calls and puts, money was received by my brokerage account. By the end of the first week, all option contracts expired worthless, and I kept the premiums I had collected for all three of my trades. This was too easy! And, as promised, it worked.

When selling one call and one put on the same index, I received about $40 in premium. Trading two or even three contracts on each returned $80 or $120 per week. Not bad, I thought. I could sell multiple contracts on these financial indexes and recover my $750 subscription fee in 4 or 5 weeks.

The investment company held online webinars for its subscribers on Tuesday mornings. The presenter, named Phil, discussed the trading system and answered questions from the members of his audience of novice option traders. Phil’s voice sounded exactly like Boris’s voice, but without the accent. Phil told us we were trading what option traders call strangles—selling a put and a call option above and below the current price of the underlying financial index (the S&P 500, Nasdaq, and Russell 2000).

I began exploring the option chain and discovered several more columns with names like Mark, Delta, Theta, Vega, Gamma, Rho, Open Interest, Last, Extrinsic Value, Intrinsic Value, Probability ITM%, and several more. I already figured out that the Mark was the premium paid to sellers and received from buyers less the brokerage commissions paid when trades were filled. Boris told us in one of his webinars that Open Interest was the number of working trades at each option price (called strike price). I didn’t have a clue about the meaning of the other column values. But I was making a modest weekly income, so I continued to enter Boris’s trade setups for about four more weeks.

I decided to google a few of those column names and found a website called Investopedia. It contained a goldmine of information about options, and I also discovered that there was nothing secret about strangles. Investopedia also described dozens of other option trading strategies. And since I had found a whole new, low-cost, and high-return trading system, I wanted to learn a lot more.

I also decided to look at how Boris’s trade setups would work if I sold them a week earlier. Wow! Giving the trade several more days increased those 15- to 40-cent premiums to the $1.00 to $5.00 range. But it was also obvious that adding time added risk, because it gave the price of those index options more time to move against the trade by moving either higher or lower. Those moves, especially on the Nasdaq and S&P 500, could be as much as a few hundred dollars in a day. I learned from my research how a large, unwanted price move could potentially result in a massive loss—even “blow out” my entire trading account.

I decided it was time to learn more about options on my own. I contacted the financial investment company to cancel my subscription, sent them my weekly trading records, and they credited my bank card for the original $750.

I enrolled in a series of market trading courses from the Online Trading Academy and TD Ameritrade’s educational unit that included studies on the use of price charts (technical analysis), options, advanced options, and futures. I also researched the foreign exchange market, called the Forex. I spent five figures in tuition—some of the best money I ever spent, because I was able to make it all back within a matter of weeks. Within just a few years, learning how options work and how to trade them earned several hundred thousand dollars.

Options math gives option traders an edge; they can quickly determine the mathematical probabilities of success for each and every trade they make. Of course, the market can be quite random. Although properly examined option trades usually succeed, the market can turn on a dime. The key is to succeed most of the time.

I also found that there’s no substitute for education. Every trade involves a buyer and a seller. Educated traders consistently take money from uneducated traders on the other side of their trades. Thanks for playing!

Seasoned investors who buy and sell stocks and exchange-traded funds (ETFs), options, futures contracts, or foreign exchange currency pairs study the way each of these four trading venues work. Once they understand the dynamics of their chosen investment venue, they develop a set of time-tested trading rules. And they follow these rules to enhance the probability of achieving successful trade outcomes. And this works—most of the time.

These rules include the analysis of price charts. Every seasoned trader uses them. This always includes examining both historical and current price charts. A series of price charts reveal typical price levels, patterns, and common trends durations, where trends can be upward, downward, or sideways. (As one of my instructors used to say, “The trend is your friend—till the end of the trend.”)

Today, after several years of high-volume trading, I know exactly what he meant and why. Price charts also reveal both historical and current trading volumes. They display the highs (resistance) and lows (support) price points for a selected security. Each security has a unique ticker symbol such as AAPL, AMZN, GOOG, and SPX for Apple, Amazon, and Google stock and the S&P 500 index, respectively. Traders also determine the average price range (or price movement) and current and historical trading volumes. The measurement of volatility and its use is discussed in detail in Chapters 4 and 5.

This information, and more, is used by all seasoned investors and market traders, where a trader is defined as a high-frequency investor. The typical trader enters and exits multiple trades each day or week. And they use much of the same information as long-term investors in order to develop a trading bias. Trader biases, sometimes called market sentiment, are usually “bullish” when expecting a price increase, or “rally,” and “bearish” when expecting a price decrease, or “drop.” They are “neutral” when the price is expected to remain within a narrow range. While this book provides readers with the essentials of options trading, it also examines the use of price charts to help develop a fact-based trading bias. This is important to every trading venue.

 

 

Disclaimer

Trading and investing always involve risk. Any money traded or invested can be lost. You alone are responsible for any trading or investing activity that you undertake. Neither the author nor the publisher is licensed, qualified, or authorized to provide trading or investing advice, nor will they assume any responsibilities for your actions. Hence, by reading this disclaimer and the information within this book, you understand that there is always risk involved in trading stocks, exchange-traded funds, financial indices, bonds, option contracts, futures, and the foreign exchange currency market. The author and publisher make no representations or warranties for your trading success, nor will they be held liable for your actions.

The Illustrations within This Book

Most of the illustrations within this book are screen captures from the popular thinkorswim trading application and used with permission, courtesy of TD Ameritrade.