Options Trading Strategies: Basic to Advanced

The most important thing I have understood in learning options trading strategies is to understand "What is an Option?" This Flagship Hub is dedicated to giving you an introduction to answer that question. This hub is also being maintained as a forum for options traders. Options University has been generous in providing unique and original (never been published) articles from some of their top writers, all active and very profitable options traders.

"Do what I say, not what I do," doesn't work in learning options trading strategies. If you want to do it right, you must learn form someone who has not only been an experienced options trader, but who is also an active trader, now. I am learning from Ron, Ryan and Wayne at Options University. These guys are active traders, Ryan and Wayne the technical analysis experts, Ron Ianieri, the veteran floor trader (head options trader on the Dell desk at its peak) and reputedly the best teacher in the options trading educational field.

I've spoken with many of his students, seen his teaching style at live seminars and during Options University's live classes on the Internet. As a teacher myself, he really understands the teaching process. "Learn the basics," he says, "and all the options trading strategies will not only be easy to understand, but you'll also comprehend when to use the proper options trading strategy or combination of trading strategies for each kind of trade.

A little about me and why I think education is so important. I was a driving instructor for three years, in-car and in-class, while going to Life Bible College, in Burnaby, B.C. and during my extensive travels teaching, part-time, English as a second language. I've been a student most of my life, almost 50 years, and learning the basics in anything lays the foundation for future learning. You can't do calculus without learning to add two plus two first.

"Give a man a fish and he eats today. Teach a man to fish and his family will eat tomorrow. Teach a man to teach others to fish and you can change the world," is my amendment and the motto of my Blog. I admire the person who teaches others well, but most importantly someone who really enjoys doing it.

I have published the top 6 articles on this Flagship Hub. There are another 30 articles available on the many satellite pages of this hub.

This hub was created to help educate and inform, but learning is a two way process, it includes teaching others, if only in asking questions.

So here's the deal, I don't think you want to refuse? I add more great content, more articles, link resources, guest passes to online webinars, special video content and other free stuff. You the reader/student/teacher, of options trading strategies do this: for every three articles you read, you vote for two and write a comment of one of them, something that will teach others something about options trading strategies. Please, no "Love the hub, great content!"

Tell me what you think about my hub, how to make it better, what you want to see.

P.S. I am working on getting some 50 hours of archived videos, all on options trading strategies on this hub, so stay tuned.

P.P.S. Greg's Options University Weekly Market Report videos will be updated weekly.

Options University is pleased to provide here a weekly stock market report with technical analysist, Greg Wolfe. This first video will be updated at the beginning of the week and last week's report will move on video spot down, and so on. All of the videos will be archived on this hub for your convenience and reference.

If Ron Ianieri is correct, we are all victims of History's greatest fraud. By a collective collusion of vested interests, we are purposefully lied to everyday.... but most particularly during Fed policy announcements and company earnings reports. If an investor or stock option trader uses fundamental analysis in trade decision making, take heed.

Ron, one of the founders of Options University, recently wrote an article in the December issue of the OU newsletter (www.optionsuniversity.com) called "What's in a Number." In the article, he asks the question most of us are asking: "If inflation is under control, am I the only one to have almost all of my expenses rising much faster than the official inflation rate?" He goes on to cast aspersions at the institutionally massaged definition of inflation and how that twisted version of the critical factor in determining interest rates can affect the economy. However, Ron carries the concern from the Fed super spin to the devious denizens of Wall Street. Yes, once again those bastions of "rational analysis-the Wall Street Analysts-may be at it again.

Ron presents an example of how some of the recent earnings reports might have been "adjusted downward" just a few weeks before actual earnings came out. These adjustments were made in reaction to the estimated effects of the subprime credit problems. Low and behold, some companies came out with earnings that exceeded the "adjusted estimated earnings" and the stock prices of those companies in question actually moved up in reaction to the "good news." Of course, the implication is that there might be a consorted effort to hoodwink the investing public. If analysts can be persuaded to make "adjustments" to fundamental information, what effect does that have on the veracity of the information and its resultant effect on stock prices? Ron's answer to the problem was to exclude fundamental analysis from his analysis of a stock.

But of course, technical analysis of stocks, stock options, etc is based on price movement and volume; as a result, it could all be a case of gigo (garbage in, garbage out). If this is indeed the case, then we investors and option traders might be a lot further out there on the probability curve that we think. Or, even more possible, it doesn't mean a damn if everybody else doesn't see a naked emperor.

This brings me to an interesting possibility. Could it be that the value of money and the perception of that value are all about marketing? If you are told continually and believe there is no inflation, will that effect your consumption patterns accordingly? If it is all a hoax, what does this mean to the economy....and our jobs....and our standard of living....and our well being. You get the picture.

Maybe we are seeing the evolution of a "new system of economics" akin to floating currency rates. The value and comparative value of currencies are based on perceived value-nothing more. If there is a way to "guide" perceived value (i.e., information from "credible sources"), the main benefit of capitalism-resource allocation-could be maintained. Old school economics of the business cycle with its gain and pain may be eradicated.

Many of us have children who are nearing thirty years old and have yet to experience anything like a recession. As an investor, it's much the same. Option traders make money when prices go where we have correctly anticipated. Regard-less of where the information came from or what the talking heads say, it all gets down to what the consensus of the "emperor watchers" think. So, as an investor or trader, is it really a matter of understanding what is the "perceived reality."

Is your understanding of stock options built on a foundation of sand? If you don't have a good grasp of the "Greeks" and the Stock Option Pricing model, you, indeed, are "hanging out there".

Many option training courses "de jour" don't seem to cover the rather complex but necessary subjects of the Option Pricing Model and the component Greeks that are produced in the process of using the Option Pricing Model.

The Greeks are variables that allow an option investor to know how an option and its price will be affected by key variables. Not only can the Greeks forecast what probability the option has of finishing in-the-money, they can also demonstrate how time and volatility will affect the price of the option... Unfortunately, not enough option traders seem to be aware of the importance of this essential information. This lack of understanding is most probably due to the lack of confidence that the option education industry has in option traders to have the patience, interest or time to learn about these concepts. And, of course, the less the general option trading population knows may be to the benefit of the "other side" normally taken by the professional option traders.

Be advised, do not trade options unless you have taken a course or studied to the point of a clear understanding the basic building blocks of stock options: the Option Pricing Model and the Greeks. If you trade options without this information and how to use it, you will be trading stock options with one hand tied behind your back. It will cost you money.

Before deciding to become a serious stock option trader, you should commit to the idea of continuing education about options and try to hook up with a provider that will help keep you up-to-date and constantly learning about options. Moreover, to become a successful option trader, it would also be a good idea to also commit to learning and applying the many strategies to option trades. Don't get locked into a certain strategy or style of trading just because you understand it better than other strategies. Learn to analyze a stock and then to choose the best strategy for the situation. Also, learn how to appraise the best risk-reward scenario comparing different strategies for similar situations.

The great strength of stock options is the flexibility they offer. But to learn about the various strategies that can be used, requires a solid and ongoing education, which first builds upon the basic building blocks-the Pricing Model and the Greeks.

It's very seductive. But is it too good to be true? Can you really make triple digit returns on your horizontal investment money just by following directions? Yeah, right. Are the returns claimed by newsletter advisory services for real? Is there any third party entity watching over the hawkers of "easy money" newsletters? Generally, Investment newsletters cater to the do-it-yourself investor who thinks they are knowledgeable and confident enough to invest without a professional investment adviser and usually too busy to track all of the potential investments. Are they just another example of P.T. Barnum's famous statement ("a sucker is born every minute")?

Most investment newsletter subscriptions appear to cost between $100 and $300 for a yearly subscription. But trading stock options are not as simple as trading stocks. Stock options have so many uses and strategies that to be a good "do-it-yourselfer" probably means that you are well trained or have too much free time. But there are many stock option traders who think they know what they are doing but are really in over their heads. If you don't believe me, just try reading some of the stock option trading blogs. Quickly, one can see that trading options is rarely about trading plain old option calls and puts. It's much more about spreads, front and back months, analyzing deltas, and understanding the differences between eagles, butterflies and other esoteric strategies. Not only is trading stock options understanding about the underlying stocks but also about the derivatives of derivatives and what makes them tick... Let's face it, it's not for everybody. The complexities of trading options belay the beauty of stock options for those who understand them.

Maybe the guys and gals who write the advisory newsletters understand options and how to trade them and maybe they don't. It should be easy to find out by having the authors of stock option advisory newsletters provide an audited trade journal with all suggested trade results to substantiate their claims. The closest thing I could find for some third party evaluations was the Hulburt Financial Digest.

Since 1980, Mark Hulbert (http://www.marketwatch.com/) has been monitoring the performance of advisory investment newsletters and publishing the information in the Hulbert Financial Digest which is considered to be the preeminent source for advice on investment newsletters. Each year, Hulbert publishes a list of his top ten newsletters, ranked by performance. But before you start hunting for inexpensive ways to make "big bucks," you need to ask yourself some fundamental questions:

Do you want to learn about trading or are you more concerned about building wealth? If you're not interested about learning the complexities of trading stock options, then you should be seeking third party confirmation of newsletter returns. Also, you need to make sure that you understand enough about trading options to enter and exit trades properly.

1. If you are interested in learning about options, you need a newsletter that is going to discuss the strategy and methodology of each trade and provide support if you have any questions.
2. Maybe a newsletter isn't the best way to go. It might be better if you hired a trading mentor or contracted a service such as the Options University Strategist program which is a real time investment advisory service with trading analysis presented on a trade-by-trade basis. You learn and you earn. It costs more, but if the returns on capital and knowledge gained is worth it-the price is just the cost of doing business.

Are your trades taking chunks out of your trading account? Maybe its time to take a break and review some of the basics of stock options trading. Options University (www.optionsuniversity.com) offers a killer online course called Options 101. This course sets the foundation for OU's Advanced Options Strategy Course.

In the Options 101 course, the novice and experienced options trader is taken through a thorough introduction and review of stock options trading. As trading options is a fairly sophisticated subject, periodic review is a good idea. Take for instance, the Protective Call strategy.

As you may or may not recall, a protective call is when an option trader feels that profits can be made when a stock is under pressure and is likely to break down. This option strategy calls for the shorting of the stock plus buying the call. This is a hedged directional stock option play. The protective call is more commonly called a "synthetic put" because it simulates the profit and loss profile of a long put option.

As a short stock position has unlimited upside risk, if the trader is wrong and the stock moves up instead of down, the trader can really get hammered. However, as stock prices tend to fall much faster than they rise, shorting can be an excellent strategy. But a little insurance is a good thing. To limit the risk, an option trader can hedge the upside risk by purchasing a call for the stock.

Of course, the option trader pays a premium for the call option and this will add to the basis of the stock and move the breakeven price correspondingly lower.

As the course states, when a trader wants to hedge a short stock position, they can either sell the put (Sell-write) or they can buy the call (protective call) to provide the hedge. If the trader opts to use the protective call, the stock is sold short and the call is purchased in a 1:1 ratio. If, for example, the option trader feels XYZ will go down and they sell short 200 shares, the option trader will purchase 2 XYZ calls.

To figure maximum loss for a protective call, a trader needs to know the basic formula:

Maximum loss= (Strike Price + Option Price) - Stock Price

For example, if XYZ is sold at $50 per share, and the Strike Price is $45 and the premium for the call is $2, then the maximum loss is $3 ($45 +$2) - $50).

The protective call strategy allows investors the opportunity to capture large gains by shorting the stock and at the same time limiting losses if there is an unforeseen reversal.

FMOC meetings are like waiting for the ancient oracles to speak. Will the Gods bless us or curse us? Should they deal with our transgressions lightly or with a heavy hand? Because of the subprime crisis, the oracles are now center stage and what they have to say carries some impact for investors and traders and, indeed, can move markets all over the world. So, for the serious stock and stock option traders, bring on the oracles and let's make some money!

Peter Stolcers of One Option (http://www.oneoption.com/) wrote a nifty little article on the day of the last FOMC meeting (Dec 11^th) on how to play the news. Pete pointed out that most investors, traders, Wall Street analysts and the markets in general were of the opinion that the FOMC meeting would bring about a 25 basis point cut in the Fed Funds rate, which indeed happened. But it was reading between the lines of the FOMC rhetoric wherein lurked the opportunity for a successful day trade on the news.

Fed watchers-which we all are these days-learn to listen closely to what is said by the Fed. As Pete noted, if the Fed makes "dovish" statements, there is a chance that we will see a rally in the markets; conversely if the statements are "hawkish", we are likely to see a decline. If, on the other hand (does that make three hands?) the Fed makes balanced statements, we are likely to see choppy back and forth action. Under this scenario, the market will settle down before the close, posting a marginal gain/loss for the day. To follow on to Fed statements are the reports on retail sales, Producer Price Index (PPI) and Consumer Price Index (CPI), which usually support the Feds decisions. One way to check the veracity of the inflation numbers is the Libor rate. LIBOR is considered by most to be the true cost of capital (LIBOR is the London Interbank Offered Rate).

Pete goes on to elaborate on a day trading strategy using the SPY Index as the benchmark. He suggests that a trader first pick the strongest and weakest stocks or options (make sure to check the bid/ask spread on the options). In the case of the recent December 11^th Fed rate adjustment, he used an SPY at or above 152.50 as a trigger point to go long on strong stocks and 150.80 to go short on weak stocks.

Well, Pete was right in that the SPY plunged to a low of around 148 at close after the Fed announcement. It would have been a nice day trade on the short side; however, traders had to be very light on their feet to get out before close. On the following day, December 12^th, the SPY gapped up and opened at 151.6. You can see Pete really meant a day trade.

The day trade was made strictly by playing on the words. What were the words that set the traders scurrying to the short side? By most accounts, the Fed left the impression that there might be no more rate cuts for some time because the Fed's statements indicated that they expected moderate growth in the economy with no implied further cuts. As most investors and option traders seem to be of the opinion that more cuts will be needed to help control the contraction in assets being forced by the subprime problem, they went short for a couple of hours to demonstrate their collective disagreement with the Fed before covering. But the next day, it was business as usual.

From Pete's article, we might say that FOMC meeting day is a day to listen carefully and be ready to jump into action at any verbal skew to either buy options on the strong or sell on the weak. And, oh yes, be ready to close out the position before close. Perhaps investors who digest the news overnight and will wake up the next morning with a completely different insight into what they thought they heard the day before. Always keep in mind that what the Fed seems to say might not be what it really means to say and vice versa. Say what?

It's a different strategy, but very interesting. It takes advantage of the fact that stocks taking a hit make much stronger moves downward than when on the rise. But for some reason, most traders shy away from taking advantage of these potential quick and sure (?) profit makers. In today's markets, using a trading strategy on weakness is usually see as going against the market and produces a logical concern about getting caught being short in a rapid upward correction back toward the predominant trend.

Most traders are always on the lookout for breakouts-upward movements that break through upward resistance levels. These may signal a more sustained move to the upside. Similarly, a breakdown is when prices break down through support levels. As most option traders look for volatility, plunging prices can be really attractive because they can become really volatile.

Of course, going against the general trend can set up a short position for an abrupt snap-back reversion to the mean and make for quick loses. However, there is a way to protect against that possibility: purchasing call options. For example, suppose an option trader knows that a stock will be coming out with some unexpected bad news that hasn't been factored into the price yet; the trader might want to consider shorting the stock and at the same time purchasing an out-of- the-money call.

Let's say that the stock shows all the technical signs of breaking down through a resistance level and is currently at $26 per share. An option trader could sell a quantity of the shares and at the same time buy the out of the money call at let's say .50 cents premium for each share. Therefore, each call option contract of 100 shares would cost $50. Most call option premiums will provide inexpensive insurance for a weak stock that might have the remote chance of reversing direction. Option traders call this strategy using a "protective call."

By selling a stock short, the trader makes a profit on the declining stock by buying it back at a lower price than at the price you sold the stock and selling it back to your broker at the higher sell price. It's still buying low and selling high but in reverse order. If for some reason the stock turns on the trader, the call option increase will offset much of the unexpected losses depending on how close to being -the-money the trader purchased the call option strike price.

So, why not feed off of the carrion of weak stocks? Instead of hunting for good news and exciting prospects, become a "grinch trader" and look for potential road kill just before it runs across the road.

It just depends on a trader's perspective. Maybe after a time, grinch traders can start dressing in all black and do all trading after midnight. All it will take is for traders to see the results before they abandon the world of daylight.

There's gas in the mine, run for your lives! If you were a miner in olden times, that's what you'd yell if you saw the canary fluttering like a fish out of water on the bottom of its cage. Its imminent death told everybody in the mine to get out.

In 1993, a new measurement for the index of volatility for the S&P 500 stock index (SPX) came out. It was to become like the canary to the miner for stock option traders. If the volatility index went up, traders should start looking for the exits. You see, there is an inverse relationship between the volatility index (called the VIX) and the movement of stocks. Usually, if the stock market starts to go down, activity in stock options increases. If stocks are going up, there is less interest in stock options (hedging against losses) and the index is subdued or goes down. In other words, the correlation between the VIX and stocks is a negative one. Moreover, the sensitivity of the VIX magnifies the movement of the stock movements. For example if the S&P 500 goes down 10%, the VIX may go up 35%. Conversely, if the S&P goes up 10%, the VIX may go down 15%. But what does this mean for investors other than the VIX as a "Chicken little"(the sky is falling in) fear indicator?

VIX as portfolio insurance

Normally, when stock option traders hear the word hedge, they think of a put or spread. If an investor has a portfolio of investments and wants to protect gains, they may purchase puts to help offset any losses; the long put options become portfolio insurance. But using VIX options can be better and cheaper protection. Because of this fact, VIX options are becoming popular as portfolio insurance. Consider the following example:

Suppose you have a portfolio and you want to protect the unrealized gains against loss. Let's say that you purchase out of the money S&P puts to protect against the down side. But as luck would have it, your portfolio grows and leaves a large gap between your out of the money puts strike price and the portfolio. Now the portfolio has more gains to lose before hitting strike price. You could close out the put position and roll up to a new strike price, but this will cost money. On the other hand, owning VIX option protection is different. There is no strike price to hit. If the S&P moves down, the VIX moves up-usually in a much larger proportion. Additionally, there is no gap to cover before going into the money. Moreover, because of the volatility of the VIX, it takes less money to "insure" against loss. It only takes about 10% VIX option coverage to portfolio value to provide enough protection.

Lawrence McMillan, President of McMillan, a registered investment advisory firm in Morristown, NJ. provides a good example: Suppose one buys SPX Dec 1400 puts with the S&P 500 near 1530; the puts are approximately 8% out of the money. If a strong summer rally develops, the S&P 500 might rise to 1700 in September, a time when protection is most needed, as stocks tend to perform relatively poorly in the fall. But the puts are now 300 points out of the money, and therefore almost useless as protection.

VIX as a sentiment indicator

VIX can also provide a good barometer of the sentiment of the market for the next 30 days. If the VIX is going up, anxiety is going up as the VIX measures option prices and volume increase. Importantly, VIX doesn't have a linear relationship with the market in general; it is much more volatile. As a result, a moderate downtrend in markets will trigger a large upward movement in the VIX.

As volatility is food for the short term trader, keeping an eye on VIX can also add valuable information in helping to get a feel for the general market and looking for times of high volatility.

All in all, learning more about the VIX and VIX options may help not only in hedging situations but also in "catching bigger waves".

The following are some VIX strategies:

Bullish on VIX, and Bearish on stocks

Might consider -

• Long VIX Call Options
• Long VIX Call Spreads
• Short VIX Put Credit Spreads
• Long VIX Futures

Investors who are -

• Bearish on VIX, and Bullish on stocks

Might consider -

• Long VIX Put Options
• Long VIX Put Spreads
• Short VIX Call Credit Spreads
• Short VIX Futures

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