Sanglucci.com Introduction to Options Training: Four Day Course Guide

Transcription

1 Sanglucci.com Introduction to Options Training: Four Day Course Guide

2 Disclaimer and Student Responsibili5es SANGLUCCI.COM ITS AFFILIATES AND REPRESENTATIVES (COLLECTIVELY SANGLUCCI.COM) HAVE THE RIGHT TO REMOVE ANY STUDENT FROM A CLASS OR ANY OTHER SERVICES PROVIDED BY SANGLUCCI.COM FOR NO REFUND IF HE OR SHE ACTS DISRUPTIVELY, DISRESPECTFULLY, OR IN ANY WAY IMPEDES CLASS PROGRESS. SANGLUCCI.COM IS NOT RESPONSIBLE FOR DECISIONS MADE BY TRADERS WHO USE INFORMATION FROM SANGLUCCI.COM WRITINGS AND/OR EDUCATIONAL COURSES. WE DO NOT CLAIM TO HAVE A SPECIAL INSIGHT INTO THE MARKETS THAT PREVENT US FROM MAKING MISTAKES. WE DO MAKE MISTAKES. TRADING OF STOCKS, AND ESPECIALLY OPTIONS, INVOLVES SUBSTANTIAL RISK OF LOSS AND MAY NOT BE SUITABLE FOR EVERYONE. DAY TRADING IN THE STOCK MARKET BRINGS WITH IT A HIGH DEGREE OF RISK. TRADERS SHOULD CAREFULLY CONSIDER THEIR DECISIONS AND KNOW THE RISKS THEY TAKE ON BEFORE PLACING TRADES. THE VALUATION OF OPTIONS MAY FLUCTUATE, AND, AS A RESULT, TRADERS MAY LOSE MORE THAN THEIR ORIGINAL INVESTMENT. YOU ARE RESPONSIBLE FOR ALL THE RISKS AND FINANCIAL RESOURCES YOU USE. BY ENROLLING IN EDUCATIONAL COURSES PROVIDED BY SANGLUCCI.COM, YOU ARE ACKNOWLEDGING THE RISKS INVOLVED IN TRADING THE STOCK AND OPTIONS MARKETS AND ARE ALSO ACKNOWLEDGING THAT YOU, THE TRADER, AND NOT SANGLUCCI.COM, ARE SOLELY RESPONSIBLE FOR ANY LOSSES, FINANCIAL OR OTHERWISE, EXPERIENCED AS A RESULT OF YOUR TRADES. SANGLUCCI.COM SHALL UNDER NO CIRCUMSTANCES BE LIABLE FOR ANY LOST PROFITS, LOST OPPORTUNITIES, MISSTATEMENTS, OR ERRORS CONTAINED WITHIN SANGLUCCI.COM WRITINGS AND EDUCATIONAL COURSES. YOU AGREE TO HOLD SANGLUCCI.COM HARMLESS FOR ANY ACT RESULTING DIRECTLY OR INDIRECTLY FROM SANGLUCCI.COM, ITS CLASSES, DATA, CONTENT, MATERIALS, ASSOCIATED PAGES AND DOCUMENTS. IF YOU DO NOT FULLY UNDERSTAND AND AGREE TO THE ABOVE STATEMENTS PLEASE CONTACT US AT [email protected] BEFORE PROCEEDING ANY FURTHER. 2

3 Class Goals This class serves two purposes: To teach you the basics of opqons, how they work, and why people trade them. To help you find the unique style of opqons trading you would like to further pursue given your: Personality Financial goals Capital base. 3

4 Table of Contents What is an OpQon? Academic vs. Logical DefiniQons of OpQons 5 DefiniQons and ExplanaQons: Strikes prices 6 ExpiraQon Date 7 Basic DefiniQon of Call 8 Basic DefiniQon of Put..9 In the Money vs. Out of the Money OpQons Exposure What You Buy When You Buy an OpQon 12 OpQons vs. EquiQes Relevant Traits of EquiQes 14 How OpQons Are Similar to EquiQes 15 How OpQons Are Different than EquiQes 16 Why Trade OpQons Instead of EquiQes.17 UQlizing Calls and Puts in Strategies Going Net Long Calls 19 Going Net Long Puts 20 Using Puts Instead of ShorQng 21 ShorQng Calls and Puts 22 MiQgaQng risk with Calls and Puts 23 Spreads 24 Straddles.25 Hedging vs. Profit Driven OpQons Strategies Using OpQons to Enhance Returns on Long Term Investments 27 ProtecQng Long Term Investments Through OpQons Hedging 28 Styles of Trading 29 Applying Your Trading Style to OpQons 30 Day Trading OpQons (weekly opqons) 31 Viewing and ExecuQng OpQons Trades OpQons Chain Analysis 33 DMA Plalorm vs. Retail Plalorm 34 ExecuQng on a Level II vs. Simple Key Ins 35 Brokers and Commissions Retail Brokers 37 InsQtuQonal & Professional Brokers 38 Proprietary Trading Firms 39 Recommended Reading 40 Contact InformaQon 41

5 What is an Op5on? Academic vs. Logical Defini5ons of Op5ons An op5on is a contract that permits the buyer (holder) the right to buy or sell an underlying security at a specified price (strike price) for a specific date (expiraqon date). Equate an op+on to a bet, like on a football game. You re not just be:ng on something happening in the game, you re also be:ng on how long it will take for that outcome to occur. For example, if you think the Packers are going to score 28 points against the Patriots, you re not just taking that bet, you re be:ng whether it will happen in the first quarter (not likely) or by the end of the game (more likely). Here s a real- world analogy: Let s say you want to buy a house and it costs $200,000. You don t have the money to buy the house right now but you know you are going to have it in three months. So the owner of the house sells you a contract to buy the house at any Qme within the next three months for $200,000. The price of this contract is $3,000 and its non- refundable. So you give the dude $3,000 and at anyqme in next three months, you can march up to the owner, give him $200,000, and the house is yours. Two weeks later somebody finds out that Michael Jackson lived in that house. The appraiser says, Hell no, this house is worth a million bucks! Now you have a contract that says you can buy that house for $200,000. You can exercise that contract, purchase the house, and then immediately turn around and sell it on the open market for $1,000,000. Or you can simply sell that contract to someone else who wants to do the same thing. Remember, the owner of that house is OBLIGATED to sell you the Michael Jackson house for $200,000. Here s the flip side: let s say arer further inspecqon of that house you find it to be in need of serious maintenance. Its clearly worth way less than $200,000. You ve bought an opqon for $3,000 but that doesn t mean you are obligated to buy the house! You walk away with just the $3,000 loss you spent on the contract, and look for the next house. 5

6 Op5ons Defini5ons: Strike Prices The Strike Price is the price at which the contract allows the buyer to trade the underlying stock at. Think of the strike price as YOUR bet on the game. If you think the Packers will score 28 points, that s your strike price. In our example of the house, the strike price would have been $200,000. If you think Apple (AAPL) s stock is going to $ per share, that s the strike price you re going to use to start developing your trade strategy. 6

7 Op5ons Defini5ons: Expira5on Date The Expira5on Date is the date at which the opqon expires or is no longer valid. Arer this date, your opqon literally no longer exists. This is the +cking clock on your bet; you have to be right BEFORE this date. If not, the value of your bet is ZERO. OpQon contracts come in mulqple Qme frames. There are weeklies, monthlies, yearlies, and LEAPS (Long Term Equity AnQcipaQon Security). Let s focus on weeklies and monthlies for now. Monthly opqons expire on the third Friday of each month at the day s trading close of 4pm. Example: An April opqon of Bank of America (BAC) expires on the third Friday in April (the 19 th ). The last chance to trade it is before the close on that Friday. Weekly opqons open up for trading at the open on Thursday and expire at market close on the following Friday, which means they only have a lifespan of seven days. They do not have weekly opqons for the week where the monthly opqons expire. ConQnuing the above example, weekly opqons issued on April 4 th expire on Friday the 12 th. However, there are no weekly opqons issued on April 11 th because those opqons would expire on the third week of the month the same week when the monthly opqons expire. Weekly opqons are more volaqle and more difficult to trade because they expire more quickly. Always know the expira2on date of your op2on before you trade it! 7

8 What is an Op5on? Basic Defini5on of a Call A Call opqon gives the buyer the right to purchase 100 shares of the stock at a certain price before a certain date. Buyers of Call op5ons want the stock price to GO UP Example: Bank of America (BAC) is trading at $8.50. You purchase one $9.00 Call for BAC because you think its going up. The expiraqon date is three weeks away. The next day, BAC trades up to $ TheoreQcally, you could exercise your opqon, in which case the seller of the opqon would have to sell you 100 shares of BAC stock at $9.00 per share. You could then go back out into the market and sell those 100 shares at $10.00, making a $1.00 ($ $9.00) profit per share, minus transacqon costs and the price you paid for your opqon. In reality, opqons trade just like stocks so you would simply sell your Call opqon for a large profit instead of translaqng it into stock. 8

9 What is an Op5on? Basic Defini5on of a Put A Put opqon gives the buyer the right to sell the stock at a certain price before a certain date. Buyers of Put op5ons want the stock price to GO DOWN Example: Apple (AAPL) is trading at $ You purchase one AAPL $ Put. The expiraqon date is 2 weeks away. Two days later, AAPL is trading at $ TheoreQcally, you could exercise your opqon, in which case the seller of the opqon would have to buy 100 shares of AAPL from you at the strike price of $ You would make a profit of $30.00 ($ $580.00) per share, minus transacqon costs and the price you paid for your opqon. In reality, opqons trade just like stocks so you would simply sell your Put opqon for a profit instead of translaqng it into stock. 9

10 Op5ons Defini5ons: In the Money vs. Out of the Money In the Money (ITM) An opqon is In the Money (ITM) if it can be exercised for a profit. Calls are ITM when the strike price is lower than the current price of the underlying stock. Puts are ITM when the opqon s strike price is higher than the current price of the stock. For ITM Calls at expiraqon: Call Price= Underlying Price Strike Price. Out of the Money (OTM) An opqon is Out of the Money (OTM) when it cannot be exercised for a profit. Calls are OTM when the strike price is higher than the current price of the underlying stock. Puts are OTM when the opqon s strike price is lower than the current price of the stock. OTM opqons expire worthless at their expiraqon date. For ITM Puts at expiraqon: Put Price= Strike Price Underlying Price At the Money: An opqon is At the Money when the stock s price matches the strike price. 10

11 Op5ons Defini5ons: In the Money vs. Out of the Money Example Example: You purchase 10 Bank of America (BAC) Calls with a strike price of $ Your friend purchases 10 BAC Puts with a strike price of $8.00. You think BAC is going up while your friend thinks BAC is going down. BAC has an insanely volaqle day and hits both $7.50 and $12.50 during market hours. In the Money (ITM): Your $12.00 Calls are In The Money when the stock is at $12.50 because the price of the stock is higher than your exercise price. Your friend s $8.00 Puts are In The Money when the stock is at $7.50 because the price of the stock is lower than the strike price. Out of the Money (OTM): Your $12.00 Calls are Out of The Money when the stock is at $7.50 because the price of the stock is lower than your exercise price. Your friend s $8.00 Puts are Out of The Money when the stock is at $12.50 because the price of the stock is higher than the strike price. 11

12 What is an Op5on? Exposure- What You Buy When You Buy An Op5on Each contract of an opqon equates to 100 shares of the underlying stock. That means that if you were to buy an opqon and exercise it you would then transact for 100 shares of the stock at the strike price of your opqon. Every Qme you see the price of an opqon mulqply it by 100 to calculate how much you ll actually have to pay. If you purchase an opqons contract (doesn t mawer if it s a Call or a Put) that costs $.55, that actually costs you $

13 OpQons vs. EquiQes 13

14 Op5ons vs. Equi5es Relevant Traits of Equi5es There are two traits of equiqes that are especially relevant to our discussion of opqons: Liquidity Represents how easily you can get in and out of your trade. For most stocks, there is very liwle risk that you will buy the stock and later be unable to find another buyer so that you can exit the trade. Very liquid stocks (i.e. Apple, Google, Bank of America) have LOTS of buyers and sellers. Someone is almost always willing to take the other side of your trade unless you are trading in enormously high volumes. Illiquid stocks (i.e. penny stocks) oren do not have many people trading them. That means you could be looking to get into or out of a posiqon or investment and not be able to find someone else willing to take the other side. You may have to sacrifice significantly in terms of price in order to execute a trade. Infinite Lifespan The stock of a company has an infinite lifespan unless the company goes bankrupt. Otherwise, the stock is always going to exist. You could buy it and hold onto it for 1 minute or for 50 years. When you buy a stock, as long as you are personally able to maintain the trade, it doesn t mawer how long it takes for you to be right. You could wait 10 years before your thesis proves correct and sqll have a profitable investment. This concept is oren taken for granted unql traders start trading opqons. 14

15 Op5ons vs. Equi5es How Op5ons Are Similar to Equi5es Liquidity Many opqons have a fair amount of liquidity. You can buy and sell opqons in these strike prices the same way you buy and sell stock with an extremely low risk of being able to get out of a trade (liquidity risk). Long and Short Capability You can both go long (buy) or short (sell) an opqon, just like a stock. You can both buy and sell a Call You can both buy and sell a Put ShorQng an opqon adds considerably more risk. More on this later. Tracking the Underlying In general, the behavior of an opqon tracks the price acqon of the underlying stock. When the stock goes up, a Call will go up When the stock goes down, Put will go up In the Money opqons will track the movement of the underlying stock much more closely than Out of the Money opqons. 15

16 Op5ons vs. Equi5es How Op5ons Are Different Than Equi5es ExpiraQon OpQons, unlike equiqes, have a finite lifespan. The opqon literally does not exist past its expiraqon. MulQple Strike Prices Unlike common stock, which has a single price (not counqng preferred shares and Class B shares), there are many different strike prices for opqons. If you want to buy a Call in Apple, you have a choice of many different strike prices and expiraqon dates to choose from. Liquidity Some opqons are not heavily traded, especially those that are far Out of the Money. This means you have liquidity risk: you could find yourself unable to get out of a trade or have to sacrifice considerably in terms of your exit price. Tracking the Underlying Some opqons don t directly track the underlying, especially Out of the Money opqons. In these opqons, you cannot assume that a Call will go up just because the stock is going up. 16

17 Op5ons vs. Equi5es Why Trade Op5ons Instead of Equi5es There are many reasons to trade opqons, including hedging stock posiqons and using spreads that profit regardless of whether the stock goes up or down. We ll cover all this later. For us at Sang Lucci, we trade opqons because they require less money for higher potenqal returns. This is the case for a large percentage of day traders. Let s say you have a $ stock. You buy 100 shares, which costs you $60, If the stock moves up $5.00 to $605.00, you make $ That s a lot of money to put on the line to make $ (1% return on investment). Instead, you could play an opqon. Lets say the 605 Call is at $3.00. If you spend $60,000 on this opqon, you would have 200 contracts. If the underlying stock moved $5.00, your 200 contracts are now probably worth DOUBLE (100% return) what you paid for them. You would be walking away with $40, to $60, in profit. There is substanqal risk that you take on in order to achieve this type of return but you can see the sizeable gains that opqons can provide over standard equity plays. 17

18 UQlizing Calls and Puts in Strategies 18

19 U5lizing Calls and Puts in Strategies: Going Net Long Calls If you think a stock is going up, you can buy a Call. In general, the value of the Call will go up as your stock goes up (as long as the strike price is right). If you have less capital, buying a Call is a less expensive way of geyng exposure to shares of stock without actually having to buy the stock itself. For instance, let s say you want to buy 100 shares of Apple. Instead of spending almost $40,000, you can spend $400- $1000 on a Call opqon to get the same exposure. You have an enqre opqons chain of different strike prices to choose from. Each strike price is bewer suited to different risk tolerances. 19

20 U5lizing Calls and Puts in Strategies: Going Net Long Through Puts If you think a stock is going down, you can buy a Put. This means you have a short posiqon; you stand to gain if the stock goes down. In general, the value of the Put will go up as your stock goes down (as long as the strike price is right). Similarly to Calls, you have a wide spectrum of strike prices with differently priced Puts. Each moves in a slightly different fashion depending on where the underlying stock trades. Different strike prices offer different degrees of risk. Puts are inherently harder to trade than Calls. When you are long (either through Calls or buying the underlying stock), you don t have to deal with a short squeeze effect. When you are net short you have to worry about short squeezes. Short Squeeze: When a stock is falling, sellers leaving their posiqons are not the only ones selling. Short sellers are also selling stock they don t actually own to benefit from the price drop. When the stock hits a bowom and begins to bounce back upwards, the short sellers cover their short they buy back their borrowed shares in the market causing increased upward buying pressure on the stock. This temporarily pushes the stock further up. AddiQonally, because a stock can t go down past zero, Puts can only increase in value so much. That is not true for Calls, which could go up forever. 20

21 U5lizing Calls and Puts in Strategies: Using Puts Instead of Shor5ng Its important to understand the difference between shorqng and buying a Put. Both are ways to capitalize on downward price movement in a stock. However, Puts have limited downside. Going long a Put means that you believe the price of the underlying will decrease. The worst case scenario for buying a Put is that the stock moves against you and you let your opqons expire worthless. All you ve lost is what you paid for the opqon to begin with, plus commissions. ShorQng a stock or an opqon does NOT have limited downside; you can lose an unlimited amount of money by taking a short posiqon. You can lose an unlimited amount of money by going short ShorQng means that you are selling shares of a stock or opqons contracts that you don t own, which means that you have to borrow them from your broker. Eventually, you have to give those shares back, no mawer how much it costs you. If the stock goes down, you can buy the shares or contracts back for less than you sold them for and profit the difference. If the stock goes up (which it could theoreqcally do forever) you have to buy those shares back at the market price to give them back to your broker. 21

22 U5lizing Calls and Puts in Strategies: Shor5ng Calls and Puts Similar to equiqes, you can also take short posiqons in opqons. ShorQng is also referred to as wriqng. Many traders don t do this because the number of strike prices and inherently confusing nature of opqons can quickly lead to overly complicated trades. However, if you were to decide to short an opqon: ShorQng a Call would mean you want the stock to go DOWN. ShorQng a Put would mean you want the stock to go UP. There is always a finite profit potenqal and infinite loss potenqal when you are short. The raqonale for shorqng opqons is that a large percentage of opqons contracts, anywhere between 50%- 90% depending on who you ask, expire worthless. That means the buyers paid for the contracts and the stock moved in such a manner that the contracts decreased in value. Whoever sold those contracts to the original buyers made money on those transacqons. For example, let s say you buy a $1.00 Bank of America Call (BAC) with a strike price of $8.00. The person who sold you that Call receives your $100. Now, let s say BAC s stock goes down to $7.00 and stays down unql your opqon expires. You have no reason to exercise the opqon so you let it expire. The transacqon is closed and the seller keeps the $100 you gave him for the contract. *Wri5ng op5ons is a sophis5cated trading technique. Do not aeempt this unless you completely understand what you re doing and accept the risks involved. 22

23 U5lizing Calls and Puts in Strategies: Mi5ga5ng Equity Risk with Calls and Puts With an equity trade, you can usually only take a long or a short posiqon. With opqons, you can theoreqcally take posiqons in both direcqons. This means you can simultaneously take posiqons that will profit if the stock goes up and different posiqons that will profit if the stock goes down. This miqgates the risk of the stock going to the downside or to the upside, depending on the direcqon you re beyng on. For example, if you have a trade on that s long a certain number of equity shares and you are a liwle uncertain about the trade, you can hedge against the downside by buying Puts. This would mean that you won t make as much if the stock goes up (you will lose what you paid for the Put) but you also won t lose as much if the stock goes down (the value of your Put will go up, decreasing your total losses incurred on the stock going down). MiQgaQng risk like this brings in your risk from a broker s standpoint as well, which means that you are more likely to have access to increased amounts of leverage. *Always remember that when you mi5gate risk you are also mi5ga5ng your returns. 23

24 U5lizing Calls and Puts in Strategies: Spreads A Spread is another way of taking a posiqon that is net a certain direcqon while miqgaqng risk. We ll look at two example spreads here: Bull Call Spread In a Bull Call Spread, you go long the Calls of one strike price and short the Calls of another strike price. Say you want to buy a $450 Call on Apple (AAPL). You are beyng that the stock is going to go up. A way to miqgate the risk of the stock going down is by shorqng the opqon that is 1-2 strike prices (same expiraqon) above the strike price you bought. If AAPL starts falling, your long Call would go down but your short Call would go up. Your successful short posiqon would reduce the losses incurred in your long posiqon. Bear Put Spread In a Bear Put Spread, you go long the Puts of one strike price and short the Puts of another strike price. Say you want to buy a $9.00 Puts on Bank of America (BAC). You are beyng that the stock is going to go down. A way to miqgate the risk of the stock going up is by shorqng the opqon that is 1-2 strike prices (same expiraqon) below the one you bought. If the price of BAC starts rising, your long Put would go down but your short Put would go up. Your successful short posiqon would reduce the losses incurred in your long posiqon. Although this may sound nice, the actual execu5on of a spread can be quite difficult. Market makers are there to take advantage of retail traders when they execute spreads! 24

25 U5lizing Calls and Puts in Strategies: Straddles Straddles provide traders the ability to take advantage of high amplitude/volaqle movement in a stock. For example, in a Long Straddle, you are longing both a Call and a Put of the same strike price. You are making a bet that the stock is going to move drasqcally in one direcqon, or possibly both. You do not make money on Straddles if the price of the stock doesn t move very much. For example, Apple (AAPL) is a parqcularly volaqle stock. You could put on a Straddle where you would buy the $430 Calls and the $430 Puts. If AAPL were to move to $460 or $400, either the Call or the Put (respecqvely) would increase in value. The other opqon would simply go to zero and you would eat that cost. If you were lucky enough, the stock could go back and forth between, say, $415 and $445, and you would be able to exit both posiqons in your Straddle (at different, opportune moments) and make money off the stock moving in both direcqons. If you put on your Straddle and AAPL sits in the $428- $432 range, your opqons are going to steadily decrease in value and you will lose money. 25

26 Hedging vs. Profit Driven OpQons Strategies 26

27 Hedging vs. Profit Driven Op5ons Strategies Using Op5ons to Enhance Returns on Long Term Investments Long term investments are posiqons with Qme horizons of greater than two weeks. Investors take acqon based on factors beyond the moment- to- moment price movement of the stock such as company financials, general market and economic condiqons, etc. Some investors may have a thesis regarding an event that could affect a stock in the future and want to construct a posiqon to benefit from it. Instead of having to put on so much cash exposure through buying the equity, your outlay can be much less while sqll maintaining exposure to the posiqon through opqons: Example: a long porlolio that believes that Google (GOOG) will have good earnings in 6 months. The owner of the porlolio, instead of buying the stock, could buy Call opqons 8 months out. This allows the investor to free up buying power to take advantage of other opportuniqes while sqll providing access to the desired exposure. More advanced strategies allow you to short Out of the Money opqons. 27

28 Hedging vs. Profit Driven Op5ons Strategies Protec5ng Long Term Investments Through Op5ons Hedging If you are in an investment and you buy the stock, you want to protect yourself from environmental factors. You can use opqons to bring in the losses from the environmental factors that act as noise and temporarily distort your stock s value. For example, you are long 500 shares of Apple. You fundamentally believe that this stock should be valued at $700. Then a debt crises breaks out and the stock market in general is falling apart. You don t want to let go of your investment but you don t want to sit by and watch it lose value either. Instead of selling, you can hedge. 1) Buying Puts 2) ShorQng Calls This obviously requires a more acqve way of watching your investment. 28

29 Hedging vs. Profit Driven Op5ons Strategies Styles of Trading Scalping Seconds to minutes. If you are scalp trading you jump in and out of stocks very rapidly, oren picking up gains on penny moves over and over again. Scalp trading usually takes place at a prop firm because the technological requirements are so expensive. It is not possible to scalp trade using a retail plalorm. Day Trading Hours to a full day. Day traders are looking for a larger move in a stock compared to scalpers. Swing Trading: Days. Swing traders hold a posiqon over mulqple days, oren adjusqng their cost on a daily basis. Inves5ng 2 weeks or longer. Dip Buyers vs. Breakout Traders Dip buyers look for bowoms in stocks where something has been oversold or is in a range. They re not necessarily looking for price acqon that dictates a higher move, they just want to see a support area. Breakout traders look for price acqon that shows strong moves higher through price levels that have not been broken through in certain periods of Qme. Technical Traders Technical traders base their entries and exits on technical analyses such as moving averages, Bollinger bands, MACD crossovers, etc. 29

30 Hedging vs. Profit Driven Op5ons Strategies Applying Your Trading Style to Op5ons There are ways to apply opqons to enhance all these styles of trading. You need to find your highest probability trades because: 1) You want to have the smallest impact on your trading as possible while transiqoning to opqons. 2) Finding your highest probability trades is half the bawle, so if you ve already fought it, don t do it again. The biggest problem with trading opqons is that people don t understand how to select which strike prices to trade. They overcomplicate things. They want to try some new strategies that they don t understand. The best way to trade opqons is to use what you already know about equity trading and apply your knowledge of opqons on top. For example, if you play a certain stock over and over again because you understand certain elements of how it moves, and you ve been successful, you can allocate a very small amount of your direcqonal trading into the opqons to get a much bewer return. In other words, DON T OVER COMPLICATE THINGS. 30

31 Hedging vs. Profit Driven Op5ons Strategies Day Trading Op5ons (weekly op5ons) Most of the Qme when opqons are day- traded they are for profit driven purposes. Hedging works best over a longer period of Qme and is usually not for day trading. Weekly opqons have developed so much volume that you can day trade them just like stocks. For instance, for smaller players that cannot just by $100,000 worth of Apple (AAPL), they can get the same exposure through buying 5-10 contracts. Inherently there is more risk that comes along with opqons. You are geyng exposure to a magnified share amount, far beyond what you would be able to expose yourself to through playing the equity. Although they can be day traded like stocks, the actual execuqon of opqons differs in a way that most traders don t understand. For instance, the underlying stock may not move while the price of the opqon falls. When day trading opqons, its much more difficult to put on complex strategies because there is too much slippage that occurs when execuqng these trades. Its best to go net- long one direcqon and get the proper read on the stock. 31

32 Viewing and ExecuQng OpQons Trades 32

33 Viewing and Execu5ng Op5ons Trades Op5ons Chain Analysis Each opqons chain looks different; it depends on the plalorm. However, there are a few universal traits common to them all. Bid and Ask for Calls Bid and Ask for Puts This week s Option Expiration Date Next week s Option Strike Price 33

34 Viewing and Execu5ng Op5ons Trades DMA Plakorms vs. Retail Plakorms DMA stands for Direct Market Access. This means you have direct execuqon to the exchanges and very low- latency. Your trades are not passed through as many middle- men and will be filled much more quickly and accurately. Proper execuqon is needed to avoid bad priced fills i.e. the current stock price is $4.00 and through your retail broker you press market and get filled at $4.05. With a DMA plalorm, you could get filled at $ You can see this with a simple comparison with how quickly your Qme and sales populates, how fast your orders execute, and the price of your actual fills. On the downside, your plalorm isn t as prewy. Your computer s memory needs to be able to handle your DMA plalorm so that you can have proper execuqon vs. your retail plalorm. You must have a processor powerful enough to run a DMA plalorm without glitches and pauses in order to take advantage of it. *Your chances of becoming a real trader using a retail plakorm are extremely diminished. 34

35 Viewing and Execu5ng Op5ons Trades Execu5ng on a Level II vs. Simple Key Ins OpQons trade just like equiqes. They have a bid and offer and certain depth of book that exists in the Level II. Some plalorms come with a Level II for the opqons itself. Many retail brokers don t even give you access to the Level II. They give you a Key In window. You don t get updated prices, you don t know the bid and the offer, etc. This puts you at an extreme disadvantage to traders that have DMA and Level II for opqons. Over Qme, the slippage incurred on simple Key In plalorms adds up, and your ability to manage risk, capture profits, and miqgate losses will get out of hand. You re paying too much to the house. Slippage: The loss in a posiqon you incur when the execuqon price for your trade is inferior to the price at which you intended to execute. With a Level II for your opqon, you can actually see if a price is being supported and how wide spreads are (which can get very wide for opqons). This gives you a much clearer view on how you should execute a trade vs. your typical Key In structure. 35

36 Brokers and Commissions 36

37 Brokers and Commissions Retail Brokers Retail brokers are usually the first place a trader starts. Examples are Charles Schwab, TD Ameritrade, Scowrade, and Fidelity. However, there are mulqple downsides to retail brokers, among them: Commissions: Retail brokers will usually charge you a Qcket fee plus a per contract fee on opqons. These Qcket fees can range anywhere from $1- $10. The per contract fees can range from $.75 and up. If you make $1K on a trade but pay $300 in commissions, that s 30% of your profits out the door. Few beginning traders can survive with those limitaqons on their trading. Some retail brokers even charge addiqonal fees for data. Execu5on: Latency Oren there is a significant gap between when hit you send on an order in a retail plalorm and when that order hits the market. Many Qmes you will put in a market order that will fill you $.20 above the market or takes 1 minute to fill. This reduces profit potenqal by adding slippage and reduces your ability to quickly react to market changes (essenqal for certain styles of trading). Flexibility Most retail brokers are selling their order flow to market makers. This means that your execuqon is not flexible and you are most likely not geyng the best pricing (further explained on next page). *For those of you not currently constrained by Paeern Day Trading (PDT), you may be able to get by with a retail plakorm. 37

38 Brokers and Commissions Professional & Ins5tu5onal Brokers Professional and InsQtuQonal Brokers provide superior: Commissions rates Typical rates for a professional trading are a plalorm fee ranging from $100- $200 per month and opqons rates of $.55 and up, with no Qcket fee. While the monthly plalorm charge is more than for retail plalorms, the commissions savings usually more than make up for the added cost. Order execu5on As a trader, you can actually select where your orders go to routes, exchanges, dark pools and some of these end points actually offer rebates. This means they compensate you for sending your order to them instead of to compeqtors. This may sound as if its only beneficial to high volume traders, but its essenqal for insqtuqonal invesqng funds as well. Many Qmes when large orders are put in, no care is really given to the execuqon of it (routes, pricing, etc.) and this leaves a lot of room for other professional traders and predatory market makers to step in front of you so you don t get the best price. Technological sophis5ca5on You have Direct Market Access (DMA), the highest quality execuqon. It is low- latency and has direct access to the markets. o Immediately arer hiyng send you will see your order filled and the price you will get will be far superior. Order types available through DMA plalorms and brokers allow you to reduce the amount of gaming that comes along with specialty execuqon types used by hedge funds and market makers. Leverage. Brokers will allow traders more intra- day and overnight leverage, allowing you to trade more capital intensive strategies and increase your profit potenqal. *Ins5tu5onal & Professional brokers require larger star5ng account sizes, typically a minimum star5ng balance of $30,000, although it varies from firm to firm. 38

39 Brokers and Commissions Proprietary Trading Firms Many traders don t have the capital to access Professional & InsQtuQonal brokers but recognize the advantages these enqqes provide. The soluqon is oren to join a proprietary trading firm. Prop firms provide all of the aforemenqoned benefits offered by Professional & InsQtuQonal brokers. Prop firms allow traders to trade with the firm s capital in addiqon to their own. Traders are required to place a risk deposit with the firm, typically between $500- $5,000. This risk deposit is then coupled with funds from the firm into an account that the trader uses to trade. By allowing access to its funds, prop firms provide access to higher amounts of leverage (aka buying power ) which allows the trader to employ more advanced strategies, trade in capital intensive instruments, and ulqmately generate more income. In addiqon, they typically provide: Educa5on A prop firm has a vested interest in culqvaqng long- term, successful traders. Therefore, most prop firms provide access to educaqon and trading methodologies available only to their members. Team Trading Prop firms usually offer access to a team trading environment, either in- person or virtually connected. This drasqcally enhances a trader s ability to learn. 39

40 Brokers and Commissions Recommended Reading The market is NOT a level playing field. Traders have a responsibility to educate themselves and react appropriately. 40

41 Contact For any further inquiries or quesqons, feel free to contact us: Further Class and Service Inquiries: Charlie Bathgate Broker and Op5ons Trading Technique Inquiries: Peter Zhang (917)