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Author Topic: An Introduction to Stock Options
Bob Frey
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http://finance.yahoo.com/how-to-guide/career-work/12827;_ylt=Ao0fHikDXB9HPi.jlS0 fFoa7YWsA

An Introduction to Stock Options on Yahoo

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Free Muney
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Ok. so i have been reading about options. It seems like a trading vehicle that an investor should learn about. whats missing from most explinations is a detailed example. Could anyone help? Please create an example of a simple call. please explain option price, timeframe, strikeprice, breakeven point, and how price is affected by the stocks movement, time left on the contract, benefits to excersicing the option vs selling it. How much the option contract costs and how contract costs vary and why? and any other risks that a newbie should consider.

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Contrarian views always appreciated.... :p

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JLo
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you get all that by studying the price chart over days,weeks,months.

Track several stocks, some aggressive, some moderate, some conservative, and see how it change by price movement of underlying, time to expiration and news.

Option pricing itself is driven by expectation which in turn is formulated by past movement (volatility) of the underlying stock. There are exception like: if underlying is new issue like a no-name drug developer and suddenly piqued the interest of big pharma to buy its technology then pricing may skyrocket before anything actually happens; likewise, bad credit home mortgagers will tanked on rumor of bankruptcy. Stable companies will have bigger volatility before earnings announcements too.

If you are new and not doing shorts, and long on calls and puts all you lose is the price you paid for.

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T e x
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fmuney,

Bob's link is to a quite thorough article; this is less thorough but simple:

http://www.fool.com/investing/options/2006/12/20/options-explained.aspx

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Nashoba Holba Chepulechi
Adventures in microcapitalism...

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Free Muney
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thank you tex, the fool article put numbers to the example which I needed to understand options better. jlo your comments help too. so If i own 100 shares of stock x, can I issue a put on my 100 shares if i think it will tank/ be flat on price. and I make the cost of the option if it is not excersized? or can only brokerages do that?

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Contrarian views always appreciated.... :p

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milliam
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If you own 100 shares of stock x and you think it will tank, you'd want to sell a call. You could sell 1 contract (100 shares) on your stock x. If the stock does tank, you keep your shares (option not exercised) and the money you made from selling your call. If the stock is above the strike price at expiration, then you sell your shares at the strike price and of course still have the money you made from selling the call.

If I'm correct, selling puts is a good bit different. Selling puts means that you agree to buy the stock at a certain price. Selling calls means you agree to sell a stock at a certain price. Thus selling puts is a bit more risky.

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JLo
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If you reverse all your steps you'd come up with this scenario and its no more risky than the example above.

1. dont buy stock X
2. instead sell put on stock x at lower market price
3. stock rose, your put expires, your profit is the premium you collected on the put
4. stock dropped and the put is exercised, and you just have 100 share of X put to you at lower than mkt price$.

The risk is if stock X sinks, then you are screwed. But remember you were going to buy stock X at appr. market price anyway. So its no more risky than buying the stock.

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JLo
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one variation: use the $ you collected on selling the put to buy a call. If stock rise, you profit as if owning the stock. If stock falls you receive discounted stock. Of course if stock$ fell big then you are screwed, but you were going to buy that stock before anyway.
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Stupid
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I was told of another training site about options.It has traning and seminars and was recommended by my broker.The site is www.888options.com and it has a lot of information.

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DDDDD

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Skyman
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What if I think a stock is going down in price and buy a put option.

And suppose the stock does go down into bankruptcy but still trades at a very low price. What happens to the option before the expiration date and what happens to the option at and after the expiration date? And does the option increase in value as the stock price goes down?

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leemalone2k3
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Options Levels
L1=Covered Calls
L2=Long calls and Puts
L3 Spreads
L4 Short Calls and Puts
L5 Short Index Options

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leemalone2k3
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Basics
An option is a contract that gives the owner the right, but not the obligation, to buy or sell a stock at a set price by a set date.
An option is a piece of paper that allows you if you own the contract to buy or sell a stock at a set price before the contract expires, or to buy or sell the contract at any time prior to expiration..
ctrct=contract
a Purchased Call option gives you the right to buy a stock a t a set price for a set period of time.
A Purchased Put option gives you the right to SELL a stock at a certain price by a set date.
Option carry the risk of total loss of your investment.
Options have leverage. When you buy 1 contract, you control 100 shares of the stock at a fraction of the price
5 Ingredients to Option Pricing
The current stock price.
The strike price you are trading.
The time till the option expires.
The cost of the money.
The stocks volatility.
Every Option has 2 Parts
Intrinsic vale
Value if the current value of the opt if it were to be exercised today.
Time value
Value if the amount you pay to exercise your contract within the next few months.
Time Value(TV) is the additional amount the MM's add to the premium, it's like a car dealers mark up price.
Example
a. Intrinsic value + Time value = option price
b. Stock=$26
c. I want to buy the $25 calls
d. The intrinsic value = $1 (26-25)
e. If the option quote price of the $25 call is 2.50, then the time value is $1.50 (see F)
f. 2.50-1.00=1.50
g. If stock is $27, Intrinsic Value=$2.00
h. Option Quote - Intrinsic Value = Time Value

Theoretical Value
1. Is the fair value of an option.
2. It not only tells us if the stock is overvalued or undervalued, but it also tells us exactly what price we should be paying for an option.
3. This T-value is derived from the BSC.
Example
a. Lets say we are looking at a 60.00 stock and the Tval is listed at .65.
b. Ask price for the strike price and the exp month is .70 for the Nov 60.00 call option.
c. If we pay .70 to buy the option and the Tval is .65 we will pay 7.6% more than we should.
d. There is a normal premium built into most options as the MM's will try to see how much more you are willing to pay.
e. As a general rule of thumb, make sure the ask price of an option is not trading more than 20% premium of the T-Val.

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leemalone2k3
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Decision Factors
A huge factor in deciding whether or not to purchase an option rests in the expected volatility (price movement) vs. the stock's historical volatility.
Volatility = magnitude of a stock move, this can be up or down.
If stock has low historical volatility, that means investors are willing to hold the stock and not trade it.
This usually indicates the stock will see low volatility in the future.
The 12m calculation for historical volatility is a good indicator.
Implied volatility measures the current expected volatility of the stock.
When we measure the historic against the implied, we can see if the stock's expected (implied) volatility is above or below normal historical volatility.
If implied volatility is higher than historic volatility, the option is overvalued.
If implied volatility is lower than historic volatility, the option is undervalued.
If implied volatility is close to the historic volatility, the option is fair valued.
All of this is done for you with a calculator called the Black Shoales Calculator.
The BSC allows you to project the future value of an option by allowing you to manually change the Strike price, share price , time to expiration, volatility, annual interest rate.
http://www.blobek.com/black-scholes.html.
Forecasting
Each time you invest, you must choose a strategy that takes advantage of your forecast for the market or a particular stock.
This is a tremendous challenge and is impossible to be right 100% of the time.
To make a forecast, use the best available info and tools and then apply your individual; interpretation of them.
Always forecast before making a trade. Most option traders focus on short time frames for their forecasting (generally 3 months or less).
As option traders we try to use the leverage of an option to profit from a short term move in the market or individual stock.
Rules
The Trend is your friend. Never buck the trend or you lose.
Spot trend of the major indexes first: DOW<S&P500,NASDAQ.
Keep in mind that the trend tells you WHAT to do, and the Indicator tells you WHEN to do it.
ALWAYS - check the trend before you check the indicator.

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leemalone2k3
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Buying a Call
You pay a premium for the right, but not the obligation to buy a stock at any time before the expiration date.
You also have in your contract the right to sell that contact ANY TIME before expiration date.
Your 5K premium is known as “as risk.” You can lose all of this investment.
So in order to make money when we purchase a call option, the price of the stock must go up over the stock price + the premium we paid per share.
Buying A Put

Same procedure as buying a call except you are betting that the stock will decrease in value. Profit is made once the stock price goes below the Strike price + the cost of your premium.


Example of Buying a Call (real estate example)
1. On August 23rd you pay a 5K nonrefundable premium to buy my house for 100K on January 1st, 2008.
2. When Jan 1st comes, if my house is worth 150K, you have the option to buy it for 100K and sell it for 150k, resulting in a 45k gain using a 105k investment. This is a gain of 43%.
3. When Jan 1st comes, if my house is worth less than 100K, you do NOT have to buy it. You would lose the premium.
4. If anytime before Jan 1st my house is worth more then 100K, you can sell the contract and take the profit. Using the example above, we can sell the option for 50k and make a 45k profit. This is the beauty of options. You use 5k to make a profit of 45k (a 900% gain) instead of using 105k to make the same profit.You make the same profit without having to purchase and sell the equity. This is known as leverage.

Selling a Put
You are credited the premium when you sell the contract.
As long as the stock stays above the strike price, the contract will expire worthless and you will make the premium.
So in order to make money, when we sell a put, we want the stock price to stay above the strike price.
You only sell Puts when you are comfortable owning the underlying stock (at a discount)
Example of Selling a Put
1. The current price of LEND is at $6 a share.
2. We sell the $2.50 strike price put for September. The premium on this sell is .80 cents per share (.80/share).
3. We sell 100 contracts (100 contracts * 100 shares = 10,000 shares).
4. The amount credited to our account for the sell is 10,000 shares X .80/share = 8,000 dollars.
5. As long as the price of LEND stays above $2.50, we get $8,000 on the expiration date.
6. Now what happens if the stock drops to $2.50? We have to buy the stock back!
7. We buy the stock back at the Strike Price – Premium.
8. For LEND that would be 2.50 - .80 = $1.70 per share.
9. The JUICY part is that when the stock fell to $2.50, we bought it at $1.70, which means that we can turn around and sell the stock at the market price of… lets say $2.45… and still make a sizeable profit (7,500).
10. (2.45-1.70) * 10,000 shares = 7,500.

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leemalone2k3
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Credit Spreads

Basics
Credit spreads have a maximum profit potential.
Credit Spreads require level 3 options trading authority
Tip: If you think the stock is going to make a dramatic move up, you would be better playing a long call
But what is really cool is that you can make money with a credit spread even if the stock stays flat and may even take a small profit even if it goes down only a little bit
Spreads have a max loss potential
Spreads have a max profit potential
When playing options, you should ALWAYS have your stop set as soon as you place your order
The are two different types of Credit Spreads
Bull Put
i. Bull Put= stock should be trending up or at least sideways
ii. So the same rules would apply to playing a bull put spread as if you were buying a bullish stock (You would want to enter the trade at support and exit at resistance)
iii. You will most likely achieve the max profit in a Bull Put spread if the stock is trending up.
iv. Because one of the two positions in a bull put spread is naked, you should enter the long side first
v. You can then enter the short side without needing naked option writing approval
vi. many platforms allow you to make a single credit spread now where both are executed simultaneously
How to play a Bull Put spread
Buy a put on a bullish stock, with a strike price below the current trading price of the stock.
Sell a put on the same stock with a strike price above the strike price that you bought the first put.
Example
a) Lets say a stock is bouncing off support at $54
b) You buy the 50 put and sell the 55 puts
c) When you buy the 50 puts- you pay .25
d) When you sell the puts at 55 you bring in 2.50
e) 2.50-.25=2.25/sh
f) Your max profit is your credit, so the max profit=225/contract
g) Max Loss = Difference between the spread less the net credit
h) 55-50=5.00
i) 5.00-2.25=$2.75/sh or -$275.00 /contract
j) If the stock closes 55.50 on exp date
i. Both puts expire worthless
ii. and you keep max gain of 225/contract
k) If the stock closes at 35
i. You would assume the max loss of $ 275/contract
l) The reason you get max gain is because both options expire worthless= $0.00 in commissions
m) Breakeven= Higher Strike price - Net credit= 55.00- 2.25=$52.75 assuming all options are worth their intrinsic value at expiration.

How to exit a trade early because we have made a profit
a) When we exit early, we have to physically close the trades=commissions
b) So let’s say the stock we spread traded is sitting at 55.00 within two weeks to expiration.
c) Now we have a profit, and even though it isn’t max profit we still grabbed 35-50% of our max profit
d) We should look to exit because the risk reward ratio starts to turn against us
e) We are holding something that might bring another 10-15% more but holding 50% gain to make that 10 –15%gain
f) I am not willing to give up a gain for the small added value it would bring
g) We entered the spread with a 2.25 credit, and we want out
a. so we buy back the $55 put and it costs us $1.00 ($1 is the ask price we bought the $55.00 put we sold earlier)
b. and we sell the $50 put for +.15
c. this gives us a profit of 1.40 or 140/contract
$2.25 - $1.00 +$0.15= $1.40/sh or $140/contract

Bear Call
i. Bear Call Credit spread=Stock should be trending flat to down
ii. You want to enter when the stock is bouncing off resistance (just as if you were shorting a stock)
How to play a Bear Call
1. You Buy a call above the current share price
2. And you sell a call below the strike price you bought.
3. This will bring a credit into your account, just like the bull put spread did
Example
1. imaginary stock ZILL is trading at 76.00/share
2. You buy the $80 call for -.50
3. You sell the $75 call for 3.00
4. Net credit= 3.00-.50=2.50
5. Net credit is you MAX GAIN= 2.50
6. Assume ZILL drops dramatically to 60 on exp date, you would get the max gain.
7. MAX LOSS= Difference between the Strike Prices-Net Credit
8. max loss=$250/contract 80 – 75 =5 – 2.50 = 2.50/sh
9. Breakeven= Lower Strike Price+credit recieved= 75+2.50=$77.50 assuming all options are worth their intrinsic values at expiration.

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leemalone2k3
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Debit Spreads
1. Basics
a. These are very similar to credit spreads with a couple of exceptions
i. In a debit spread we pay out $$$$$$ first and collect after the trade is closed
ii. You buy a higher priced option while simultaneously selling a lower priced option
iii. Some debit spreads must be closed manually by expiration date.
2. Bull Call
a. Bull Call spreads allow you to make money on stocks that are trending up or remain sideways.
b. We enter the trade on a bounce off support and exit at resistance or exit once we make our spread profitable
c. The max profit is equal to the spread between the two strike prices minus the initial debit
d. Select an expiration date of 20-40 days away.
e. As a rule, if the maximum profit potential is at least 30% to 50% of the maximum loss potential, the spread is acceptable. To determine the Return on an investment you divide the maximum potential profit and divide it by the nest debit (max potential loss).
f. When volatility rises, buying an out of the money spread may be less attractive because premiums are higher.
g. You would attain the max profit at expiration if the stock closes above the sell call strike price ($37 in example below).
h. An out of the money spread unlike a bull put spread will only be profitable if the underlying stock price increases. Conservative investors should buy In The Money options. Aggressive investors should buy Out of the Money options.
i. The max profit would be the difference between the strike prices less the net debit.
j. If the stock closes in between the strike prices, you must exit the In The Money call manually. Do not expect your broker to sell your in the money option on expiration date
k. The max loss is the net debit
l. You can also exit early if your profit target has been reached
m. Assume the stock rises to 36.80 with a week or two until expiration (see example below)
i. The differences in the long and short call premiums will have changed
ii. We would buy back the 37.00 call for -.0.10
iii. And we would sell the 36.00 call for +0.85
iv. or a profit of .10
v. or 10.00/contract
vi. -.65 +.85 -.10=.10

How to Play a Bull Call Debit Spread.
If you cannot do this trade as a single transaction, always enter the BUY (LONG) side before selling the call.
1. We sell a call above the current trading price
2. We buy a call below the strike you sold
3. ENTER THE BUY FIRST OR YOU ARE NAKED
4. ALWAYS ENTER THE LONG SIDE FIRST

Example
1. Current stock price is at $36.70
2. We sell a 37 call for .20
3. We Buy a 36 call for -.85
4. This results in a -.65/share debit, or -$65 per contract
5. Max profit = 36 – 37 = 1, 1-.65 = .35 or 35/ per contract. Max profit occurs when the stock closes above the 37 strike price on expiration. Both calls expire in the money.
6. Max loss = 65/ contract= Net Debit
7. Assume Stock is at $34 on expiration date…
a. Both calls expire worthless and you assume max loss
8. To determine the breakeven point, take the net debit, multiply it by –1 and add it to the lower strike price.
In this case:
-.65 x –1= .65.
36.00 + .65=36.65


Exiting the Spread

1.Same Day Substitution- his describes the process that takes place when the option buyer exercises the short option, causing your broker to immediately exercise the long option to offset your obligation in the trade. This means you wil not have to buy the stock. Your broker will automatically liquidate your position. Always contact your broker prior to playing credit spreads to make sure they offer same day substitution.

2.If the stock closes through the spread (above the higher strike price) on expiration date, both calls will expire In The Money and you will achieve max profit and will need to take no other action if your broker offers same day substitution.

3. If on expiration date the stock closes between the two strike prices, the spread could break even or even be slightly profitable.

Bull Call Spread Review

*Find optionable stocks in a bullish to neutral trend with good fundamentals


* Conduct TA on those stocks. Concentrate on support and resistance.

*Buy a call option option (either in or out of the money) with a strike price close to the current trading price of the stock. Then sell a call with a strike price above the strike price that is higher than the call you purchased. This transaction will create a debt. An extremely bullish investor would buy the call with a strike price above the current trading price of the stock.

*Enter the spread with a “buy to open” for the call with the lower strike price and a “sell to open” for the call with the higher strike price. If possible, enter the trade as a single position instead of legging into the trade one side at a time.

*Monitor the trade daily. Watch the price of the stock. If it drops unexpectedly, consider exiting the trade.

*Exit the spread by entering a “But to Close” order to exit the short call and a “sell to Close” order to exit the long call, by letting both options expire worthless, or by allowing the spread to be exercised.

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leemalone2k3
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Bear Put Debit Spreads


you sell call at a strike above the current trading price
you buy a call below the strike price you bought
:the stock should be trending UP or at least sideways

we are talking vertical spreads

You play a vertical spread for 20-40 days

its a short term trade

Bear = trending down

With a spread, you can make a profit even if the stock trends sideways
And may even break even if it the stock moves up a small amount
You would use a Bear Put spread in the same conditions you would play a
long Put.
: You would want to enter the trade at a bounce off resistance or a break of
Remember with any spread, one side of the trade is SHORTor NAKED
So you should ALWAYS enter the trade on the Long Side(Buy) first if you use
a single entry platform
You can then enter on the Short (Sell) side without needing Naked Option
Writing approval
The Long side will COVER the short side if the contract is assigned
unexpectedly
You can use spread stategies in any market condition, but remember, if you
are expecting your stock to move violently in either direction, you may be better off playing straight
calls or puts

How to Play a Bear Put Spread:
You buy a Put option on a bearish stock. This option should have a strike price that is higher than the strike price of the Put that will be sold in the next stepThen you sell a Put option with a strike price that is lower than the current trading price of the underlying stock.

example
Stock price= 49.12
Buy a put for 50.00 = -2.10
Sell a 47.50 Put= +.85

Net Debit= -$1.25/share or -$125.00/contract 2.10- .85= 1.25

Max Profit Potential= Difference between the spread minus the initial net debit
50.00 - 47.50 - 1.25 = 1.25/share or $125.00/contract

Maximum Loss= Net Debit
[n this case Max. Loss= 1.25
: No matter how far the stock rises, you cannot lose more than 125.00/contract
Breakeven Point= Upper Strike Price-Net Debit= $50-$1.25=$48.75
As a rule, if the max potential profit is at least 100% of the max potential loss , the spread is acceptable

When volatility rises, buying an out of the money spread will bring in higher premiums
Be careful though,
Volatility often rises prior to any major news. and the stock could move against you lightning fast and you lose


Lets assume the stock falls to 48 with 20 days till expiration
The premiums for both the long put and the short put wil have changed
If the difference between the two premium prices is larger than the net debit, you can close the trade for a profit
Its a good idea to have an optional profit target of 30-50% of the maximum potential gain
Exiting early lets you take gains sooner and enter another trade
Because a Bear Put Spread is a Debit spread, you pay up front so you must have the funds available in your account to make the trade
But there is no margin requirement as there is in a credit spread

stock is at 48.00
We buy back the 47.50 put = -$0.50
and we sell the 50.00 put for +$2.65
We entered the spread with a net debit of -1.25
2.65 - .50 - 1.25= +.90 or $90.00/contract


example 2:

Current stock= 72.45
We Buy the 70.00 put for -2.50
We sell the 65.00 put for +0.95
Net Debit= -1.55
Max Profit- 70.00 - 65.00 - 1.55 = 3.45

Lets assume the stock drops drastically to 58.00/share on exp date- you would get the max profit

Max Loss
The max loss is equal to the net debit
in this case tha max loss would be 155.00/contract

Return on Investment:
ROI= Max potential profit/Max potential loss
3.45/1.55=233%
which is well above the acceptable 100% ROI mentioned earlier

Assume the stock rises to 72.00 unexecpectedly and stays there until expiration
Since the stock closed above both strike prices, both options will expire out of the money : and the spread will realize the maximum loss : because both puts expire worthless

Exiting at Expiration
If the stock closed "through the spread" (below the lower strike price) on exp. date, both calls will expire In The Money, you will achieve max gain and will not need to exit the trade. That is how you make the max profit, because there are no commissions


Exiting If the Stock Moves Higher by Expiration:
[f on expiration day the stock closes below the higher strike price, but above the lower strike price, the spread could still break even or even be a little profitable


Break Even Price
Subtract the net debit from the higher strike price
70.00-1.55=68.45. As long as the stock fallss below 68.45 you can break even or make a small profit


Whenever the stock closes in between the stock prices you need to close the trade manually. This is very important:
To capture any value from the spread, you will have to sell the option you purchased (70) with a "Sell To Close" order and allow the lower strike price (65) to expire worthless
DO NOT EXPECT YOUR BROKER TO AUTOMATICALLY SELL YOUR IN-THE-MONEY OPTION SIMPLY BECAUSE IT STILL HAS VALUE ON EXPIRATION DATE
You must manually close the trade

Exiting a Bear Put Spread early is appropriate under the right conditions.
Exiting early can prevent you from taking the Max loss
Lets say the stock drops slightly then rises back above the breakeven price of 68.54
with no signs of resuming the downtrend, it is a good idea to exit early
Stock falls to $66.00 during the next few weeks then climbs up too 69.00 with one week till expiration
The short put (sell) would have lost some of it's valuue due to time melting away
The long (buy) put will have added some intrinsic value and will most likely still have some time value left
You buy back the short put and sell the Long put to exit the trade

69.00 is above the breakeven price of 68.45
You sell the 70 put for +$1.00
And you buy back the 65 put for -$0.05
Your net loss would be -$0.50
Our intial net debit was -1.55
-1.55 +1.00 - .05= -0.50


Review:
1. Find an optionable stock in a bearish trend. Fundametals are not important.
2. Perform TA, enter at a bounce off resistance or a break of support
3. Sell a put option with a strike price that is below the current trading price of the stock ( do this only after entering the long leg) and buy a put with a strike price that is higher than the put we sold: this creates a debit
An extremely bearish investor might buy a strike price that is out of the money
4. Enter the trade by "buying to Open" the put with the hiher strike price and "Selling to Open" the put with the lower strike price. If possible, enter the trade as a single position instead of legging into the trade (one side at a time)
5. Monitor your trade on a daily basis
6. Close out the trade if the stock starts to show signs of strength or is rising unexpectedly
Exit by "Sell To Close" the put with the higher strike price and "buy to close" the put with the lower strike price
7. Always find out what your brokers rules for exercising a spread are just in case the call you sold is exercised.

An Easy way to remember how to play credit or debit spreads:

When it is a bullish spread, you Buy a Strike price below the stock price and you sell above the price you bought. These are known as Bull Put (credit) and Bull Call (debit).

When the spread is bearish, you sell a strike price below the stock price and buy above the price you sold. These are known as Bear Call (credit) nd Bear Put (debit).

That is the final chapter for vertical spreads!

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Diagonal Spreads


Basics
You create a Diagonal Spread by buying a long-term option while simultaneously selling a shorter-term option with a different strike price.
There is a maximum profit potential, like a vertical spread
There is also a maximum loss potential
You can trade the same diagonal spread for multiple months in a row
There are NO margin requirements
You must have Level 3 options trading authority
The difference between diagonal spreads and vertical spreads is that the two trades involved in the Diagonal have different expiration dates
Diagonals are also called Calendar Spreads or Time Spreads too
Diagonal Spreads allow you to offsetting the costs of entering a long option position. But by doing so, you put a cap on the max gain potential
If the spread you are considering will consist of the major % of the existing open interest, the market may move to meet the order and the spread could be entered at an unfavorable price
Always check the open interest and make sure the number of contracts you want to play does not exceed 1-2% of the open interest
Open interest of 100 contracts or more is desirable
Diagonal Bull Calls
Diagonal Bull Spread- Stock should be neutral to up trending
You will get the max gains if the stock is trending up
Use in the same conditions that you would play a covered call or a long call.
If the short call expires worthless, you can generate monthly income by selling another call for the next month and the next, and so on.
Advantage of a Diagonal Spread over a covered call: The Diagonal Bull Spread is much cheaper to get into.
The long side will cover the short side if the contract is assigned unexpectedly.
Conservative investors should buy In The Money Options
The long call should be 4-6 months away
The short call should be 20-40 days till expiration
How to play a Diagonal Bull Call spread
1. Buy a Long-Term option on a Bullish stock at a Strike price below the current trading price of the stock.
2. Sell a shorter-term call option that is higher than the stike price of the call you purchased.
3. When you purchase the option lower than the Share price, this allows you to buy the stock from someone else at a lower price as long as the stock remains above the strike price.
4. You achieve max profits if the stock closes above the higher strike price on expiration date


Diagonal Spreads Cont.

Example
1. Sept. 5 trade date
2. Stock =31.00
3. Feb $25 call is bought for -$7.00
4. Sept $35 call is sold for +.50
5. Net Debit= - $6.50
6. Maximum Profit potential: = Difference in the Strike Prices less the net Debit
7. $35.00- $25.00= $10.00 // $10.00-$6.50=$3.50
8. Max Profit=$3.50/share or $350.00/contract
9. Max Loss= Net Debit= $6.50/share or $650.00/contract
10. Assume the stock drops to $20.00 tomorrow and remains below $25.00 through Feb = You would get the max loss
11. Lets assume the stock climbs quickly to 38.75 on day 10 with a week left until expiration
12. You buy back the $35 call for -2.00
13. You sell the Feb $25 call for +11.90
14. 11.90 -6.50 - 2.00= $3.40 Profit

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leemalone2k3
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Straddles


Basics
A straddle is created when you buy a call and a put on a stock
You buy at the same price (strike price)
Straddles and Strangles are classified as trend-neutral positions
With Straddles and Strangles you are looking for the stock to move in one direction or the other
To be profitable, the stock has to move far enough in one direction so that the gains of one side offset the maximum loss of the other
If you are confident a stock will move in one direction or the other, simply buying a call or put is more profitable
Allow 40-60 days before expiration
2 Categories of Straddles and Strangles:
Long
i. Long Straddles and Strangles rely on high volatility to make a profit
ii. A Long Straddle is composed of a long call and a long put with the same expiration date and the same strike price
iii. Buy purchasing a call and a put, you limit your risk to the amount you invest
iv. You profit regardless of direction the stock moves, as long as it moves substantially
v. Long Straddles have unlimited profit potential and also carry excellent downside protection
How to enter a long straddle
1. Buy an At The Money call option
2. Buy a put option with the same expiration date and same strike price

Example
1. Stock is $20
2. buy the 20 call for -1.50
3. buy the 20 Put for -1.20
4. net debit is -2.70
5. Profit Potential:
i. Lets say the stock hits 30$
1. The $20 call is sold for +10.00
2. and the $20 Put expires worthless= $0.00
3. Net Profit= 10.00- 2.70= $7.30
ii. Assume the stock drops to 17.30
1. The 20 call expires worthless
2. the 20 put is sold for 2.70
3. Net profit=0.00
6. Max Loss.
i. If the stock closes exactly at 20.00

Exiting Early:
7. Exit when a profit target has been reached
i. Stock climbs to 23.75 and starts to show weakness, exit the trade for profit
ii. In this case you would sell the call option and let the put option ride.
iii. If the stock declines the put may might regain some vvalue
iv. So you only want to exit early if the stock has moved significantly and is starting to reverse direction
v. in the example we sold the 20 puts when the stock was 23.75
vi. we got 4.00 on the sell
vii. the profit to exit early is 4.00-2.70=1.30
8. We are holding the puts now
i. Suddenly the CEO is caught embezzling funds and the stock drops to 19.00
ii. You sell the $20 put for $1 and make more profit!
iii. total profit now is 2.30

Review Of Straddles
a. find stocks with high volatility
b. Fundamentals are not important
c. Do some TA and concentrate on support and resistance
d. Select an At The Money call, then a put at the same strike price and same exp date
e. Enter with a buy to open on both the call and the put
f. Monitor the straddle daily
g. Exit the stradle with a sell to close. Eit the straddle if the stock rises or falls past your breakeven level and shows signs of turnong direction. To exit, sell to close the option that is in the money.

Long Strangles

Consists of a long call and a long put with the same expiration date, but different strike prices.
Can be In the Money or Out of the Money.
By buying a long call and a long put, you limit your risk to the amount you invest in the trade.
You profit regardless of the direction the stock moves, as long as it moves far enough.
Long Strangles rely on high volatility to make max gains. Earning announcement and other news can cause these movements.
Long strangles have unlimited profit potential and awesome downside protection. If the call is losing value, the put will most likely gain value and vice versa. The downside protection is nice, but it also makes realizing a profit more difficult. The stock has to move far enough in one direction to cause the gains of one side of your trade to offset the max loss of the other side.
Avoid a flat trend.
IF you are confident a stock will move one way or the other,it may be wise to play a straight directional call or put.

How to Trade a Long Strangle

Buy a call option. Buy in or out of the money
2. Buy a Put option with the same exp. Date but with a different strike price.. If the call was bought In The Money. The Put should be bought In the Money. If the call was bought Out of the Money, the Put should also be bought Out Of The Money.


Example:
Share Price: $44
Buy OCT $40 Call for -$6
Buy OCT $50Put for -$8
Net Debit= -$14

Profit Potential: The stock must move past the net debit before you realize a profit!
Stock rises to 60.00 share on Exp Date:
The $40 Call is sold for +20
The $50 Put expires worthless
Net Profit= +6.00 ($20-$14=$6)


Breakeven point: $36 and $54
Assume the stock drops to $36. on exp date. This is your breakeven point.
The $40 Call expires worthless=$0.00
The $50 put is sold for $14
Net Profit= 0.00 ($14-$14=$0.00)
The other breakeven point would be $54.00.
$40 call is sold for $14
$50 Put expires worthless=$0.00
Net Profit =$0.00


Max Loss- Depends on if you pay an In the Money Trade or Out of the Money Trade. You make max loss if the stock closes in between the two strike prices.
Max loss potential is limited to the total Time Value in your trade.
When you purchase OUT of The Money, all of the NET DEBIT is made up of TIME VALUE. For In The Money trades, only a potion of your NET DEBIT is composed of TIME VALUE.

In this case we played In the Money:
Assume the stock closes at $46 on Exp Date:
The $40 Call is sold for +$6
The $50 Put is sold for +$4
Net Loss= -$4.00 ( 14-10=4)

Exiting Early When You have reached a profit target and stock starts to reverse.
Sell the option that is profitable and let the other one ride

Stock climbs to $60 then shows signs of weakness:
Sell the $40 call for $20.
Hold the put for $0
Net Profit= $6

Now if the stock drops below $50 before expiration, you can sell it for a profit as well.
On Exp date the stock is at $46, you can sell the put for $4.00 and see a total profit of $10 ($6+$4=$10)

Out of the money LONG STRANGLE can lose the entire net debit if it closes between the two strike prices.
Stock is $28.91
Buy $30 call for –1.80
Sell $27.50 put for –1.38
Net Debit= -3.18


Profit Potenntial:
Stock closes $35 on Exp date
Sell $30 call for 5.00

$27.50 Put expires worthless
Net Profit= 5.00-3.18=$1.82


Upper Breakeven point= $30+$3.18=$33.18
Lower Breakeven point= $27.50-$3.18=$24.32


Max Loss:
Stock closes 28.50 on exp date
30 call expires worthless= $0
27.50 put expires worthless=$0
Net Loss= -$3.18

ROI
Avoid the desire to exit too early just make make a small profit on a strangle. Most of the time strangles are expected to return small losses and large gains. Avoid exiting early just because you received a small gain. Allow your profits to run when on the profitable trades

ROI=max gain/Net Loss.
You determine ROI after the trade is complete because theoretically gains are unlimited. In this case:
1.82/3.18=57%

Exit the strangle manually with Sell To Close orders or by exercising any option that still has value.Do not expect your broker to automatically sell or exercise any option that is in the money just because it has value on exp date. You must exit manually.


EXITS:
OTM
Stock is 32.00 (below upper breakeven point of 33.18) on Exp date
The $30 call is sold for 2.00
The $27.50 put expires worthless=0.00
Net Loss=-1.18 ($2.00-$3.18= -1.18)

ITM

Stock
Stock closes 26.50 (above the breakeven point of 24.32, but below the strike price of 27.50)
$30.00 call is worthless=$0.00
Sell $27.50 put for +$1.00
Net Loss= -$2.18 (3.18-1.00=2.18)

Exiting Early:
Exit early if the stock moves past the breakeven point loses momentum and starts to turn. Sell the in the money option and hold the other. It may reverse into your favor

Stock is $34 two weeks prior to exp date.
Sell the 30 call for 4.00
Hold the 27.50 put in case the stock drops back below 27.50, you may see a return on it as well

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leemalone2k3
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Short Strangle (Naked Strangle)

You play a short call and a short put with the same expiration but different strike prices. Always play OUT OF THE MONEY!!!!!!!!!!!!!!!!!!!!!!!!

Rely on LOW VOLITILITY. Use when the stock is expected to stay flat.
Limited Profit Potential and Unlimited Loss Potential
The stock needs to stay in between the two strike prices to be profitable.
No investment is required, but you must have enough margin in your account to cover the loss. If your loss exceeds your margin, your broker may execute a margin call and exit the unprofitable trade for you.

Naked Strangle:
Sell a call that is out of the money- This allows an option buyer to buy the stock from you if the stock rises dramatically.
Sell a put that is out of the money. This allows an option buyer to sell the stock to you if the stock drops drastically.
Allow 20-40 days before expiration.

Stock is $50
Oct 52.50 call is sold for +1.25
Oct 47.50 Put is sold for +1.13
Net Credit= + 2.38


Max profit=Net Credit= 2.38


Max Gain Exp date- stock must close in between both strike prices
Stock is 51.30
52.50 call expires worthless=0.00
47.50 put expires worthless-0.00
Net Profit=2.38


Max Loss-Max loss can be unlimited if the stock moves violently!

Stock closes 57.50 on exp
52.50 call is exercised for –5.00
47.50 Put expires worthless=0.00
Net Loss= -2.62 (5.00-2.38=2.62)


Exiting Early:
Exit early if it looks like you may get a large loss.
Stock=52.25 and climbing!
Buy back the 52.50 call= - $2.37
Hold the 47.50 put- it is way out of the money=0.00
Net Gain= +$.025 (2.62-2.37=.25)

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Butterfly Spreads


Butterfly spreads are the most popular combination spread. They are usually played on indices.
Consists of a debit (Bull Call)and a credit spread (Bear Call) on the same stock. (index)
Has the best chance of making a maximum profit if the stock (or index) is flat.
If playing the indices, use calls because calls on indices provide more time value than puts.
Butterfly spreads perform best in NEUTRAL markets.

One of the three positions on a butterfly spread is naked so always enter the long side first if you leg into a trade. You can then enter the short side without needing naked option approval. The long sides will cover the short side if your contract is assigned unexpectedly.

Butterfly spread:
(We will use an index)

1. Buy a call on a flat trending index that is higher than the identified resistance level.
2. Buy another call on the same flat trending index. This call should be the same distance away from the index price that the first call was bought. For example if the first call was bought 100 points above the index, the second one should be bought 100 points below the current value of the index.
These first two steps are called The Wings
3. Sell two calls on the same flat trending index At The Money. This is the body.

Butterfly spreads are debit spreads. You calculate the net debit by adding the total premium received from selling the calls to the total cost of buying the ITM and OTM calls.

We will use a fictitious index call MWX (mrweekend Index)

MRX= 1000.00
Support is 980.00
Resistance is 1020.00

Buy the 1020.00 call for –7.00
Buy the 980.00 call for –18.00
Sell (2) 1000.00 calls for +24.00
Net Debit= -1.00

Max Profit= If MRX closes at 1000.00
Max Profit= The difference between the spread between the ITM strike price and the ATM Strike price minus the net debit. In this case it is 19.00. (1020-1000-1=19)


Max Loss = Net Debit=1.00
Assume MWX drops to 975.00
1020 call expires worthless=0.00
Both 1000 calls expire worthless=0.00
980 call expires worthless=0.00
Max loss=-1.00

Exiting Early:

Exit if a profit target has been reached.

MRX drops to 990.00 on day 21 and is within two weeks till expiration, the premiums for all of the call options will have changed. If the difference between the three positions is larger than the net debit, close the trade for a profit.

Net Debit = -1.00
Hold the 1020 call
Buy back both 1,000 calls for 5.00 each (5x2=-10.00)
Sell the 980.00 call for 15.00
Net profit=+4.00 (-1.00 –10.00 +15.00=+4.00)

Current Index is 1320.00

Buy the 1340 call for -790
Buy the 1,290 call for -41.80
Sell the two 1315.00 calls for +41.40
Net Debit= -8.30
Max gain would be at 1315.00
Lets say SPX closes at 1315 on exp date
The spread is 25.00
Spread-Net Debit-Net Profit
25-8.30=+16.70

Assume the stock is at 1,360 on exp date= max loss
Since the index closed above all 3 strike prices each option will be exercised and the spread will be exercised and it will assume max loss


1340 is exercised for +10.00
Both Oct 1350 calls are exercised for -70.00
35.00 x 2=70
The 1290 call is exercised for +60.00
+10 -70 +60 -8.30= -8.30
The same thing will happen if the index drops to 1280
All the calls expire worthless and we assume max loss

Assume the index closes at 1300 on exp date
the 1340 call expires worthless=0.00
Both 1315 calls expire worthless=0.00
The 1,290 call is sold for 10.00
net profit = 1.70
10.00- 8.30=1.70


Assume the index is 1,320 at expiration
1,340 call expires worthless=0.00
Both 1315 calls are bought back for -10.00
The 1290 call is sold for +30.00
Net profit=+11.70
-8.30 - 10.00 + 30.00=11.70

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Iron Condor Spreads

Iron means we are selling both calls and puts. A condor usue 4 strike prices and a butterfly uses 3 strike prices.
Butterfly- Only Calls or only Puts, 3 strike prices
Condor-Only calls or only puts, 4 strike prices
Iron Butterfly-Both calls and puts, 3 strike prices
Iron Condor, Both calls and puts, 4 strike prices

An Iron condor Consists of a bear call and bull put credit spreads.
It is important to understand support and resistance levels as you will be placing your trades at these levels.
Each leg of the iron condor is sold Out of the Money.
We want the stock or index to stay in between the strike prices on the short side.
The tighter the condor, the less max loss you can incur. The wider the wondor, the more loss you incur.

Stock is trading at 110.10
Resistance is 120.00 with very strong resistance at 125.
Support is 100.00
Enter the Bear Call Spread.

Buy Oct 125 call= -2.90 This is the Bear
Sell Oct 120 call = +420 Call credit spread
Net Credit= +1.30
Break even= Lower strike price + credit received= 120.00+1.30=121.30

Sell the Oct 100 put= +425 This is the Bull
Buy the Oct 95 put= -2.90 Put credit spread
Net Credit= +1.35
Breakeven= Upper Strike Price- credit received= 100-1.35=98.65


Total Credit= 1.30+1.35=2.65
Max Loss (Risk)= 5.00-2.65= 2.35
ROI=2.65/2.35= 112.7%


We want the stock to stay in between $100 and $120.
Breakout above 120. The Bull Put spread is at it’s max gain, but the bear call is losing value.
There are several ways to exit this trade. If the stock breaks out above 120, you could exit the trade for a small loss or let it ride as this is the resistance and it may break back down through it prior to expiration. It depends on how strong the break above 120 is and if it looks to continue. I would probably hold it if it starts to look weak after a break of 120.

Another way to play this is if it looks like it may break above the 121.30 break even price. You could buy back the short side (120 call you sold) and maybe the 125 call gains some value if it continues to rise.

The same strategy can be applied if the stock breaks below the Lower breakeven point. You could buy back the the short side of the bull put spread (the 100 puts we originally sold) if it looks as if the stock will break below the $95 put we bought.

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Greeks help you anticipate changes in option price compared to change in the stock price

Delta:
A ratio that compares the price change of an option with the price change of the stock
Ranges from 0.00 to 1.0
A delta of 1 means that for every dollar the stock rises or falls, the option will also rise and fall one dollar
A delta of of .50 woulf mean that for every dollar the stock rises or falls, the option rises or falls 50 cents
Out of the money strike prices deltas range between .5 and .75
The farther In the money an option becomes, the higher the delta climbs

Gamma:
A ratio that compares the rate of change of DELTA with the rate of change of the stock
Gamma shows how DELTA rises and falls as the stock rises and falls
Gamma=.10 means that for ever dollar the stock moves, DELTA will move by .10

Theta:
Theta compares the rate of TIME DECAY with the passing of each calande day.
Theta= .05 means that the option will lose time value at a rate of .05/share or $5.00 per contract per day
Theta will increase and Time Value will erode more quickly as exp date approaches
there are factors which affect time decay such as volatility


Vega:
Vega estimates how much the theoretical value will change when volatility changes by 1%
High volatility means higher options prices
Low volatility= lower options prices
+VEGA means the value of the option position will increase when the volatility increases and the value of the option position will decrease when the volatility decreases
-VEGA means that the value of the option position will decrease when volatility increases and increase when the volatility decreases
Example: A vega of +.03 and volatility of 20% has a value of 5.00.
(This is a call)
If the volatility rises to 21%, the call will be worth 5.30
If the volatility falls to 195, The call will be worth 4.70
19%


Rho:
Estimates how much the theoretical value will change when interest rates change 1%
RHO is rarely used
Long calls and short puts have +RHO
Short calls and long puts have -RHO
An increase in interest rates increases the values of calls and decreases the value of puts
A decrease of interest rates decreases the values of calls and increases the value of Example:
A call with a RHO of +.05 is worth 5.00 when the interest rate is 5%
If Interest rates rise to 6%, the call would be worth 5.05


Implied Volatility:
Indicates how much the stock is expected to move during the life of the option
This number is almost always higher than historical volatility, because the future is not certain
You should view an option as overvalued if the option's implied volatility is greater than it's historical volatility
If the options current implied volatility is lower than its historic volatility, the stock is undervalued
In theory anyway
In real life, determining whether an option is under or overvalued is quite difficult because implied volatility changes from day to day
sometimes violently
: News, earnings and other factors cause the implied volatility rates to rise sharply because there is s greater chance the stock may move very high or low quickly
Implied volatility can also drop as quickly as it climbs.
Comparing current implied volatility to past implied volatility is better than comparing current implied volatility to Historical volatility
High Implied Volatility means the MM's expect the stock to move alot in the future
If implied volatility is 31%, that means the stock must move 31% to make a profit


Greeks and Spread Positions

If net Delta is +, you want the underlying to rise.
If net Delta is -, you want the underlying to fall.

If net gamma is +, you want the underlying to move rapidly, up or down.
If net gamma is -, you want the underlying to move slowly, up or down.

If net Theta is +, time decay benefits you.
If net Theta is -, time decay hurts you.

If net Vega is +, you want volatility to rise.
If net Vega is -, you want volatility to fall.

Implied Volatility and Spreads

Note:Vertical spreads are usually not as sensitive to volatility spreads as the spreads listed below.

If implied volatility is low and expected to rise, spreads with a net + vega will benefit.
1. Long Straddles and strangles
2. Long calendar and diagonal spreads
3. Short Butterfly spreads
4. Ratio Backspreads

If implied volatility is high and is expected to fall, spreads with a net - Vega will benefit.
1. Short straddles and strangles
2. Long butterfly spreads
3. Short Calendar and diagonal spreads
4. Ratio Vertical Spreads-


I was reaseraching Gamma today:

Preliminarily I found out that:

Low Gamma- Large shift in stock price will be beneficial to option value

High Gamma- Even small shift in underlying will be beneficial to option value

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Gary59
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OK OK ,,,,,MY HEAD JUST EXPLODED TRYING TO FIGURE THIS OUT...OUCH.... [Eek!] [Confused] [Roll Eyes] [BadOne]
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Gary I don't even mess with all that. If you believe a stock will rise. You buy an option. The closer the expiration month the more risk. Farther from current price means more risk, greater return.

YOU NEED TO SELL THE OPTION BEFORE IT EXPIRES. Otherwise worthless. Very important.

Puts are you saying a stock will fall. It's almost like buying a stock short. Your risk however is limited to what you paid for the stock.

DONT ever sell naked calls, puts etc. unless you know what you are doing. Your risk is more than original amount.

NEVER put all your money in one option. 10-15% is a lot since you can lose it all.

OPTIONS are stock on crack. Move around 2 to 20 times as fast.

Good luck. If you have any questions ask me.

I used to be a broker / financial advisor.

This stuff is very dangerous, you can make a lot though.

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Rockster
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Notice this board died between October and Jan.

Most were trading call options since the market was up for the last 4 years or so.

Then it started going down. Losing money on call options. Now puts is where the money was at for the last year.

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