Options Trading For Dummies book cover

Options Trading For Dummies

By: Joe Duarte Published: 09-28-2021

When it comes to boosting your portfolio, you’ve got options! 

Looking for a new way to flex your investing muscle? Look no further!  Options Trading For Dummies offers trusted guidance for anyone ready to jump into the versatile, rewarding world of stock options. And just what are your options options? This book breaks down the most common types of options contracts, helping you select the right strategy for your needs. Learn all about the risk-reward structure of options trading and reduce your risk through smart mixing and matching.  

Today’s markets are more topsy turvy than ever before, but there is also more potential for everyday investors like you to profit, regardless of economic conditions. Options are great for broadening your retirement portfolio or earning a little extra scratch through shorter-term positions.  Options Trading For Dummies is your plain-English resource for learning how! 

  • Demystify the world of options contracts and how to trade them, including index, equity, and ETF options 
  • Use technical analysis to create a solid trading strategy that limits your risk 
  • Protect your assets and avoid the pitfalls common to first-time options traders 
  • Learn about covered calls, butterfly positions, and other techniques that can enhance your gains 

Thinking of trading options, but not sure where to start? This latest edition of Options Trading For Dummies provides you with step-by-step advice for boosting your income under today’s market conditions. 

Articles From Options Trading For Dummies

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32 results
32 results
The Basics of Trading Options Contracts

Article / Updated 07-01-2021

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. Here are the key definitions and details: Call option: A call option gives the owner (seller) the right (obligation) to buy (sell) a specific number of shares of the underlying stock at a specific price by a predetermined date. A call option gives you the opportunity to profit from price gains in the underlying stock at a fraction of the cost of owning the stock. Put option: Put options give the owner (seller) the right (obligation) to sell (buy) a specific number of shares of the underlying stock at a specific price by a specific date. If you own put options on a stock that you own, and the price of the stock is falling, the put option is gaining in value, thus offsetting the losses on the stock and giving you an opportunity to make decisions about your stock ownership without panicking. Rights of the owner of an options contract: A call option gives the owner the right to buy a specific number of shares of stock at a predetermined price. A put option gives its owner the right to sell a specific number of shares of stock at a predetermined price. Obligations of an options seller: Sellers of call options have the obligation to sell a specific number of shares of the underlying stock at a predetermined price. Sellers of put options have the obligation to buy a specific amount of stock at a predetermined price. In order to maximize your use of options, for both risk management and trading profits, make sure you understand the concepts put forth in each section fully before moving on. Focus on the option, consider how you might use it, and gauge the risk and reward associated with the option and the strategy. If you keep these factors in mind as you study each section, the concepts will be much easier to use as you move on to real time trading. Use stock options for the following objectives: To benefit from upside moves for less money To profit from downside moves in stocks without the risk of short selling To protect an individual stock position or an entire portfolio during periods of falling prices and market downturns Always be aware of the risks of trading options. Here are two key concepts: Option contracts have a limited life. Each contract has an expiration date. That means if the move you anticipate is close to the expiration date, you will lose our entire initial investment. You can figure out how these things happen by paper trading before you do it in real time. Paper trading lets you try different options for the underlying stock, accomplishing two things. One is that you can see what happens in real time. Seeing what ­happens, in turn, lets you figure out how to pick the best option and how to manage the position. The wrong strategy can lead to disastrous results. If you take more risk than necessary, you will limit your rewards and expose yourself to unlimited losses. This is the same thing that would happen if you sold stocks short, which would defeat the purpose of trading options. Options and specific option strategies let you accomplish the same thing as selling stocks short (profiting from a decrease in prices of the underlying asset) at a fraction of the cost.

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Trading Options For Dummies Cheat Sheet

Cheat Sheet / Updated 06-30-2021

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.

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Trading Order Types

Article / Updated 06-30-2021

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.k.a., trading book) and the depth of the market. Limit order: A limit order is one that guarantees price, but not execution. When placing a limit on an order, it will be treated like a market order if: When buying, your limit is at or above the current market ask price and there are sufficient contracts to satisfy your order (for example, limit to buy at $2.50 when the asking price is $2.50 or lower). When selling, your limit is at or below the current market bid price and there are sufficient contracts to satisfy your order (for example, limit to buy at $2.50 when the asking price is $2.50 or higher). Stop order: A stop order, also referred to as a stop-loss order, is your risk management tool for trading with discipline. A stop is used to trigger a market order if the option price trades or moves to a certain level: the stop. The stop represents a price less favorable than the current market and is typically used to minimize losses for an existing position. Stop-limit order: A stop-limit order is similar to a regular stop order, but it triggers a limit order instead of market order. While this may sound really appealing, you’re kind of asking a lot in terms of the specific market movement that needs to take place. It may prevent you from exiting an order you need to exit, subjecting you to additional risk. If the stop gets reached, the market is going against you. Duration: The two primary periods of time your order will be in place are The current trading session or following session if the market is closed Until the order is cancelled by you, or the broker clears the order (possibly in 60 days — check with your broker) Cancel or change: If you want to cancel an active order, you do so by submitting a cancel order. Once the instructions are completed, you receive a report notifying you that the order was successfully canceled. It's possible for the order to already have been executed, in which case you receive a report indicating that you were too late to cancel, filled with the execution details. Needless to say, you can’t cancel a market order. Changing an order is a little different than canceling one because you can change an order one of two ways: Cancel the original order, wait for the report confirming the cancellation, and then enter a new order. Submit a cancel/change or replace order, which replaces the existing order with the revised qualifiers unless the original order was already executed. If that happens, the replacement order is canceled.

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Breaking Even with Options

Article / Updated 06-30-2021

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. There are three key value points for option trades: break even, in the money (ITM), and out of the money (OTM). So, calculating potential option rewards requires you to add option premiums to call strike prices and subtract option premiums from put strike prices to come up with a price known as the position’s breakeven level. A stock’s price must Rise above the breakeven for call option profits to kick in. Fall below the breakeven for put option profits to kick in. In each case, this results in profits that are slightly less than your stock profits. A stock’s breakeven point is your purchase price when buying stock or your sell price when shorting a stock. As soon as the stock moves away from this price, you have gains or losses. Call option Purchasing a call option gives you rights to buy stock at a certain level. As a result, the option increases in value when the stock moves upward. After a stock moves above your call option’s strike price, the option has intrinsic value which increases as the stock continues to rise. Calls with strike prices below the price of the stock are referred to as ITM. For a call position you own to be profitable at expiration, it must remain above the strike price plus your initial investment. At this level, option premiums will minimally equal your cost when you bought the call. The breakeven for a call option is: Call Breakeven = Call Strike Price + Call Purchase Premium After a stock’s price is at the option’s breakeven level, it can continue to rise indefinitely. Your call option can similarly rise indefinitely until expiration. As a result, call option profits are considered to be unlimited, just like stock. An option’s moneyness is determined by the option type and the price of the underlying stock relative to the option strike price. Call options with a strike price that is below the stock price are OTM, and their premium is all time value. After the stock moves above the strike price, it is referred to as ITM and has intrinsic value along with the time value. Put option Purchasing a put option gives you rights to sell stock at a certain level. As a result, the option increases in value when the stock’s price moves downward. When a stock moves below your put option’s strike price, the option has intrinsic value, which increases as the stock continues to fall. Puts with strike prices above the price of the stock are referred to as ITM. For a put position you own to be profitable at expiration, it must remain below the strike price minus your initial investment. At this level, option premiums will minimally equal your cost when you bought the put. The breakeven for a put option is: Put Breakeven = Put Strike Price – Put Purchase Premium When a stock is at the option’s breakeven level, it can continue to fall until it reaches zero. Your put option can continue to increase in value until this level is reached, all the way to its expiration. As a result, put option profits are considered to be high, but limited, just like a short stock. Call options have risks and rewards similar to long stock, whereas put options have rewards that are similar to short stock. Put option risk is limited to the initial investment. The reason your rewards are similar rather than the same is because you need to account for the premium amount when you purchased the option.

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Understanding Countertrend Trading Systems

Article / Updated 10-26-2017

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. This approach may work in a few narrowly defined situations, such as in a trading range or a trend channel, but it’s likely to fail in a spectacular and expensive way if attempted on a broader scale. The vast majority of trading systems follow market trends. This is simply a higher‐probability practice. Trend‐following systems tend to outperform countertrend systems, especially for position traders. Swing traders and some day traders sometimes use a countertrend approach, but even then, they usually do so in conjunction with a trend‐following component. Countertrend systems usually depend on oscillating indicators, reversal patterns, and channeling strategies to find turning points. Some countertrend systems also are based on cycle theory, and others are based on volatility, expansion, and contraction. Don't spend too much time evaluating countertrend systems, at least until you’re confident in your ability to use trend‐following systems to successfully make your trades. Countertrend systems generate a large volume of trades, and the more you trade, the more you spend on transaction and slippage costs. These costs alone often swamp potentially profitable systems. Although a countertrend strategy can sometimes work profitably in a trading range or trend channel, it’s still risky, especially for a new trader. Until you can confidently (and honestly) consider yourself a thoroughly experienced trader, stick with the proven techniques that are more likely to lead to profitable results over the long term.

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Understanding Trend‐Following Trading Systems

Article / Updated 10-26-2017

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. Even the best trend‐following systems have a relatively large percentage of failed trades, primarily because they depend on several extremely profitable trades to make up for the large percentage of losing trades. If your trend‐following system is also a discretionary system, your discretion (or lack of it) can cause you to miss a few of these profitable trades. In this case, your overall results will suffer. Trend‐following systems are typically based on either moving averages or breakout patterns. Moving average–based trading systems are the most popular and can be quite profitable; however, they work only when a stock is trending. These trading systems depend on long‐lasting trends to generate enough profit to outweigh a relatively large number of losing trades. In fact, the number of losing trades can easily outnumber the winning trades with this type of trading system. When a stock is range bound (stuck moving sideways within a specific price range), a moving average–based system generates a large number of losing trades. Because of the high overall number of trades, this system is often accompanied by relatively high transaction and slippage costs. Smart money management protocols are critical when using a trend‐following trading system. You can make some adjustments to a trend‐following system that may improve its performance. For example, you can insist that its trading signals be confirmed by another condition before actually entering any positions. If your system triggers a buy signal, for example, you may want to see whether the signal remains in effect for at least a day or two before entering a position.

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Understanding Mechanical Trading Systems

Article / Updated 10-26-2017

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. Put another way, mechanical trading systems take your judgment out of the equation. In fact, some mechanical systems even enter buy and sell orders directly with your broker without your intervention. If your greedy impulses or your fear of losing routinely cause you to make poor trading decisions, a mechanical system may be a better choice for you. An automated approach tends to reduce the stress and anxiety that arise when you have to make difficult decisions quickly. As such, you can make and execute trading decisions in a consistent, methodical way. A mechanical trading system also enables you to automatically include rigorous money management protocols in your trading methodology. Another benefit of the mechanical approach is having the ability to thoroughly test the system. Through testing you can confirm whether your trading system performs the way you expect it to and explore ways to improve your system before actually committing your trading capital. You can adjust and fine‐tune your system after seeing the test results. Unfortunately, fine‐tuning your system may lead to other problems.

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The Risks of Trading Options and Futures

Article / Updated 10-26-2017

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. The document gives you the opportunity to determine whether you have the experience and financial resources necessary to engage in option trading and whether option trading is appropriate for meeting your goals and objectives. Topics that must be covered in the disclosure statement include the risks inherent in trading futures contracts or options and the effect that leveraging your account can have on potential losses or gains. The statement also must include warnings about trading futures in foreign markets because those types of trades carry additional risks from fluctuations in currency exchange rates and differences in regulatory protection. Commodities options and futures also can be risky because many of the factors that affect their prices are totally unpredictable, such as the weather, labor strikes, inflation, foreign exchange rates, and governmental policies. Because positions in futures and options are so highly leveraged, even a small price movement against your position can result in at least the loss of your entire premium payment and possibly even much greater liability for additional losses. After you begin trading options and futures, you can’t close your account until all open positions are closed — if, that is, you’re trading through an account with a commodities exchange. This restriction doesn’t apply to options traded in a stock brokerage account. Any accruals on futures contracts are paid out daily. Any funds in your margin account that are beyond your required margin or account‐opening requirements can be withdrawn, but other such funds have to remain in the account until all your positions are closed. Any restrictions on the withdrawal of your funds are stated in the original disclosure document. Be sure that you understand those restrictions before committing your funds. After opening your account, your broker usually mails or emails confirmation of all purchases and sales, a month‐end summary of transactions that shows any gains or losses, and an evaluation of your open positions and current account values. You need to be able to get information from your broker on a daily basis after you begin to trade. Brokers are required to segregate any money you deposit in your account from the brokerages’ own funds. The amount that is segregated either increases or decreases depending on the success of your trades. Even if the brokerage firm segregates your funds, you still may not be able to get all your money back if the brokerage firm becomes insolvent and is unable to cover all the obligations to its customers. In other words, the money you put into your brokerage account is not insured. Whenever problems with your broker arise and you can’t resolve them without help, you have several dispute‐resolution options. You can contact the reparations program of the Commodity Futures Trading Commission (CFTC) and ask for an industry‐sponsored arbitration, or you can take your broker to court. Before deciding how you want to proceed, you must consider the costs involved with each option, the length of time it may take to resolve the problem, and whether you want to contact an attorney. You can get more information about dispute‐resolution alternatives by contacting the CFTC on their website or by calling 202‐418‐5250.

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Options for Getting Out of Options

Article / Updated 10-26-2017

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. If you want to get out of an option before its expiration date, you can try to sell it for whatever price you can get. Doing so either enables you to take your profits or reduces your potential loss by the amount you receive for the option. As long as you bought your option in an active market, other investors usually are willing to pay for the rights your option conveys. The key, of course, is how much they’re willing to pay. Your net profit or loss for this option is determined by the difference between what you originally pay in premiums, commissions, and other transaction costs minus the premium you receive when you liquidate the option after deducting commissions and other transaction costs. Holding the option If your option is not yet in the money but you still believe it may get there, you can continue to hold the option until the exercise date. If you’re right, you can exercise the option before the expiration date or liquidate at a later date, which means to buy or sell the option before the expiration date at some time in the future. If you’re wrong, you risk the possibility that you won’t find a buyer or that you’ll have to let the option expire and take a loss that is equal to the amount of the premium, commission, and transaction costs you paid. Some traders take an even riskier position by buying options that are deeply out of the money for just pennies a share. Even if these options never grow any nearer to being in the money, as long as they move in the right direction, the premiums will rise. Although this strategy isn’t recommended , you can make profits as long as you’re able to sell the option before its expiration date. Options decline in value as they get closer to their expiration dates, so if you think you’ve made a mistake and the market moves against your position, bite the bullet as soon as possible and try to liquidate your option to minimize your losses. Exercising the option You can exercise an option any time prior to its expiration date, as long as you’re trading in American‐style options. You don’t have to wait until the exercise date to exercise an American‐style option. (Some option contracts sold in the United States are European‐style, which can be exercised only on the expiration date.) Exercising an option means Buying the underlying asset when you own a call Selling the underlying asset when you own a put In general, call options are exercised only when the trader plans to hold the underlying asset, and put options are exercised only when the trader owns the underlying asset and wants to sell it. Option traders are more likely to realize any gains or losses by closing their option positions rather than exercising them.

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Evaluating Trading Systems for Hire

Article / Updated 10-26-2017

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. Consider this: A system that offers profits of 100 percent per year supposedly grows $10,000 into $10 ­million dollars in only ten years. Be skeptical. Experienced traders know that no system consistently returns 100 percent per year. Consider this: If you created such a system, would you sell it? When evaluating these systems, the devil is in the details. Advertisements often are unclear about how a system actually works in real‐world trading, and some vendors make claims based on nothing more than the results of system testing based only on simulated trades and historical data. In fact, the system’s author may never have traded the system using real capital. Constructing a system that shows great profits when simulating trades with historical data is easy. If you designed a trend‐following system and tested it against data during the period 1997–2000, or 2003–2007, you can be fairly certain that the system is going to perform well in simulated testing. But that doesn’t mean you should use it to trade real money. If a system sounds too good to be true, it probably is. So do your own homework. Find out what works and what doesn’t, and save your hard‐earned trading capital for trading.

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