STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE Using options to trade short-term with limited risk for unlimited profits

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1 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 1 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE Using options to trade short-term with limited risk for unlimited profits By Hiten Jhaveri For FREE Trial of OPTIONSWHIZO Daily Newsletter on Futures & Options Price Forecasting with a RISK-FREE GUARANTEE, Call us NOW at Tel. Nos. : (022) / 82, Fax Nos. : (0) Or send an to : info@stockwhizo.com Visit us at for Stock Market Forecasting with 75%+ PROFIT trades. STOCKWHIZO INVESTMENTS, MUMBAI

2 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 2 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE Using options to trade short-term with limited risk for unlimited profits July 2001 Edition Pages: 144 By Hiten Jhaveri STOCKWHIZO INVESTMENTS 401-B Wing, Remi Bizcourt, Next to Empire Studio, Veera Desai Road, Andheri (West), Mumbai Maharashtra. INDIA. Tel. Nos. (022) / 82, Fax Nos: info@stockwhizo.com Website : Copyright 2001 by Hiten Jhaveri, StockWhizo Investments, Stockwhizo.com. All rights reserved worldwide. The following content is provided by Mr. Hiten Jhaveri, Director, StockWhizo Investments for educational and investment purposes only. Material written in this book is protected under copyright laws. Except as permitted under the Copyright Law, No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Although both the authors and the publisher believe the information, data, and contents presented are accurate, they neither guarantee their accuracy and completeness nor assume any liability. It should not be assumed that the methods, techniques, or indicators presented in this book will be profitable or that they will not result in losses. Trading involves the risk of loss, as well as the potential for profit. Past performance is not a guarantee of future results. Options trading involve risk and are not suitable for all investors.

3 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 3 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE JULY 2001 Edition Pages: 144 Table of Contents Foreword 5 Brief Options History 6 Chapter One Introduction to Basics What is an Option? 9 Type of Options 10 Basic Options Terminology 12 How to Start Trading Options? 12 Factors that affect the Value of an Options Premium 20 Option Greeks DELTA, GAMMA, VEGA, THETA, RHO 24 Possible hedging strategies with the Greeks 25 Benefit of Options Trading 25 Stock Index Options 26 Options with Options 29 Chapter Two Option Trading Strategies Spreads 32 Selecting an Option Trade 33 Long Call 36 Long Put 38 Married Put 40 Protective Put 42 Covered Call 44 Covered Put 46 Bull Call Spread 49 Bear Put Spread 51 Collar 54 Quick Snapshot of Option Trading Strategies Bullish Strategies 56 Bearish Strategies 57 Neutral Strategies 58 Option Trading Strategy Formulas 59 Intrinsic and Premium Formulas 61 Rules for Buying Calls and Puts 61

4 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 4 Chapter Three The World of Options Trading Options Players 63 How to Hedge risk and protect profits with options? 65 How market operators will trap the public? 69 The trump card of market operators: Hedging 71 How to select an Options Broker? 74 Position Management 75 7 myths about Stock Options 77 Traders Psychology 78 Secrets of Top Trading Performance 82 Chapter Four Money Management Keys to the Kingdom Managing money to succeed as a Master Trader 86 The 2 percent rule 88 Five steps to determine the proper position size 90 How to Win with a Stop-Loss 93 Mind games that create millions for operators 97 Time Tested rules to be a Master Trader 111 About StockWhizo 113 Afterword 119 Options Glossary 122

5 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 5 FOREWORD In Global Financial Markets, for many years, options have been a means of conveying rights from one party to another at a specified price on or before a specific date. Options to buy and sell are commonly executed in real estate and equipment transactions, just as they have been for years in the securities markets. There are two types of option agreements: CALLS and PUTS. A CALL OPTION is a contract that conveys to the owner the right, but not the obligation, to purchase a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date. A PUT OPTION is a contract that conveys to the owner the right, but not obligation, to sell a prescribed number of shares or futures contracts of an underlying security at a specified price before or on a specific expiration date. Consequently, if the market in a security were expected to advance, a trader would purchase a call and, conversely, if the market in a security were expected to decline, a trader would purchase a put. With the advent of listed options, the inconvenience and difficulties originally associated with transacting options have been greatly diminished. The purpose of this book is to provide an introduction to some of the basic equity option strategies available to option and/or stock investors. Exchange-traded options have many benefits including flexibility, leverage, limited risk for buyers employing these strategies, and contract performance guaranteed by Stock Exchanges. Options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright. Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing (selling) options, to earn premium income. Options give you options. You re not just limited to buying, selling or staying out of the market. With options, you can tailor your position to your own financial situation, stock market outlook and risk tolerance. Whether you are a conservative or growth-oriented investor, or even a short-term, aggressive trader, your broker can help you select an appropriate options strategy. The strategies presented in this book do not cover all, or even a significant number, of the possible strategies utilizing options. These are the most basic strategies, however, and will serve well as building blocks for more complex strategies. Despite their many benefits, options are not suitable for all investors. Individuals should not enter into option transactions until they have read and understood the risk disclosure section coming later in this document which outlines the purposes and risks thereof. Further, if you have only limited or no experience with options, or have only a limited understanding of the terms of option contracts and basic option pricing theory, you should examine closely another industry document. STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE. This documents, and many others, can be obtained from your brokerage firm or by either calling (022) / 82, or visiting or sending an to info@stockwhizo.com An investor who desires to utilize options should have well-defined investment objectives suited to his particular financial situation and a plan for achieving these objectives. Options are currently traded on the following Indian exchanges: The Stock Exchange, Mumbai (BSE) and National Stock Exchange (NSE). Like trading in stocks, options trading is regulated by the SEBI. These exchanges seek to provide competitive, liquid, and orderly

6 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 6 markets for the Purchase and sale of standardized options. It must be noted that, despite the efforts of each exchange to provide liquid markets, under certain conditions it may be difficult or impossible to liquidate an option position. Please refer to the disclosure document for further discussion on this matter. All strategy examples described in this book assume the use of regular, listed, American-style equity options, and do not take into consideration margin requirements, transaction and commission costs, or taxes in their profit and loss calculations. You should be aware that in addition to SEBI margin requirements, each brokerage firm may have its own margin rules that can be more detailed, specific or restrictive. In addition, each brokerage firm may have its own guidelines with respect to commissions and transaction costs. It is up to you to become fully informed on the specific procedures, rules and/or fee and commission schedules of your specific brokerage firm(s). The successful use of options requires a willingness to learn what they are, how they work, and what risks are associated with particular options strategies. Individuals seeking expanded investment opportunities in today s markets will find options trading challenging, often fast moving, and potentially rewarding. BRIEF OPTIONS HISTORY Ancient Origins Although it isn t known exactly when the first option contract traded, it is known that the Romans and Phoenicians used similar contracts in shipping. There is also evidence that Thales, a mathematician and philosopher in ancient Greece used options to secure a low price for olive presses in advance of the harvest. Thales had reason to believe the olive harvest would be particularly strong. During the off-season when demand for olive presses was almost non-existent, he acquired rights at a very low cost to use the presses the following spring. Later, when the olive harvest was in full-swing, Thales exercised his option and proceeded to rent the equipment to others at a much higher price. In Holland, trading in tulip options blossomed during the early 1600s. At first, tulip dealers used call options to make sure they could secure a reasonable price to meet the demand. At the same time, tulip growers used put options to ensure an adequate selling price. However, it wasn t long before speculators joined the mix and traded the options for profit. Unfortunately, when the market crashed, many speculators failed to honor their agreements. The consequences for the economy were devastating. Not surprisingly, the situation in this unregulated market seriously tainted the view most people had of options. After a similar episode in London one hundred years later, options were even declared illegal. Early Options in America In America, options appeared on the scene around the same time as stocks. In the early 19thCentury, call and put contracts known as privileges were not traded on an exchange. Because the terms differed for each contract, there wasn t much in the way of a secondary market. Instead, it was up to the buyers and sellers to find each other. This was typically accomplished when firms offered specific calls and puts in newspaper ads. Not unlike what happened in Holland and England, options came under heavy scrutiny after the Great Depression. Although the Investment Act of 1934 legitimized options, it also put trading under the watchful eye of the newly formed Securities and Exchange Commission (SEC).

7 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 7 For the next several decades, growth in option trading remained slow. By 1968, annual volume still didn t exceed 300,000 contracts. For the most part, early over-the-counter options failed to attract a following because they were cumbersome and illiquid. In the absence of an exchange, all trades were done by phone. To make matters worse, investors had no way of knowing what the real market for a given contract was. Instead, the put-call dealer functioned only to match the buyer and seller. Operating without a fixed commission, the dealer simply kept the spread between the price paid and the price sold. There was no limit to the size of this spread. Worse yet, all option contracts had to be exercised in person. If the holder of the option somehow missed the 3:15 pm deadline, the option would expire worthless regardless of its intrinsic value. Chicago Board of Trade In the late 1960s, as exchange volume for commodities began to shrink, the Chicago Board of Trade (CBOT) explored opportunities for diversification into the option market. Joseph W. Sullivan, Vice President of Planning for the CBOT, studied the over-the-counter option market and concluded that two key ingredients for success were missing. First, Sullivan believed that existing options had too many variables. To correct this, he proposed standardizing the strike price, expiration, size, and other relevant contract terms. Second, Sullivan recommended the creation of an intermediary to issue contracts and guarantee settlement and performance. This intermediary is now known as the Options Clearing Corporation. To replace the put-call dealers, who served only as intermediaries, the CBOT created a system in which market makers were required to provide two-sided markets. At the same time, the presence of multiple market makers made for a competitive atmosphere in which buyers and sellers alike could be assured of getting the best possible price. Chicago Board Options Exchange (CBOE) After four years of study and planning, the Chicago Board of Trade established the Chicago Board Options Exchange (CBOE) and began trading listed call options on 16 stocks on April 26, The CBOE s first home was actually a smoker s lounge at the Chicago Board of Trade. After achieving first-day volume of 911 contracts, the average daily volume skyrocketed to over 20,000 the following year. Along the way, the new exchange achieved several important milestones. As the number of underlying stocks with listed options doubled to 32, exchange membership doubled from 284 to 567. About the same time, new laws opened the door for banks and insurance companies to include options in their portfolios. For these reasons, option volume continued to grow. By the end of 1974, average daily volume exceeded 200,000 contracts. The newfound interest in options also caught the attention of the nation's newspapers, which voluntarily began carrying listed option prices. That s quite an accomplishment considering that the CBOE initially had to purchase news space in The Wall Street Journal in order to publish quotes. The Emergence of Put Trading After repeated delays by the SEC, put trading finally began in Determined to monitor the situation closely, the SEC only permitted puts to be traded on five stocks. Despite the rapid acceptance of puts and the rising interest in options, the SEC imposed a moratorium halting the listing of additional options. Nevertheless, annual volume at the CBOE reached 35.4 million in 1979.

8 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 8 Today, more than ever, option volume and open interest continues to climb. In 1999 alone, option volume at the CBOE doubled. By the end of 1999, the number of open contracts reached almost 60 million. Today, options on all sorts of financial instruments are also traded at the Chicago Mercantile Exchange, the CBOT, and other exchanges. Employee Stock Options With the rapid growth in Internet companies over the past few years and the enormous wealth created by employee stock options, more and more people are developing an interest in the concept of owning and trading options. Although there are fundamental differences between the options granted to an employee by a company and the options traded on the exchange, there are important similarities. When a company grants stock options to an employee, it gives that person the right to buy a certain number of shares at a price often well below market value. Although the options granted by a company eventually expire, they are usually good for extended periods (e.g., 10 years). Generally speaking, options issued by a company are not transferable. Therefore, they cannot be sold or traded to a third party. However, if the company is publicly traded, the employee can exercise the options and convert it to stock. This stock can then be sold on the open market. For example, the person might have options to buy 1,000 shares at an exercise (strike) price of 120 per share when the stock (in the case of a public company) is actually trading at 250. In this case, the person pays Rs.120,000 for stock that is worth Rs.250,000 on the open market. Not a bad deal at all. Exchange Traded Options Although there are a variety of different types of options (e.g., stock options, index options), this section will focus exclusively on stock options. Once you understand the basic principles, they can easily be applied to the other financial instruments. Exchange-traded stock options, also known as equity options, differ from those granted to employees by their company in a number of important ways. First, they typically have shorter-term expirations. Options granted by companies are often good for several years. During that period, they can be exercised (converted to stock) at any point. However, employee stock options cannot usually be sold or transferred. In contrast, exchange traded options (with the exception of LEAPS) are generally valid for only a few months and can be bought or sold at any time prior to expiration. To many people, it seems odd that exchange-traded options are not issued by the companies themselves. Instead, they are issued by the Exchange Options Clearing (EOC). By centralizing and standardizing options trading, the EOC has created a more liquid market. Unless otherwise specified, each option contract controls 100 shares of stock. In simplest terms, an option holder has the right, but not the obligation, to buy or sell a particular stock at a set price (strike) on or before the day of expiration (assignment). For example, someone holding a Nifty June 1120 Call would have the right to buy 200 units of Nifty for 1120 per unit. Likewise, a Nifty June 1120 Put gives the holder the right to sell 200 units of Nifty for 1120 per unit.

9 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 9 CHAPTER ONE INTRODUCTION TO BASICS WHAT IS AN OPTION? We all know many opportunities exist in trading today. Everywhere you turn, someone is waiting to inform you of the tremendous profits to be realized in the stock and futures markets. However, many people are unaware of the derivative trading possibilities that are available within and across several different markets. Option trading is just one of the many ways to participate in these secondary markets. And contrary to popular belief, this potential trading arena is not limited strictly to the practice of selling or writing options. Options are an important element of investing in markets, serving a function of managing risk and generating income. Unlike most other types of investments today, options provide a unique set of benefits. Not only does option trading provide a cheap and effective means of hedging one s portfolio against adverse and unexpected price fluctuations, but it also offers a tremendous speculative dimension to trading. One of the primary advantages of option trading is that option contracts enable a trade to be leveraged, allowing the trader to control the full value of an asset for a fraction of the actual cost. And since an option s price mirrors that of the underlying asset at the very least, any favorable return in the asset will be met with a greater percentage return in the option provides limited risk and unlimited reward. With options, the buyer can only lose what was paid for the option contract, which is a fraction of what the actual cost of the asset would be. However, the profit potential is unlimited because the option holder possesses a contract that performs in sync with the asset itself. If the outlook is positive for the security, so too will the outlook be for that asset s underlying options. Options also provide their owners with numerous trading alternatives. Options can be customized and combined with other options and even other investments to take advantage of any possible price dislocation within the market. They enable the trader or investor to acquire a position that is appropriate for any type of market outlook that he or she may have, be it bullish, bearish, choppy, or silent. While there is no disputing that options offer many investment benefits, option trading involves risk and is not for everyone. For the same reason that one s returns can be large, so too can the losses leverage. Also, while the potential for financial success does exist in option trading, the means of realizing such opportunities are often difficult to create and to identify. With dozens of variables, several pricing models, and hundreds of different strategies to choose from, it is no wonder that options and option pricing have been a mystery to the majority of the trading public. Most often, a great deal of information must be processed before an informed trading decision can be reached. Computers and sophisticated trading models are often relied upon to select trading candidates. However, as humans, we like things to be as simple as possible. This often creates a conflict when deciding what, when, and how to trade a particular investment. It is much easier to buy or sell an asset outright than to contend with the many extraneous factors of these derivative markets.* If an investor thinks an asset s value will appreciate, he or she can simply buy the security; if an investor thinks an asset s value will depreciate, he or she can simply sell the security. In these scenarios, the only thing an investor must worry about is the value of the investment relative to the value of the prevailing market. If only options were that easy!

10 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 10 *A derivative security is any security, in whole or in part, the value of which is based upon the performance of another (underlying) instrument, such as an option, a warrant, or any hybrid securities. Typically, option trading is more cumbersome and complicated than stock trading because traders must consider many variables aside from the direction they believe the market will move. The effects of the passage of time, variables such as delta, and the underlying market volatility on the price of the option are just some of the many items that traders need to gauge in order to make informed decisions. If one is not prudent in one s investment decisions, one could potentially lose a lot of money trading options. Those who disregard careful consideration and sound money management techniques often find out the hard way that these factors can quickly and easily erode the value of their option portfolios. Because of these risks and benefits, options offer tremendous profit potential above and beyond trading in any other instrument, including the underlying security itself. This is the juncture at which option theoreticians enter the picture. Once the benefits have been defined, it is now a matter of determining how to best attain them. Up to now, the vast majority of option techniques have been elaborate mathematical models designed to help identify when option-writing or selling opportunities exist. However, we hope to break new ground by introducing simple market-timing techniques that will enable traders to buy options with greater confidence and with greater success. TYPE OF OPTIONS Call Options A call option gives the holder (buyer/ one who is long call), the right to buy specified quantity of the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. Example: An investor buys One European call option on Infosys at the strike price of Rs at a premium of Rs If the market price of Infosys on the day of expiry is more than Rs. 3500, the option will be exercised. The investor will earn profits once the share price crosses Rs (Strike Price + Premium i.e ). Suppose stock price is Rs. 3800, the option will be exercised and the investor will buy 1 share of Infosys from the seller of the option at Rs 3500 and sell it in the market at Rs 3800 making a profit of Rs. 200 {(Spot price - Strike price) - Premium}. In another scenario, if at the time of expiry stock price falls below Rs say suppose it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the investor loses the premium (Rs 100), paid which should be the profit earned by the seller of the call option. Put Options A Put option gives the holder (buyer/ one who is long Put), the right to sell specified quantity of the underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short Put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise his option to sell.

11 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 11 Example: An investor buys one European Put option on Reliance at the strike price of Rs. 300/-, at a premium of Rs. 25/-. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's Break-even point is Rs. 275/ (Strike Price - premium paid) i.e., investor will earn profits if the market falls below 275. Suppose stock price is Rs. 260, the buyer of the Put option immediately buys Reliance share in the Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 {(Strike price - Spot Price) - Premium paid}. In another scenario, if at the time of expiry, market price of Reliance is Rs 320/ -, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs 25/-), which shall be the profit earned by the seller of the Put option. (Please see table) Option buyer or option holder Option seller or option writer The Options Game Call Option Buys the right to buy the underlying asset at the specified price Has the obligation to sell the underlying asset (to the option holder) at the specified price Put Option Buys the right to sell the underlying asset at the specified price Has the obligation to buy the underlying asset (from the option holder) at the specified price Options are different from Futures There are significant differences in Futures and Options. Futures are agreements/contracts to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obligated to buy/sell the underlying asset. Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas options have asymmetric risk profile. In options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset. In case of Options, for a buyer (or holder of the option), the downside is limited to the premium (option price) he has paid while the profits may be unlimited. For a seller or writer of an option, however, the downside is unlimited while profits are limited to the premium he has received from the buyer. The futures contracts prices are affected mainly by the prices of the underlying asset. Prices of options are however, affected by prices of the underlying asset, time remaining for expiry of the contract and volatility of the underlying asset. It costs nothing to enter into a futures contract whereas there is a cost of entering into an options contract, termed as Premium.

12 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 12 BASIC OPTION TERMINOLOGY Underlying - The specific security / asset on which an options contract is based. Option Premium - This is the price paid by the buyer to the seller to acquire the right to buy or sell. Strike Price or Exercise Price - The strike or exercise price of an option is the specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day. Expiration date - The date on which the option expires is known as Expiration Date. On Expiration date, either the option is exercised or it expires worthless. Exercise Date - is the date on which the option is actually exercised. In case of European Options the exercise date is same as the expiration date while in case of American Options, the options contract may be exercised any day between the purchase of the contract and its expiration date (see European/ American Option) Assignment - When the holder of an option exercises his right to buy/ sell, a randomly selected option seller is assigned the obligation to honor the underlying contract, and this process is termed as Assignment. Open Interest - The total number of options contracts outstanding in the market at any given point of time. Option Holder - is the one who buys an option which can be a call or a put option. He enjoys the right to buy or sell the underlying asset at a specified price on or before specified time. His upside potential is unlimited while losses are limited to the Premium paid by him to the option writer. Option seller/ writer - is the one who is obligated to buy (in case of Put option) or to sell (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option. His profits are limited to the premium received from the buyer while his downside is unlimited. Option Class - All listed options of a particular type (i.e., call or put) on a particular underlying instrument, e.g., all Sensex Call Options (or) all Sensex Put Options Option Series - An option series consists of all the options of a given class with the same expiration date and strike price. E.g. BSXCMAY3600 is an options series which includes all Sensex Call options that are traded with Strike Price of 3600 & Expiry in May. (BSX Stands for BSE Sensex (underlying index), C is for Call Option, May is expiry date and strike Price is 3600) HOW TO START TRADING OPTIONS? Before we devote our attention to more sophisticated option applications, it is important that we introduce a basic option foundation. While this introduction to options will be descriptive in its scope, its coverage will by no means be exhaustive. The sheer magnitude of option terminology and strategy could comprise an entire book on its own, and that is not our primary focus. For us to give our interpretation of existing material is much like making an entire career out of singing covers of popular songs of the past. Therefore, we will only be addressing the items necessary to understanding option basics and the techniques we will be

13 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 13 presenting throughout the book. This simple introduction is tailored to those who are unfamiliar with options. Whether they apply to stocks, indices, or futures, all options work in the same manner. Simply stated, an option is a financial instrument that allows the owner the right, but not the obligation, to acquire or to sell a predetermined number of shares of stock or futures contracts in a particular asset at a fixed price on or before a specified date. With each option contract, the holder can make any of three possible choices: exercise the option and obtain a position in the underlying asset; trade option, closing out the trader s position in the contract by performing an offsetting trade; or let the option expire if the contract lacks value at expiration, losing only what was paid for the option. We will discuss the benefits and implications of each action later in this chapter. Option contracts are identified using quantity, asset expiration date, strike price, type, and premium. With the exception of the option s premium, each of these items is standardized upon issuance of a listed option contract. In other words, once an option contract is created, its rights are static; the price that one would pay for those rights is not; it is dynamic and determined by market forces. Seeing as there are many items which make up the definition of an option contract, it is important that each be addressed before moving on. The first aspects of an option contract is the option s quantity. The number of shares or contracts that can be obtained upon exercising an exchange-listed option contract is standardized. Each stock option contract allows the holder of that option to control 100 shares of the underlying security while each futures option contract can be exercised to obtain one contract in the underlying futures contract.* *Futures are leveraged assets typically representing a large, standardized quantity of an underlying security which expire at some predetermined date in the future. Each futures option contract allows the holder to control the total number of units that comprise the futures contract until the option is liquidated, but no later than its expiration date. Another item that identifies the option contract is the asset itself. The asset refers to the type of investment that can be obtained by the option holder. This asset could be a futures contract, shares of stock in a company, or a cash settlement in the case of an index contract. The type of option is critical in determining the trader s market outlook. Unlike trading stocks or futures themselves, option trading is not simply being long a particular market or short a particular market. Rather, there are two types of options, call options and put options, and two sides to each type, long or short, allowing the trader to take any of four possible positions. One can buy a call, sell a call, buy a put, sell a put, or any combination thereof. It is important to understand that trading call options is completely separate from trading put options. For every call buyer there is a call seller; while for every put buyer there is a put seller. Also keep in mind that option buyers have rights, while option sellers have obligations. For this reason, option buyers have a defined level of risk and option sellers have unlimited risk. A call option is a standardized contract that gives the buyer the right, but not the obligation, to purchase a specific number of shares or contracts of an underlying security at the option s strike prices, or exercise price, sometime before the expiration date of the contract. Buying a call contract is similar to taking a long position in the underlying asset, and one would purchase a call option if one believed that the market value of the asset was going appreciate before the date the option expires. The most trader can lose by purchasing a call option is simply the price that he or she pays for the option; the most the trader can make is unlimited.

14 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 14 On the other side of the transaction, the seller, or writer, of a call options has the obligation, not the right, to sell a specific number of shares or contracts of an asset to the option buyer at the strike price, if the option is exercised prior to its expiration date. Selling a call contract acts as a proxy for a short position in the underlying asset, and one would sell a call option if one expected that the market value of the asset would either decline or move sideways. (See Payoff Diagram) The most an option seller can make on the trade is the price he or she initially receives for the option contract; the most the trader can lose is unlimited. In order to offset a long position in a call option contract, one must sell a call option of the same quantity, type, expiration date, and strike price. Similarly, in order to offset a short position in a call option contract, one must buy a call option of the same quantity, type, expiration date, and strike price. Long With respect to this booklet s usage of the word, long describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account. For example, if you have purchased the right to buy 100 shares of a stock, and are holding that right in your account, you are long a call contract. If you have purchased the right to sell 100 shares of a stock, and are holding that right in your account, you are long a put contract. If you have purchased 1,000 shares of stock and are holding that stock in your brokerage account, or elsewhere, you are long 1,000 shares of stock. When you are long an equity option contract: You have the right to exercise that option at any time prior to its expiration. Your potential loss is limited to the amount you paid for the option contract.

15 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 15 Profit + PAYOFF DIAGRAM Profit diagrams for a Long Call and a Long Put LONG CALL OUTLOOK = BULLISH S = STRIKE PRICE BEP = BREAK-EVEN-POINT = S+DR DR = DEBIT = INITIAL OPTION COST = MAXIMUM LOSS MAXIMUM GAIN = UNLIMITED 0 BEP S DR Underlying Asset Price Loss - Stock Price Lower Higher LONG PUT OUTLOOK = BEARISH S = STRIKE PRICE BEP = BREAK-EVEN-POINT = S-DR DR = DEBIT = INITIAL OPTION COST = MAXIMUM LOSS MAXIMUM GAIN = UNLIMITED Profit + Underlying Asset Price 0 S DR BEP Stock Price Loss - Lower Higher

16 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 16 Short With respect to this booklet s usage of the word, short describes a position in options in which you have written a contract (sold one that you did not own). In return, you now have the obligations inherent in the terms of that option contract. If the owner exercises the option, you have an obligation to meet. If you have sold the right to buy 100 shares of a stock to someone else, you are short a call contract. If you have sold the right to sell 100 shares of a stock to some-one else, you are short a put contract. When you write an option contract you are, in a sense, creating it. The writer of an option collects and keeps the premium received from its initial sale. When you are short (i.e., the writer of ) an equity option contract: You can be assigned an exercise notice at any time during the life of the option contract. All option writers should be aware that assignment prior to expiration is a distinct possibility. Your potential loss on a short call is theoretically unlimited. For a put, the risk of loss is limited by the fact that the stock cannot fall below zero in price. Although technically limited, this potential loss could still be quite large if the underlying stock declines significantly in price. PAYOFF DIAGRAM Profit diagrams for a Short Call and a Short Put SHORT CALL OUTLOOK = BEARISH S = STRIKE PRICE BEP = BREAK-EVEN-POINT = S+CR CR = CREDIT = INITIAL OPTION PAYMENT RECEIVED = MAXIMUM GAIN MAXIMUM LOSS = UNLIMITED Profit + CR Underlying Asset Price BEP 0 S Stock Price Loss - Lower Higher

17 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 17 SHORT PUT OUTLOOK = BULLISH S = STRIKE PRICE BEP = BREAK-EVEN-POINT = S-CR CR = CREDIT = INITIAL OPTION PAYMENT RECEIVED = MAXIMUM GAIN MAXIMUM LOSS = UNLIMITED Profit + CR BEP 0 S Underlying Asset Price Stock Price Loss - Lower Higher A put option is a standardized contract that gives the buyer the right, but not the obligation, to sell a predetermined number of shares or contracts of an underlying security at the option s strike price, or exercise price, sometime before the expiration date of the contract. A put contract is similar to taking a short position in the underlying asset, and one could purchase a put option contract if one believed that the market price of the asset was going to decline at some point before the date the option expires. The most a trader can lose by purchasing a put option is simply the price that he or she pays for the option; the most the trader can make is unlimited (in reality, it is the full value of the underlying asset which is realized if its price declines to zero). Conversely, the seller, or writer, of a put option has the obligation, not the right, to buy a specific number of shares or contracts of an asset to the option buyer at the strike price, assuming the option is exercised prior to its expiration date. Selling a put contract acts as a substitute for a long position in the underlying asset, and a trader would sell a put contract if he or she expected the market value of the asset to either increase or move sideways. Again, the most an option seller can make on the trade is the price he or she initially receives for the option contract; the most the seller can lose is unlimited (in reality, the most one can lose is the full value of the underlying asset which is realized if its price declines to zero). (See Payoff Diagram) In order to offset a long position in a put option contract, one must sell a put option of the same quantity, type, expiration date, and strike price. Similarly, in order to offset a short position in a put option contract, one must buy a put option of the same quantity, type, expiration date, and strike price. Open An opening transaction is one that adds to, or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, consider both:

18 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 18 Opening purchase a transaction in which the purchaser s intention is to create or increase a long position in a given series of options. Opening sale a transaction in which the seller s intention is to create or increase a short position in a given series of options. Close A closing transaction is one that reduces or eliminates an existing position by an appropriate offsetting purchase or sale. With respect to an option transaction: Closing purchase a transaction in which the purchaser s intention is to reduce or eliminate a short position in a given series of options. This transaction is frequently referred to as covering a short position. Closing sale a transaction in which the seller s intention is to reduce or eliminate a long position in a given series of options. Note: An investor does not close out a long call position by purchasing a put, or vice versa. A closing transaction for an option involves the purchase or sale of an option con-tract with the same terms, and on any exchange where the option may be traded. An investor intending to close out an option position must do so by the end of trading hours on the option s last trading day. Just remember, call buyers want the market price of the underlying security to go higher so the option will gain in value and they can make money; and call writer want the market to go sideways or lower so the option will expire worthless and they can make money. Put buyers want the market price of the underlying security to go lower so the option can gain in value and they can make money; and put sellers want the market price to go higher or sideways so the option will expire worthless and they can make money. Also remember, option buyers can choose whether they wish to exercise their options; option sellers cannot. The strike price or exercise price is simply the price at which the underlying security can be obtained or sold if one were to exercise the option. For a call option, the strike price is the price at which the holder can buy the security from the option writer upon exercising the option. For a put option, the strike price is the price at which the holder can sell the security to the option writer upon exercising the option. These option strike prices are standardized, with the strike increments determined by the asset s price. Newly created contracts can only be issued with strike prices that straddle the current market price of the security; however, at any one time, several different previously existing strike prices trade on the open option market. Which of the standardized strike prices the trader chooses depends upon his or her investment needs and capital outlay. Obviously, depending upon the prevailing underlying market price, the rights to some option strike prices will cost more than others. Strike prices for futures options contracts are different than those for stock options. Much like options on stock, the trader can choose from any of the standardized futures option strike prices that are issued. However, the strike prices that are set for the futures options are more contract-specific, contingent upon the market price of the underlying contract, how the future is priced, and how it trades. For obvious reasons, the issued strike prices for Treasury bond options will be different than those for soybean options. Because strikes vary depending on the commodity, it is important that traders familiarize themselves with the option contract and the underlying security before they initiate an option position. The expiration date refers to the length of time through which the option contract and its rights are active. At any time up to and including the expiration date, the holder of an option is entitled to the contract s benefits, which include exercising the option (taking a position in the underlying asset), trading the option (closing one s position in the contract by trading it away to another individual), or letting it expire worthless (if the contract lacks value at expiration). While the trader can choose from any of the listed option expiration months he

19 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 19 or she wishes to purchase (or sell), the trader cannot choose the specific date the option will expire. This date is standardized and is determined when the option is listed on the exchange on which it is traded. For most options on equity securities, the final trading day occurs on the third Friday of each month. The actual expiration occurs the following day, the Saturday following the third Friday of the month. The expiration date for futures options is more complicated than that for stock options and depends upon the contract that is being traded. Some futures option contracts expire the Saturday before the third Wednesday of the expiration month while others expire the month before the expiration month. Since an option s expiration date depends upon the type of asset that is traded, it is important for a trader to know the specific date the contract will expire before investing in the option. The majority of listed options are issued with expiration dates approximately nine months into the future. In addition to these standard options, there are also options that possess a longer life than the nine-month maximum for regular stock options. These are called long-term equity anticipation options, or LEAPS. LEAPS are issued each January with an expiration up to 36 months into the future. LEAPS allow traders to position themselves for market movement that is expected over a longer period of time: weeks, months, even years. They are more expensive than standard options because the added life increases the likelihood that the option will have value at some point prior to expiration. However, LEAPS can be traded only on stocks, indices, and interest rate classes and not every security offers them and currently are available in United States and not in India. American Style of options An American style option is the one which can be exercised by the buyer on or before the expiration date, i.e. anytime between the day of purchase of the option and the day of its expiry. European Style of options The European kind of option is the one which can be exercised by the buyer on the expiration day only & not anytime before that. Leverage and Risk Options can provide leverage. This means an option buyer can pay a relatively small premium for market exposure in relation to the contract value (usually 100 shares of underlying stock). An investor can see large percentage gains from comparatively small, favorable percentage moves in the underlying index. Leverage also has downside implications. If the underlying stock price does not rise or fall as anticipated during the lifetime of the option, leverage can magnify the investment s percentage loss. Options offer their owners a predetermined, set risk. However, if the owner s options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk. In-the-money, At-the-money, Out-of-the-money An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls. A call option is said to be in-the-money when the strike price of the option is less than the underlying asset price. For example, a Sensex call option with strike of 3900 is 'in-themoney', when the spot Sensex is at 4100 as the call option has value. The call holder has the right to buy a Sensex at 3900, no matter how much the spot market price has risen. And with the current price at 4100, a profit can be made by selling Sensex at this higher price.

20 STOCKWHIZO OPTIONS TRADING STRATEGY GUIDE.. 20 On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Sensex call option, if the Sensex falls to 3700, the call option no longer has positive exercise value. The call holder will not exercise the option to buy Sensex at 3900 when the current price is at (Please see table) In-the-money At-the-money Out-of-the-money Striking The Price Call Option Strike Price less than Spot Price of underlying asset Strike Price equal to Spot Price of underlying asset Strike Price greater than Spot Price of underlying asset Put Option Strike Price greater than Spot Price of underlying asset Strike Price equal to Spot Price of underlying asset Strike Price less than Spot Price of underlying asset A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, a Sensex put at strike of 4400 is in-the-money when the Sensex is at When this is the case, the put option has value because the put holder can sell the Sensex at 4400, an amount greater than the current Sensex of Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Sensex put option won't exercise the option when the spot is at The put no longer has positive exercise value. Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price. The amount by which an option, call or put, is in-the-money at any given moment is called its intrinsic value. Thus, by definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium. This does not mean, however, these options can be obtained at no cost. Any amount by which an option s total premium exceeds intrinsic value is called the time value portion of the premium. It is the time value portion of an option s premium that is affected by fluctuations in volatility, interest rates, dividend amounts and the passage of time. There are other factors that give options value, therefore affecting the premium at which they are traded. Together, all of these factors determine time value. Option Premium = Intrinsic Value + Time Value FACTORS THAT AFFECT THE VALUE OF AN OPTION PREMIUM There are two types of factors that affect the value of the option premium: Quantifiable Factors: Underlying stock price, The strike price of the option, The volatility of the underlying stock, The time to expiration and; The risk free interest rate.