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Trading Options For Dummies


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Table of Contents

Introduction 1 About This Book 1 Foolish Assumptions 2 Icons Used in This Book 4 Beyond the Book 4 Where to Go from Here 4 Part 1: Getting Started 7 Chapter 1: Options Trading and the Individual Investor 9 Giving Yourself a Financial and Strategic Checkup 10 Understanding Options 11 Knowing option essentials 12 Trying different strategies before deploying them in real time 14 Putting options in their place 15 Differentiating Between Option Styles 16 Using options to limit your risk 17 Applying options to sector investing 17 Using Options in Challenging Markets 18 Reducing your directional bias and making money in flat markets 18 Controlling your emotions 19 Chapter 2: Introducing Options 21 Understanding Option Contracts 21 Tuning in to option basics 22 Comparing options to other securities 23 Valuing Options 25 Knowing your rights and obligations as an options trader 25 Terms of endearment and importance 26 Making Sense of Options Mechanics 27 Identifying options 27 Rotating with the expiration cycle 28 Options expiration is decision time 29 Detailing your rights 30 Creating Option Contracts out of Thin Air 30 Opening and closing positions 31 Selling an option you don't own 31 Keeping Some Tips in Mind 33 Chapter 3: Trading Places: Where the Action Happens 35 The U.S Options Exchanges 36 Navigating the Markets 36 Trade execution 36 Option market participants 37 Transactions unique to options 38 Trading rules you should know 39 Weighing Option Costs and Benefits 42 Identifying costs unique to options 43 Valuing options benefits 44 Grasping Key Option Pricing Factors 47 Introducing option Greeks 48 Connecting past movement to the future 49 Chapter 4: Option Risks and Rewards 53 Understanding Your Trading Risks 54 Risking money with stocks 54 Calculating option risks 57 Reaping Your Rewards 58 Benefiting from stocks 58 Breaking even with options 59 Profiling Risk and Reward 61 Profiling stock trades with risk graphs 61 Profiling option trades with risk graphs 63 Combining option positions 65 Considering the worst-case scenario 67 Part 2: Evaluating Markets, Sectors, and Strategies 69 Chapter 5: Analyzing Mood Swings in the Market 71 A Few Words About Select Macro Factors 72 Assessing the Market's Bias 73 Judging the strength of a move 73 (Psycho)-analyzing the market 79 Watching Call and Put Activity 81 Understanding put-to-call ratios 81 Using the put volume indicator 84 Using Volatility to Measure Fear 85 Measuring volatility 85 Recognizing impact from changing volatility 86 Spelling fear the Wall Street way: V-I-X 86 Applying Breadth and Sentiment Tools 88 Locating neutral areas for indicators 88 Identifying indicator extremes 89 Chapter 6: Sector Analysis: Technical and Fundamental 91 Getting Technical with Charts 92 Chart basics 92 Adjusting your time horizon for the best view 93 Visualizing supply and demand 94 Identifying Relatively Strong Sectors 97 Relative ratios 97 Rate of change indicator 99 Using Sector Volatility Tools 101 Displaying volatility with indicators 102 Analyzing volatility with Bollinger bands 106 Projecting Prices for Trading 107 Support and resistance 108 Trends 110 Channels 111 Price retracements and extensions 114 Projections and probabilities 116 Chapter 7: Practicing Before You Swing 119 Monitoring Option Greek Changes 120 Tracking premium measures 120 Changing volatility and option prices 121 Paper Trading a Trading Strategy 123 Trading on paper: Pluses and minuses 124 Implementing electronic paper trades 124 Using Trading Systems 125 Knowing what you're getting 126 Performing a backtest 126 Adding risk management to a backtest 130 Shifting from Knowledge to Mastery 132 Setting the right pace 133 Achieving mastery through longevity 135 Chapter 8: Designing a Killer Trading Plan 137 Developing a Reliable Plan 138 Managing Your Costs 139 Optimizing Order Execution 141 Understanding option orders 141 Entering a new position 146 Executing a quality trade 148 Exiting an existing position 150 Part 3: What Every Trader Needs to Know about Options 153 Chapter 9: Getting to Know Different Option Styles 155 Nailing Down Index Options 155 Getting to the nitty-gritty of indexes 156 Capitalizing on an index with options 158 Watching Out for Style Risk 160 American-style options 161 European-style options 162 Exercising Your Options, American Style 164 Knowing the nuts and bolts 165 What you see is what you get 165 To exercise or not, that is the question 166 Exercising Your Options the Euro Way 167 Tracking index settlement (the SET) 167 Cashing in with exercise 167 Satisfying Option Obligations 168 American-style stock options 168 Expiring options 170 European-style options 173 Breaking It Down: American-Style Index Options 174 Exercising rights 174 Meeting obligations 175 Chapter 10: Protecting Your Portfolio with Options 177 Putting Protection on Long Stock 178 Combining puts with long stock 178 Weighing protection cost versus time 183 Limiting Short Stock Risk with Calls 185 Protecting a short stock position 185 Further reducing short stock risk 186 Hedging Your Bets with Options 187 Protecting a portfolio partially 188 Protecting a portfolio completely 191 Avoiding Adjusted Option Risk 194 Justifying option adjustments 194 Adjusting from adjustments 196 Chapter 11: Increasing Profit Potential and Decreasing Risk 199 Leveraging Assets to Reduce Risk 200 Determining your total dollars at risk 200 Relying on market timing 205 Combining Options to Reduce Risk 207 Spreading the risk with a debit trade 208 Spreading the risk with a credit trade 215 Chapter 12: Combination Strategies: Spreads and Other Wild Things 221 Combining Options with Stocks 222 Creating "covered" positions 222 Covering the covered call position 223 Reducing protected stock costs 226 Varying Vertical Spreads 228 Changing your vertical spread risk profile 229 Spreading time with calendars 230 Defining diagonal spreads 233 Chapter 13: ETFs, Options, and Other Useful Tricks 237 Exploring the Exchange-Traded Fund 237 Comparing ETFs to indexes 238 Distinguishing ETF and index options 241 Reducing Portfolio Volatility with ETFs 244 Revisiting volatility 244 Investing with ETFs 249 Tilting Your Portfolio with Sector ETFs 256 Adding sector ETFs to tilt your portfolio 256 Selecting the right strategy 260 Part 4: Advanced Strategies for Options Traders 263 Chapter 14: Making Money without Worrying About the Market's Direction 265 Limiting Directional Risk 266 Capitalizing on a big move 266 Reducing straddle risk and reward 272 Neutral View versus Neutral Position 275 Identifying neutral positions 276 Calculating delta for combination positions 276 Trading with Delta 277 Monitoring two key Greeks 278 Creating a delta neutral straddle 279 Understanding Trade Adjustments 282 Deciding when to adjust a trade 283 Deciding how to adjust a trade 284 Chapter 15: Letting Volatility Show You the Way to Trading Opportunities 285 Analyzing Implied Volatility Levels 286 It's all relative but not overly scientific 286 When options are skewed 293 Understanding Ratio Spreads 296 Reviewing ratio spread risk profiles 296 Identifying best conditions for ratio spreads 300 Deciding your strategy 301 Using Ratio Backspreads 303 Defining ratio backspreads 303 Spotting best conditions for ratio backspreads 312 Chapter 16: Trading Profitably When Markets Move Sideways 315 Winning Positions in Sideways Markets 316 Managing existing positions 316 Option strategies for sideways moves 321 Understanding Butterfly Positions 323 Defining the butterfly 324 Digging deeper into butterfly risk 332 Creating an iron butterfly 334 Understanding Condor Positions 338 Defining a condor spread 338 Recognizing condor risks 340 Part 5: The Part of Tens 343 Chapter 17: Ten Top Option Strategies 345 Married Put 346 Collar 347 Long Put Trader 348 LEAPS Call Investor 349 Diagonal Spread 351 Bear Call Credit Spread 352 Straddle 353 Call Ratio Backspread 355 Put Ratio Backspread 356 Long Put Butterfly 357 Chapter 18: Ten Do's and Don'ts in Options Trading 359 Do Focus on Managing Risk 360 Don't Avoid Losses 361 Do Trade with Discipline 361 Don't Expect to Remove Your Emotions 362 Do Have a Plan 363 Do Be Patient 364 Don't Suffer from Analysis Paralysis 365 Do Take Responsibility for Your Results 365 Don't Stop Learning 366 Do Love the Game 367 Index 369

About the Author

Joe Duarte, MD is a financial writer, private investor and trader, and former money manager/president of River Willow Capital Management. His work has been quoted in Barron's, Marketwatch.com, and The Wall Street Journal. He is the author of Trading Futures For Dummies and Market Timing For Dummies.

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