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Published:
September 28, 2021

Options Trading For Dummies

Overview

An easy-to-read and authoritative collection of strategies, tools, and resources for new and experienced options traders

In the newly revised fifth edition of Options Trading For Dummies, experienced finance writer, investor, and money manager, Joe Duarte, walks you through practical and actionable strategies for traders seeking to boost their income while keeping risk in check. The book explains the most common kinds of options contracts and helps you select the options most suited to your financial situation, capabilities, and goals. It also shows you exactly how to deploy options contracts to help reduce the risk associated with your trades.

This plain-English resource for both beginning and advanced traders demystifies the world of options contracts and how to trade them. You'll learn about index, equity, and ETF options, as well as how to incorporate technical analysis to create a solid trading strategy. You'll also find:

  • Up-to-date info about covered calls, butterfly positions, and other return-enhancing techniques
  • Strategies to protect your assets and avoid common mistakes and pitfalls experienced by many first-time traders
  • Accessible explanations of the risk-reward structure of options trading

An exciting and easy-to-read resource for investors and traders at any skill level, Options Trading For Dummies is an insightful, comprehensive toolkit for anyone interested in using trading as a source of income.

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About The Author

Joe Duarte, MD is a financial writer, private investor and trader, and former money manager/president of River Willow Capital Management. In addition to Options Trading For Dummies, he is the author of Trading Futures For Dummies and Market Timing For Dummies.

Sample Chapters

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, it's important that you know order types, how to read changes in the market with charts, how to recognize how stock changes affect indexes and options, and how indexes are built.Trading order typesA variety of order types are available to you when trading stocks; some guarantee execution, others guarantee price.

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Articles from
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Here’s a hypothetical scenario that a trader might encounter. The market is trying to begin a new bull market by entering a bullish transition phase. At this time, your $100,000 example portfolio is sitting 100 percent in cash. Your goal: Establish ten positions by the height of the bull market, which means that you plan to allocate an average of $10,000 of your initial capital for each position.
To help you get a feel for entering and exiting positions, take a look at a sample trade made by a hypothetical position trader. The idea is to help you understand the rationale and the timing. You can also use this example to practice picking entry and exit points based on historical pricing.As a position trader, your week begins during the weekend.
Successful traders share a common trait: They all successfully manage their money. The critical points of successful money management may be difficult to implement, but they’re easy to identify. They include Planning your trades carefully by identifying entry and exit points Minimizing losses by ruthlessly adhering to your stop‐loss points Protecting your profits by setting trailing stops on your trades and adjusting them over time to lock in gains Being objective about your positions and quickly exiting your trades when the trend ends When using technical analysis to make your trades, you may not always get the lowest entry price or the highest exit price.
A few arguments against technical analysis may actually make some sense, but the irrelevant complaints far outweigh the legitimate. For example, some people wrongly assert that no technicians have been successful over the long run and that no technician has mustered the stature or success of illustrious market moguls like Warren Buffett, Benjamin Graham, or Peter Lynch.
A call option provides you with profits similar to long stock, whereas a put option provides you with profits similar to short stock. This makes sense given your rights as an option holder, which allow you to buy or sell stock at a set level. There is one slight difference between stock rewards and option rewards: Options require an initial premium payment that you must consider when identifying potential gains.
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.
Both simple moving averages (SMAs) and exponential moving averages (EMAs) are used regularly by long‐term investors, position traders, and short‐term traders alike. Each moving average has its strengths and weaknesses. Which you choose can be a matter of personal preference, but one may be better suited than the other depending on the time frame you’re trading.
You’ll see advertisements on the Internet, in trade magazines, and in newspapers for foolproof systems that promise amazing returns. Sometimes you’ll even see claims for systems that regularly return hundreds of percent with little or no risk.Although some stocks do actually achieve astronomical returns of hundreds and sometimes thousands of percent, those cases are rare.
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.
To help understand financial index changes, you should know how indexes are built. Indexes are not created equal (well . . . one is). Financial indexes are constructed in three different ways: Price-weighted: Favors higher-priced stocks Market cap-weighted: Favors higher-cap stocks Equal dollar-weighte
The currency exchange market is made up of about 2,000 dealer institutions that are particularly active in Forex. Most of the players are commercial or investment banks that are geographically dispersed in the key financial centers around the world. Among these 2,000 dealers, about 100 to 200 members carry on the core trading and market‐making activities.
Despite what some naysayers would have you believe, traders can get a wealth of information from analyst calls. In addition to what senior management is saying, you also need to listen to how they’re saying it. If management is happy with the results, they’ll probably be upbeat and talking about a rosy future for the company.
Considering the amount of lag time between events and official pronouncements, you’re likely wondering how you can determine which part of the cycle the economy is in and how you, as a trader, can use this information. Most economists attribute changing business cycles to disturbances in the economy.Growth spurts, for example, result from surges in private or public spending.
One of the most impactful, high‐leveraged activities you can adopt is to keep track of all your trading activities in a trading journal. Doing so tracks your experiences in the market, helps you process and carefully analyze them while also keeping them in a permanent place, and then allows you to return to those journal entries at a later time to learn from your past experiences.
After you’ve identified the dominant trend, the leading and lagging sectors, and the current economic climate, it’s time to select the most promising stocks to trade. Beyond general market conditions, two factors drive a stock’s price higher or lower: The fundamental condition of the company’s business The technical condition of the company’s stock These topics can be covered in great detail.
Similar to moving average–based systems, a breakout trading system can take many forms. To test a different approach, you can define a breakout system as follows: Buying at tomorrow’s opening price when today’s closing price is above the highest high price that occurred during the last 20 days Selling at tomorrow’s opening price when today’s closing price is below the lowest low that occurred over the last 20 days These trading rules are loosely based on the rules for Donchian channels (sometimes called price channels), which comprise a breakout system developed by Richard Donchian in the 1950s.
The stochastic oscillator indicates momentum and is intended to help show buying and selling pressure. This indicator compares current closing prices with the recent range of high to low prices and displays the results on a chart. Stochastic oscillator values cycle, or oscillate, between 0 and 100 percent.The stochastic oscillator cycles between 0 and 100 percent.
Traders sometimes need strategies for getting out of an option. After you buy an option, you have to decide how you want to opt out of that position. You can choose one of the following three alternatives: Offset the option. Continue holding the option. Exercise the option. Offsetting the option You offset an option by liquidating your option position, usually in the same marketplace that you bought the option.
A financial option is a contractual agreement between two parties. Although some option contracts are over the counter, meaning they are between two parties without going through an exchange, standardized contracts known as listed options trade on exchanges. Option contracts give the owner rights and the seller obligations.
Trading in options and futures is risky business, and regulations governing those trades are stringent, even with regard to allowing you to open an account. Before opening an account for you, a broker must provide you with a disclosure document that describes the risks involved in trading futures and options contracts.
When analyzing ETFs, you need to consider two things: First you must research the underlying indexes and classification benchmarks so you know what types of stocks are likely to be part of the ETF. Then you need to research the fund’s trading history to know how it performed in the various types of markets.For example, if you believe that a full recession is underway, then you may want to consider weighting your portfolio more heavily with cyclical and technology stocks.
As any experienced investor will tell you, there’s no single magic tool guaranteed to make you a profitable trader. Finding success in the market is about discovering, learning, and committing to the strategies and techniques that fit your trading style best.Technical analysis is a useful trading tool that can help you decide what action to take when stocks trend a certain way.
Many trend‐following trading systems use a moving average for their starting points. In this trend‐following example, the system is designed for position trading, which means you use a relatively long moving average. Short selling isn’t permitted with this simple system.The first step is to define buy and sell rules for your initial testing.
Trading options is a bit different from trading stocks, but they both require research and study. If you're going to trade options, it's important that you know order types, how to read changes in the market with charts, how to recognize how stock changes affect indexes and options, and how indexes are built.Trading order typesA variety of order types are available to you when trading stocks; some guarantee execution, others guarantee price.
A variety of order types are available to you when trading stocks; some guarantee execution, others guarantee price. This brief list describes popular types of trading orders and some of the trading terminology you need to know. Market order: A market order is one that guarantees execution at the current market for the order given its priority in the trading queue (a.
For many traders, the quest to find a profitable countertrend trading system is all consuming. Countertrend systems appear desirable because their goal is to buy low and sell high. These systems try to identify inflection points, or the moments when stocks change direction, so traders can take positions close to when they occur.
A discretionary trading system makes you an active participant in all phases of the trades you make and provides you with a great deal of leeway when making trading decisions. With this approach, evaluating the economic data, analyzing the broad‐market indexes, determining which sectors are showing strength, and identifying high‐relative‐strength stocks that are breaking out of long trading ranges and hoping to catch a new trend all are up to you.
How do you know which part of the business cycle the economy is in? Officially, you don’t usually find out until months after that part of the cycle has either started or ended. The National Bureau of Economic Research (NBER) officially declares the peaks and troughs. The NBER is responsible for formally announcing the ends of peaks and troughs and signaling when a recession (end of a peak) or expansion (end of a trough) starts.
A mechanical trading system addresses some of the problems that arise when using discretionary systems. Mechanical systems usually are computer‐based programs that automatically generate buy and sell signals based on technical and/or fundamental data. You’re expected to blindly follow the resulting trading signals.
Trend following is favored by many technicians for one simple reason: Trends offer excellent trading opportunities for profit. Unfortunately, the popularity of the trend‐­following approach is one of its greatest weaknesses. Too many of these systems generate very similar buy and sell signals, which, in turn, makes outperforming the average trader difficult for any individual trend‐following trader.
It’s important to understand the array of risks that traders, investors, and other market participants face. The three general categories are market risks, investment risks, and trading risks. Market risks For the most part, market risks are out of your control. Of course you know the risk that the markets are bound to rise and fall, but understanding the risks you face when they do helps you manage your money better.
No matter which analyst’s report you’re reading, you must remember that the analyst’s primary income is coming either from the brokerage house or the large institutional clients that he or she serves. Analysts rate stocks on whether you should consider purchasing them, but no standardized rating system exists.
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