Uncle Bob’s Money
Generating Income
with
Conservative
Options Trades
By Uncle Bob Williams
www.UncleBobsMoney.com
Copyright 2011 Jumping Ahead, Inc.
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DISCLAIMER
Neither Jumping Ahead, Inc. nor any of its directors, officers, shareholders, personnel, representatives, agents or independent contractors (collectively, the "Operator Parties") are licensed financial advisers, registered investment advisers or registered broker-dealers. None of the Operator Parties are providing investment, financial or legal advice, and nothing in this book or on the UncleBobsMoney.com website should be construed as such by you. This book and the UncleBobsMoney.com website should be used as an educational tool only and is not a replacement for licensed investment advice. You should seek advice from an independent financial advisor if you have any questions relating to the information found on, or your activities in connection with, this book or the UncleBobsMoney.com website.
The full disclaimer can be found at the end of this book.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Please read “Characteristics and Risks of Standardized Options” before investing in options, available at: http://www.optionsclearing.com
CONTENTS
2 Understanding The Profit / Loss Graph
6 Volatility & Standard Deviation
12 Strategy: The Double Diagonal
Proven money-making secrets should not belong to the privileged few.
Every investor should know how to generate income using conservative options trades so the risk of loss is low.
It's important to shatter the mystery and secrecy to end the status quo, where options pit traders and large investment firms with math geniuses onboard are able to earn consistently using options trades while the rest struggle to find the same strategies they use.
TO THIS END:
This book provides all the learning materials you need to understand how to make income-generating options trades.
You can learn what you need to know, then walk away to start trading options profitably without ever coming back to us.
But we do hope you'll join our community of successful options investors, where you'll access super-easy tools to take the process of successfully finding, trading and monitoring your options trades to maximum profitability.
— — — — — — — -
This is not a typical "What are Options" course. We can find plenty of well written and technical explanations about Options and Options strategies at almost every Broker that provides Options Trading.
For standard explanations, we suggest reviewing the current list at:
http://www.UncleBobsMoney.com/links
We are going to try to show what Options are, and what specific
information we need to know to successfully trade the Strategies at
Uncle Bob’s Money:
http://www.UncleBobsMoney.com
Stocks and Options are very different and when we understand the difference, it will remove all of the mystery, mystique and 'danger' from Options.
If we buy a stock, say 100 shares of Acme Company for $50 per share, which works out to be a $5,000 total investment, plus a transaction fee from our Broker:
=> We now own part of Acme Company.
=> We may get paid dividends from profits that Acme Company makes, and we may be entitled to vote on certain company actions, and if we have enough stock we may actually control the company.
=> Our investment has a 50% chance of going up or down.
=> The Profit / Loss graph of our investment in Acme Company looks like this.
Since the risk a stock will go up or down is 50/50, and since the value of the stock can go to zero, many people like to buy Mutual Funds. If we buy a Mutual Fund that tracks the S&P 500, our investment risk is still 50/50, but that risk is spread out over 500 companies. The hope is that all 500 companies will do well overall; meaning that they hope the share price overall will go Up and that the risk of all 500 companies going bankrupt is small.
For people who are more advanced Stock Traders, they will also sell a Stock that they don't own, which is called "Selling Short" or just "Short". These Traders are betting that the Stock price will go down, and they will be able to buy the shares they just sold at a lower price. IE: We sell 100 shares of the stock at $50 per share (we get paid $5,000), and if the price goes down to say $49 per share, we buy the 100 shares that we sold before but didn't own. (It cost us $4,900 to buy those shares.) And we walk away with a $100 profit.
So, all the above should be clear for most people who have Stock and Mutual Fund investments.
What the heck is an Option?
An Option is not a Stock, and it doesn't work like a Stock, so when we think about Options, we need to remove our "Stock Thinking" hat, and put on a new hat that is quite similar to an Insurance Policy. Yep, Options are like Insurance.
Let’s buy an Option on Acme Company stock. (we'll get into the parts of an Option next - but let’s first look at the basics, how the Option compares to a Stock.) It's OK if you don't understand the Options Terminology that follows, we will explain them shortly. Let's say that we buy 1 Contract, on a CALL Option at the $53 Strike which has an Expiration 2 months from now, and we pay $1.00 per share for that Option. 1 Option Contract = 100 shares of stock, so the total cost for this Option is $100.
=> We do NOT own part of Acme Company.
=> We will NOT get paid dividends from the profits of Acme Company, we will NOT be entitled to vote on certain company actions, and we will never have any control over the company no matter how many Options we purchase.
=> Our investment in this Option has a 50% chance of going up or down.
=> The Profit / Loss graph of our investment in the OPTION looks like this:
The graph doesn't go to zero because our loss is limited to how much we pay for the Option.
We can see that as the price of the stock goes above $53 per share, our profits start to skyrocket. In fact, the profits of our Option will be many, many times greater than the profit of the Stock.
In this case, our total investment is only $100, and that is the maximum we can lose.
The Options trader also has the possibility to buy PUT Options, which means we will make money if the price of the stock goes DOWN. The Options trader can buy the $47 PUT Option, and if the price of the stock goes below $47, we can also make massive profits with a very limited loss. We will explain PUTs and CALLs later, so don’t worry if any of this is unclear.
We see that with Options, we can put a small amount of money at risk, and our potential for profits is very, very high. So high it’s what Dan Sheridan of Sheridan Mentoring calls "Mafia Money".
But don't get excited yet.
The CALL Option that we purchased has an Expiration Date, and if the stock doesn't go above $53 before expiration, then our Option will expire worthless and we will lose our $100 investment in that Option. The same is true with the PUT Option, if the stock doesn't go below $47 before expiration, then our Option will expire worthless and we will lose our $100 investment in that Option.
It is possible to trade Options on Indexes, like the S&P 500. So we can leverage the stability of the index on our Options trades. Uncle Bob's Money only trades Options on the Indexes because of their greater stability over individual stocks.
BIG CAVEAT:
If we start looking around for people who have Options Courses, we will come across many who practice what's called "Directional Trading", which is very similar to trading Stocks. What they show is how to use Options to make massive profits IF the market goes a certain direction. Remember, the probability of a stock going up or down is 50/50. If we buy a stock and it goes up, we can make money. If the stock goes down, we can lose money. What these "Directional Traders" do is very similar to our examples above: they show how to use a fraction of our savings to potentially make massive profits instead of buying stocks. In our example above, the stock trader spent $5,000 to buy 100 shares and ALL of his money is at risk. However the CALL Options Trader invested only $100, and he still has the possibility of massive profits if the Stock goes up, with only the risk of his $100 investment if the stock goes down.
There are more advanced "Directional" techniques, like Back Spreads and many others, which have very cool sounding names, but they all boil down to making a bet on which direction the price of a stock is going to go: UP or DOWN. If the stock price goes the direction you guessed, then you make money, and if not, you lose your investment. There are also Directional Options strategies where you can "Short" Options, and these have the potential to have a higher probability of making a small amount of money, but with a massive potential for loss.
All of these "Directional" techniques sound very enticing, and there are many guys who do an excellent job of selling you on this investment technique.
Repeatedly it has been proven statistically that the stock market is truly random. Yet even so, there are no shortages of people trying to come up with trading models that will predict the future. If you have a 'crystal ball', there are plenty of ways to use Options to cash in. You can find free ways to learn those techniques if that is what you are interested in.
Now, it is easy to think: “Hey, I don't need to guess which way the market is going. I can buy a CALL Option to make money if the stock goes up, and I can buy a PUT Option if the stock goes down. Either way, I have very limited risk - I risk only the amount I pay for the Options, and I have massive profit potential if the stock moves in either direction.”
This is true. However, there is a catch. The catch is that Options are priced based on the probability of the market price hitting your Option Strike Price before the Options Expiration. Think of it like going to the Casino—the odds are always slightly out of your favor. If you bet long enough, the house will eventually get all of your money. The same is true with Options pricing. If you were to consistently purchase a PUT Option and CALL Option, you may very well get lucky and have a big hit, but the odds are against you and if you play long enough, you will eventually lose all of the investment money.
There is hope.
However, there are proven strategies that use Options which allow us to put the odds in OUR favor. It is possible to use Options to generate income no matter which way the market moves.
The Options Strategies we use at Uncle Bob's Money are called "Non-Directional" Options Strategies and they have been used by Options Market Makers and Options Pit Traders since the beginning of Options trading in the 1970's. It is very possible to use a combination of Options positions where we put the odds of winning IN OUR FAVOR. Some strategies, like the Iron Condor, can have probabilities of success exceeding 90%! We won't ever see those odds in Las Vegas or on any Stock!
We aren't creating any new secret techniques to outsmart the Nobel Prize winners who created the Options Pricing Formulas, but we are able to use specific Options Strategies to sway the Odds of making money in our favor, while minimizing the amount of risk we take.
What Uncle Bob's Money offers is:
=> We show which proven "Non-Directional" Options Trading Strategies will generate income, and how they work.
=> We provide Model Portfolios for the "Couch Potato" Investor who just wants to sit back and watch their money grow.
And For More Active Traders:
=> We provide a Trading Calendar that shows the ideal time to enter into each specific Options strategy.
=> We provide a Trading Checklist that constantly evaluates the key trading factors for each trading strategy and it shows when to enter into an Options Trade, and when to exit.
=> We provide a Trade Finder tool that shows the best Options Trades for each strategy. We won't have to do any math or get lost trying to figure out the best possibilities from the Options Chain; the Uncle Bob's Money tools do all the work.
=> We provide a Trade Monitor tool that will constantly monitor your Option Strategy positions and suggest specific points to both maximize profits and minimize potential losses.
=> We provide a Trade Monitor Checklist that will constantly evaluate the key Market conditions and suggest exit points when those conditions hit warning levels.
[2] UNDERSTANDING THE PROFIT / LOSS GRAPH
The Profit / Loss Graph is the key tool used to evaluate Options Trades, and it's easy to understand. It is important to take a minute to examine the graph, so we can easily understand what the potential Profit and Loss is of our various Options positions.
(1) The Left side of the graph (The Y or Vertical Axis) shows us the AMOUNT OF PROFIT and LOSS:
The $0 or Break Even line is in the middle. Anything above the Break Even line is where we make a Profit, anything below the Break Even line is where we have a loss.
(2) The Bottom side of the graph (The X or Horizontal Axis) shows us the PRICE OF THE STOCK / INDEX:
The Current price is near the middle.
(3) Here is an example if we bought a SHARE OF STOCK at the Current price.
The diagonal line shows the Profit / Loss of our Stock as the price of the Stock goes up and down.
If the Price of our Stock goes UP, our Profit goes UP.
If the Price of our Stock goes DOWN, our Profit goes DOWN. (We have incurred a loss.)
(4) Now that we understand how the Profit / Loss Graph works, let's show an example using an Option:
=> We buy a CALL Option at the Strike of the Current Market Price. CALL Options make money when the Price goes UP.
=> If the price of the Stock goes DOWN, we only lose what we paid for this Option.
=> If the price of the Stock goes UP, we start making profits, and we start making profits like a rocket heading for space.
=> Note the Break Even Point, that is where the value of the Option equals what we paid for it. If the price of the Stock keeps going up, we will start making significant profits fast.
Before we jump ahead, into the strategies, let's first understand the Options Terms and the "Greeks".
We said earlier that Options are like Insurance. Let's explain:
Car Insurance, for example, is like a PUT Option. We pay an annual Premium, and for that year the Insurance company agrees to pay us for the value of the car should it get stolen or damaged. In exchange for the Premium we paid, we can 'put' the value of the car back to the Insurance company. If our car was worth $10,000 and it gets stolen, the Insurance company will pay us $10,000.
A PUT Option works just like the Insurance Policy. Let's say we have Acme stock which is currently selling at $50 per share. We are concerned that the price of the stock will go down, and it will jeopardize the value of our investment. We can buy a PUT Option at the $48 strike, which will expire 2 months from now. We pay a small premium for that PUT Option, say $1.00 per share. If the market price of Acme stock goes below $48 during the next 2 months, we can sell or exercise the Option.
Here is how it works: Imagine that Acme announces some really bad news, and the price of their stock drops down to $42/share, which would be pretty upsetting as it would represent an 18% loss of our investment. But thankfully we purchased a PUT Option to 'hedge' (meaning that we bought a type of insurance called an Option) against a price drop. We can sell our PUT option which will now have a value of at least $6 per share: The Strike of our PUT Option is $48, and the current price of the stock is $42, so our PUT Option has an Intrinsic Value of $6 per share.
If we thought Acme stock was going to continue to drop, we can sell our shares for $42 on the open market, and sell our PUT Option for $6 on the open market = $48 per share. The PUT Option cost us $1 per share, so we are left with $47 per share, which is a lot better than $42. At the end of the day, we would have lost only 6% of our investment, instead of 18% like everyone else.
If we thought that Acme stock was going to go back up, we could still sell our PUT Option for $6 per share, and now if the price of Acme stock goes back up to $50 per share, we already made a healthy profit of $5 per share or 10% of our investment. ($6 Option sale price, minus the $1 that we paid for the Option).
A CALL Option will make money if the price of the stock goes UP. It works the same way as a PUT Option, but in the opposite direction. We don't buy 'insurance' for things that increase in value, but we do make bets.
For example, If Acme stock is current selling at $50 per share and we think the price of the stock will go up, it is possible to place a bet on that hunch using a CALL Option. For example, we can buy a CALL Option at the $52 strike for $1.00 per share, which will expire 2 months from now. If the price of Acme stock goes up to $56 per share before the expiration, then we can sell the CALL Options and keep the profit. In this case, the Intrinsic Value of the Call Option is $4.00 ($56 current price of the Stock, minus the $52 strike of this Option), and since it cost us $1.00 to buy the Option that leaves us with a $3.00 profit per share.
We will dive into the details of the Options terms soon.
Before we do that, let's explain one of the more common Options techniques that we hear about— the "Covered Call".
For example, we have 100 shares of Acme Company stock that is currently trading at $50 per share. It's a stock that we plan on holding on to for a while, and we think that the stock price will remain the same or even go down a little. So we decide to make some extra cash on the side and do a "Cover Call": We sell the $53 strike CALL Option, which will expire next month for $0.50 per share. One Options contract equals 100 shares of stock, so in this case we will sell 1 contract. When we sell that CALL Option, our broker will put the money from the sale immediately into our trading account, in this case: $0.50 per share * 100 shares = $50.00. And we say to ourselves, "Sweet! We just made $50 on stock we plan on keeping, and we can do that every month!" As long as the stock price stays below $53, the CALL Option will expire worthless, and we will keep the $50 profit. If however the stock price goes above $53, in this case, we have our 100 shares of stock to protect us. If the price of the stock shoots up to $60 per share, we can sell our stock at $60, and then buy the CALL contract to close it out for $7.00 per share. ($60 price minus $53 strike of our CALL Option equals $7.00 of intrinsic value in the Option that we need to pay to buy it back so we can close it.) So, at the end of the day, we were able to cover the loss of the CALL Option with the sale of our stock, and we ended up cashing out at $53 per share, instead of $60 per share.
So why do some people give Covered CALLs such a bad reputation? It seems that as long as the price of the stock doesn't shoot up past our Short CALL, we can consistently make a little extra money on the side, and a lot of people do.
The reason that people warn about Covered CALLs is that the profit / loss graph of a Covered CALL is the same as selling a Naked PUT (Selling a PUT Option or also called a Short PUT). This means that the fact that we own the stock to cover the potential loss of the CALL doesn't change how much money we lose. We will lose the same amount of money as if we had just sold a PUT Option Short. As long as we are willing to take that kind of risk, we don't need to limit doing "Covered Calls" to stocks that we own, and we could do Short Puts on any stock that we thought was stable.
Profit / Loss of owning 100 shares of stock:
If the price of the stock goes up, we make a profit, if the price of the stock goes down, we have a loss:
Profit / Loss of a Covered CALL:
Own 100 shares of stock, and selling 1 CALL contract (Short CALL):
Note that the Profit / Loss is very similar to owning the stock except that the amount of profit we can make is capped at our Short CALL. We took in a premium for that risk.
Profit / Loss of a Short PUT
(Selling a PUT contract / a Naked PUT):
If the price of the stock goes down, we have the same loss as the Covered CALL, and it is also the same loss as if we had owned the stock. If the price of the stock goes up, we have limited our profit to the amount of premium we took in on the sale of the PUT Contract.
When we understand that the real risk of a Covered CALL is like selling a Naked PUT, it puts both owning stocks and selling Naked Options into a new perspective.
Most investors would never consider selling Naked Options: the amount of risk is significant. It's OK to do Covered CALLs as long as we are aware of the risks. For some investors, they may have stock that they never plan on selling: they might have an emotional attachment to the company and are willing to risk all of their investment for the emotional high they get by owning that particular stock. If we have stock that fits that description, then trying to make a little extra money on the Covered Call at the risk that we won't make a profit if the stock goes up can be OK for some investors.
The same is true for owning stocks, it’s great when the stock goes up, but the chance of a stock going down is very real—with only 50/50 odds—and the potential for loss is significant.
We don't trade Covered CALLs at Uncle Bob's Money. At Uncle Bob’s Money, we focus on using Options to make trades where our probability of profits is high, the amount of risk we take is both limited and known, and the amount of time that we expose ourselves to market fluctuations is limited.
We've been discussing some of the more common Options terminology, so it will ideally become more familiar. Let's now delve into the different parts of an Option, so when we get to the specific strategies we'll be closer to a complete understanding. Don't worry, we will keep explaining the terms in different ways, and when we are done, these Option terms will be familiar and come as second nature.
We said that Options are like Insurance, and we will keep with that analogy to be consistent.
Options are available on some stocks and some Indexes. Not all stocks have Options, because some stocks lack sufficient trading volume or interest to have Options. Like an Insurance Policy, we need someone willing to sell the Insurance in exchange for the Premium, and we need someone to buy the Insurance - there is no limit to the amount of Insurance that can be bought and sold as long as we have people on both sides of the transaction. The same is true for Options: we need someone willing to sell the Option in exchange for the Premium, and we need someone willing to buy the Option. On stocks like Apple or Google, and on Indexes like the S&P 500 (SPX Index) there are plenty of people willing to buy and sell Options, so we have a healthy Options market.
When there is a lot of demand and buying/selling activity on the Options for a specific stock or Index, we call that 'Liquidity'. It is good to have liquidity when we trade Options. With more liquidity, the price of the Options is generally lower, and it is easier to buy and sell because a Trade Order will generally be filled quickly.
Here is a typical Option Order:
BUY 10 | RUT | JULY | 600 | PUT
(Buy 10 Options Contract | RUT [Russell 2000 Index] is the Underlying | July Expiration | 600 Strike | PUT Option)
We will touch on some of the more common terms here. For a more complete glossary, we suggest Options Industry Council Online Glossary:
http://www.888options.com/help/glossary/default.jsp
Underlying
The "underlying" is what we are buying or selling an Option on. For example, if we buy a PUT Option on Google, the 'underlying' is Google.
Options Chain
Here is a typical Options chain, this is on GOOG (which are the Options on Google Stock) from http://Finance.Yahoo.com.
We can see Real Time Options pricing in our Brokerage account, and some Options tools allow us to select what columns we want to see, for example we may want to see some of the Greeks or the Implied Volatility. (We will explain the meaning of those terms shortly.)
PUTs & CALLs
A PUT, as we mentioned before, is like Insurance. We will make money if the price of the underlying goes below the Strike of our PUT.
A CALL Option makes money if the price of the stock goes UP. It works the same way as a PUT Option, but in the other direction.
Expiration
The expiration is the date when the Option will expire. The expiration date for all listed stock options in the U.S. is the third Friday of the expiration month (except when it falls on a holiday, in which case it is on Thursday).
The value of the Option at expiration will depend on whether the Option was "IN THE MONEY" or "OUT OF THE MONEY". We will explain the meaning of this next.
Strike
The Strike is the price of the Underlying where we buy or sell our Option. In the CALL example above, we bought a CALL Option at the $52 strike. We can buy or sell a CALL or PUT Option at any strike that is available.
The amount of available strikes will depend on:
=> Demand for the underlying, IE: more popular stocks or Indexes will have more strikes on which to trade Options.
=> How close it is to Expiration. The month of Expiration, for example, may have more strikes available because there will be more Options trading activity.
Options Symbol
Each Option has a specific symbol, as this is how the Option Exchanges identify the specific Options.
The Options Symbols changed in February 2010 to the new version we see here which provide more information than the older versions.
The symbols are created by using this format:
The basic parts of new option symbol are: Root symbol + Expiration Year(yy)+ Expiration Month(mm)+ Expiration Day(dd) + Call/Put Indicator (C or P) + Strike price
In the top Symbol from the example above: GOOG110618C00290000
GOOG | 11 | 06 | 18 | C | 00290000 (290.00 strike)
Price
We will look at the prices for the Options which are closer to the current price so that the numbers will be more meaningful. In this case we will look at the 510 CALL strike: (GOOG market price was $ 509.05 when these screen shots were taken)
We can see below that the 500 strike is highlighted, which means it is IN THE MONEY.
We can also see the big price difference between the 500 Strike ($11.80) and the 510 Strike ($5.10). The reason the 500 strike is so much more expensive is because it is $9.05 IN THE MONEY:
$11.80 (Option market price)
MINUS
$9.05 (Intrinsic Option Value: amount IN THE MONEY)
EQUALS
= $2.75 (Time Value of this Option)
The 510 Strike ($5.10) on the other hand is OUT OF THE MONEY, so there is no Intrinsic Value, and the $5.10 price of the Option is all TIME VALUE.
Look at the 510.00 strike highlighted above:
=> Last = Last price for this Option PER SHARE.
This shows the last price that someone paid for the 510 Strike Option is $5.10 per share.
=> Chg = Price change since last trade.
Advanced: The market was closed when this screen shot was taken, and the price of GOOG dropped in After Market trading, so there was a big drop in the Options prices on the Strikes NEAR THE MONEY (Near The Money means near the current price of the underlying).
=> Bid = This is the Market Price if we want to SELL an Option on the 510 Strike.
In this case, the Market Price is $4.80 PER SHARE. (100 shares = $480.00 PER OPTION CONTRACT)
=> Ask = This is the Market Price if we want to BUY an Option on the 510 Strike.
In this case, the Market Price is $5.20 PER SHARE. (100 shares = $520.00 PER OPTION CONTRACT)
Bid/Ask Spread
"Hey! Why is there such a big difference in price between the selling price and the buying price?!"
The difference between the "Bid" (selling price) and the "Ask" (buying price) is called "The Spread" or "Bid/Ask Spread".
The "Market Makers" are the guys who will fill our orders, and they have to make a profit. Market Makers also take on risk: they are taking the exact opposite position of what everyone else thinks is a good trade. Therefore, there is a price difference between the 'buy' and the 'sell' price. The spread also provides a small buffer for the Market Makers against small price movements of the Underlying so they won't get stuck losing money if it takes them time to unload what they just bought / sold from us.
The amount of "Bid/Ask Spread" can vary greatly, and it's important to keep these differences in mind when making trades.
=> The amount of Options trading activity can affect the "Bid/Ask Spread". Generally, Options that have more trading activity will have narrow spreads; narrow means that the price difference between the Bid and the Ask will be smaller. In plain terms, it means we get a better deal when we trade Options that have narrow "Bid/Ask Spreads".
=> The number of Exchanges that an Option trades on can affect the "Bid/Ask Spread".
The SPX (S&P 500 Index Options) only trade on ONE Exchange:
CBOE Exchange (Chicago Board of Options Exchange http://www.CBOE.com) and so the "Bid/Ask Spread" on the SPX tend to be really wide - meaning we will pay more, even though the SPX is one of the most popular Underlyings for Options trades.
When Options are traded on multiple exchanges like the RUT (Russell 2000 Index), it creates competition between Market Makers on the different exchanges and so the "Bid/Ask Spread" will generally be narrower, and we get better pricing.
Don't Pay Full Price
IMPORTANT: We do not have to take the "bid” or “ask” price. We can negotiate how much we are willing to buy or sell for, and that negotiation is a critical part of Options trading. The price negotiation can make a big difference in how much profit we make.
It's easy to negotiate, and doesn't require any special tools or knowledge. We simply make an Options order and wait to see if it is accepted.
Let's use the Google 510 CALL Option from the pricing example above:
"Bid" (selling price) = $4.80
"Ask" (buying
price) = $5.20
We negotiate by placing an Options order and seeing if it gets filled / Executed. Executed means that they accept our offer and our trade gets filled.
In this case, we want to buy:
BUY 1 | GOOG | JUNE 11 | 510 | CALL
(Buy 1 Options Contract | Google is the Underlying | June 2011 Expiration | 510 Strike | CALL Option)
Version 1: Pay Full Price
We could be willing to pay full price for this Option, and the current "Ask" (buying price) is $5.20 per share. We can place a "Market Order" for 1 contract, and we will pay the market price of $5.20 per share. (We will explain "Market Orders" later in greater detail.)
In this case, the 1 Contract will cost us $520, plus the trading fee from our Broker. ($5.20 per share * 100 shares = $520. Remember that 1 Options Contract = 100 shares)
Version 2: Cheapest Price Possible
We could insist on getting the best price possible, and could offer to pay only $4.80 per share (which is the 'selling' market price). It's always possible, but not likely, that this order will be filled. If the Market Maker fills this order, it means he won't make any profit on the trade, which they are not likely to do. It doesn't cost us anything to place the order, so we may decide it’s not worth it to pay any more than that amount, so we can make the order and just wait. It is possible that the price of the underlying changes and the price of this Option goes down, and the Market Maker will fill our order when he is going to make profit. If however, the price of this Option does not change, it is unlikely that our order will get filled and we just wasted our time.
(When we specify a specific price we are willing to pay for an Option it is called a "Limit Order" and we will discuss these in more detail later.)
Since we don't want to pay full price, and we don't want to waste our time, we want to make an offer to buy somewhere between the Bid and the Ask.
If we have a lot of time, we can start at the lowest price and wait to see if our order is filled. If our order is not filled, we can cancel that order, change the price by the smallest amount possible (some Options contracts trade in 1 penny price increments, some in 5 cent increments, some in 10 cent, etc.). We can keep doing that until our order gets filled.
At Uncle Bob’s Money, we usually trade multiple Options at the same time, which are called spreads.
A "vertical spread", otherwise known as a Condor, could be:
Sell a Call (Bid: $1.20, Ask: $1.30)
Buy a Call (Bid: $0.50, Ask: $0.60)
By combining the Best price of each, where we get the maximum amount on the position we sell: $1.30, and the cheapest price on the position we buy $0.50, the NET Maximum best price is $0.80 Credit. We could place our first order for this 'spread' as a $0.80 credit and then slowly go through the process of increasing our price until our spread gets filled.
Volume
The Trade Volume is the amount of contracts traded on this Option.
If the volume is low, it means the liquidity is low and your ability to negotiate price will be low.
Open Interest
The Open Interest is the amount of outstanding Options contracts for this strike. Open Interest is used as a liquidity gauge. It is best to trade on Option Strikes that have a lot of Open Interest, because it means there will be more liquidity and more opportunity to negotiate a better price.
NOTE: It is important to pay attention to the amount of Open Interest on each leg of the spread we want to trade on. It is possible that one of the legs has very little activity which can happen. As the Options get closer to Expiration, more Options Strikes will become available. If one of our Option positions is in a spread with very little Open Interest, we won't be able to negotiate the price too much. It is always better to pick strikes with a lot of Open Interest so we have the most activity and likelihood of getting a good price.
How to evaluate how much to offer to get both the best price and to optimize the time spent making trades:
We will generally trade Options on only 1 or a few Indexes or Stocks. It’s important, especially in the beginning, to limit ourselves because we need to get familiar with the price movements of the underlying and how much negotiation flexibility we have when trading Options.
An intuitive understanding of price movements is important when we evaluate different Options trades. The Uncle Bob’s Money Trade Finder (http://www.UncleBobsMoney.com/tradefinder/) will show us possible trades that meet both the Trade Finder Checklist "Green" status and the appropriate trading criteria for each trading strategy. However, that doesn't mean that every trade is a good trade for us to make. The suggested trade may meet all of the criteria, and the probabilities might look perfectly fine, but we may know intuitively that a specific trade looks either too risky, or looks really good. We try to take the emotion and guess work out of trading by using the Uncle Bob’s Money online tools, and we are not saying that we need to rely on our gut or emotions - we don't. The issue here is our personal comfort level with the risks involved in taking a specific Options trade. These trades do have risks, and we need to be comfortable with those risks. If we dive into a trade that has all the right numbers, but doesn't sit well in our gut, we will end up having unnecessary stress and worry.
After we make a few trades on a specific underlying, we will have a good idea as to how much we can negotiate to get the best price. In some cases we may be able to get close to MARK / Mid-Price (The 'MARK' is the middle price between the "Bid" [selling price] and the "Ask" [buying price]).
In our Google Option example the price for the 510 CALL:
"Bid" (selling price) = $4.80
"Ask" (buying
price) = $5.20
The MARK in this case would be $5.00 per share. On an underlying where we think we can get close to the Mark, we might make our first trade offer at the Mark price. If we don't get it filled, we can incrementally increase our bid amount until the trade is filled.
The SPX (S&P 500 Index) only trades on the CBOE, as we mentioned above, so the "Bid/Ask Spread" is pretty wide, and the market makers don't move very much on the price. Starting at Mark as our opening offer probably won't be successful.
But, it's very important to remember that it doesn't cost us anything to put in a trade order and to wait to see what happens. We could start at a very optimistic price and then just cancel that order and replace it with a new order that is the smallest increment higher. The exercise of putting in orders at really optimistic pricing, and then cancelling and placing new orders is really important to do when we are starting out. It's important to get familiar and confident placing orders, and to get a good feel for how flexible the pricing is on that underlying. As long as we don't have time constraints, we should always try to get the best price possible. In some strategies, we may need to enter 2 or more Spreads (Spreads are combinations of 2 or more Options positions - we will delve into them at length later) and it may not be practical for us to tarry too long getting into all of our positions. We may lose money because of price movements in the underlying, which affect the pricing of the Options we are trying to trade. We try to avoid those type of market movement profit fluctuation. So, when we have a specific Option Strategy we want to trade, we should try to make all of our trades in an efficient manner: we shouldn't be in a panic, and we should try to negotiate our pricing as much as possible, but we don't want that process to drag out too long because it can affect our profits.
If the Market is moving fast, like what happens when there is a National Crisis and the market experiences a big price drop, 2 key things will happen:
1) The "Bid/Ask Spread" will get really wide. Meaning that it will become very expensive to buy and sell Options.
2) We will not be able to negotiate on the price. We will be forced to pay the Bid or Ask price. If the Market is dropping fast, and we have reached one of our exit points for a specific strategy, we should place a Market Order and get out of our positions.
It will cost us more than normal to exit our positions, but it is better to take the small loss and move on to trade another day, rather than taking the risk of experiencing a large loss. While it is true that many times the Market will 'bounce' back up after a big drop, it doesn't always bounce back up. The smart Options Investor will take the small loss and move on, and live to trade another day.
In Uncle Bob's Money, we will show where to place "Conditional Orders" so that one need not sit and monitor their positions. If we have Conditional Orders, we will be automatically pulled out of our Options positions if the Market has a big drop.
When we place a trade for a single Option position, we can usually get better pricing than when we place a "spread" Options order. Most of the orders we will make trading the strategies in Uncle Bob’s Money are "spread" orders, which means you can place a 'net' order for 2 or more positions at one time (and we will touch on those briefly). First, let’s see how much control we have on the pricing of Options:
There is always a Bid price and an Ask price for each Option and each Exchange will have their own rules regarding the displayed Bids and Asks. The CBOE, for example, explains this in the CBOE's Rule 6.45 (http://tinyurl.com/CBOE-rules).
It is possible to get our offer up on the displayed Bid and Ask board so that the entire market has an opportunity to fill our trade. Let's explain how it generally works in practice. This is in no way a definitive explanation or guide to the actual rules employed by each Exchange: please refer to the specific rules for each exchange. Our purpose here is to give a first glance at how trading individual Options can sometimes work in order to get the best price possible.