Options Trading For Dummies Cheat Sheet

Trading options is a bit different from trading stocks, but they both require research and study. If you’re going to trade options, make sure you know what the different order types are, how to read changes in the market with charts, how to recognize how stock changes affect indexes and options, and how indexes are built. In this market, you need to know how artificial intelligence traders, often called algos, do their work.

Trading order types

When you trade stocks you may use limit orders or market orders; some guarantee execution, others guarantee price. To make life a little easier for you, this list describes popular types of trading orders and some of the trading terminology you need to know.

Charts used for tracking investments

Price data is used in charts to give you a view of market trading activity for a certain period. The following list gives you the lowdown on some of the chart types you might encounter while you track your investments:

• Line chart: This chart uses price versus time. Single price data points for each period are connected using a line. This chart typically uses closing value. Line charts provide great “big picture” information for price movement and trends by filtering out the noise from the period’s range data. One advantage to line charts is that more minor moves are filtered out. A disadvantage to line charts is that they provide no information about the strength of trading during the day or whether gaps occurred from one period to the next.
• Open-High-Low-Close (OHLC) bar chart: This chart uses price versus time. The period’s trading range (low to high) is displayed as a vertical line with opening prices displayed as a horizontal tab on the left side of the range bar and closing prices as a horizontal tab on the right side of the range bar. A total of four price points are used to construct each bar. OHLC charts provide information about both trading period strength and price gaps. Using a daily chart as a point of reference, a relatively long vertical bar tells you the price range was pretty big for the day.
• Candlestick chart: This chart uses price versus time, similar to an OHLC chart, with the price range between the open and the close for the period highlighted by a thickened bar. Patterns unique to this chart can enhance daily analysis. Candlestick charts have distinct pattern interpretations regarding the battle between bulls and bears that are best applied to a daily chart. They also incorporate inter-period data to display price ranges and gaps.

How financial indexes are constructed and how changing stock affects indexes

To help understand financial index changes, you should know how indexes are built. Indexes aren’t created equal (well . . . one is). Financial indexes are constructed in three different ways:

1. Price-weighted: Favors higher-priced stocks
2. Market cap-weighted: Favors higher-cap stocks
3. Equal dollar-weighted: Each stock has same impact

A financial index is a measuring tool of prices for groups of stocks, bonds, or commodities. A change in one stock translates into index changes. Some examples are:

• When a high-priced stock declines in a price-weighted index, it leads to bigger moves down in an index when compared to declines in a lower-priced stock. The Dow is an example of a price-weighted index that is affected more by Boeing (trading near 225) than Pfizer (trading near 40).
• A market-cap weighted index, such as the S&P 500, is impacted more by higher market capitalization stocks regardless of price. Even though Microsoft may only be trading at 30 per share, its market cap is huge — about 290 billion. When it moves up or down it creates a greater change in the S&P 500 than, say, Amgen, which trades at 55 per share, but only has a market cap of approximately 64 billion.
• All the stocks in an equal-dollar weighted index should have the same impact on the index value. In order to keep the index balanced, a quarterly adjustment of the stocks is required. This prevents a stock that has seen large gains over the last three months from having too much weight on the index.

How artificial intelligence affects options trading

Artificial intelligence (also known as algos in market lingo) is the largest influence on prices.  Specifically, algos are the computer programs used by large trading houses, hedge funds, broker dealers, and even day traders, and they’re in all markets. Remember these points about algos:

• Algos account for more than 80 percent of all the market’s trading volume. Without algos, trading volumes would likely be much lower than they are at any one time in the markets.
• They use options to hedge (prevent or reduce potential losses), a fact that not only swells trading volume but also creates opportunity for those who know what to look for. In other words, if you keep track of the algos and imitate their trades, the odds of your trading success are likely to increase.
• Their high-speed (high frequency) trading can affect price trends dramatically. This is visible on days where price volatility is extreme as well as when price trends, up or down, are in place for extended periods of time. At the same time, if you’re not aware of their tactics, you can be fooled on a regular basis and lose money.