Options Education

The Power of Options

Many people have discovered the power of options. Their acceptance in everyday financial management is growing as more and more investors begin to see them as a nice complement for the modern investment portfolio. Options can become a very powerful tool in the hands of the educated investor, allowing investors - conservative and aggressive alike - to make money in any type of market environment.

The versatility of options allows them to be used in a wide range of investment strategies and for a variety of goals.

You can:

• Increase income against current stock holdings.
• Prepare to buy a stock at a lower price.
• Benefit from a stock price rise without incurring the cost of buying the stock outright.
• Make a monthly paycheck on stock that you own.

You have probably heard of the inherent risks in options and have been told they are primarily used for speculation. In reality, options can be very conservative or very aggressive, depending on the forecast you have for the stock and the strategy you want to employ.

In fact, some of the earliest option applications were intended to reduce risk. For example, in the commodity markets, options are used to lock in fair or reasonable prices in a possibly volatile future.

You may have already heard of the Dutch tulip mania in the 1600's. When tulips gained popularity with those of royalty, the general demand increased for all types of bulbs. Tulips became a status symbol and tulip bulb prices rose dramatically. As bulb prices increased, Dutch growers and dealers began to trade tulip bulb options to lock in prices and insure profits. As public interest grew, greater numbers of people speculated on future price increases. In the beginning, this proved to be profitable. This situation only caused the speculation to increase and tulip bulb prices continued to soar even higher.

The bubble soon burst and as prices dropped, the buying frenzy became a selling panic. People lost their homes and their livelihoods, banks failed, and fortunes were lost. Although greed, reckless speculation, and the use of borrowed funds to invest caused the financial collapse, people blamed options. This was because tulip options were responsible for enabling people to speculate with small amounts of money and large amounts of leverage.

We should learn the lesson that leverage can work against a trader just as easily as it can work in his or her favor.

In America during the 1920's, the option market was unregulated and there were many abuses by underground options pools. During the congressional hearings to establish an oversight committee, which eventually became the Securities and Exchange Commission, the initial reaction was to make all options trading illegal. However, Congress gave the Put and Call Dealer's Association a chance to speak.

The Association explained the difference between options where put-call dealers deal openly for a consideration and manipulative options secretly given for no fee. In other words, there were both good and bad options, but the lack of knowledge about the proper use of options and the heightened public awareness of option pools led many in Congress to conclude that all options were speculative.

The proposed bill read: "not knowing the difference between good and bad options, for the matter of convenience, we strike them all out." Members of the committee also expressed concern about the number of options that expire worthless. It was stated: "If only 12 ½ percent are exercised, then the other 87 ½ percent of the people who bought options have thrown money away?" The reply was, "No sir. If you insured your house against fire and it didn't burn down you would not say that you had thrown away your insurance premium." The committee initially saw expired options solely as a monetary loss rather that a means of insurance against potential loss.

This argument convinced the committee that options have economic value and when properly used, options are a valuable investment tool. The options business survived the hearings and the SEC assumed regulatory authority under the Securities and Exchange Act of 1934. The SEC still regulates the options industry today.

Review - What is an Option?

An option is a contract that derives its value from an underlying asset. That contract either gives the owner the right to buy the asset (call option) or the right to sell the asset (put option) at a predetermined price and within some predetermined time frame.

The key idea here is that the owner of an option has a right, not an obligation. If the owner of the option does not exercise this right before the predetermined time, then the option and the opportunity to exercise it cease to exist, and the option expires.

Seller (Writer)

On the other hand, the seller (writer) of an option is obligated to fulfill the obligations (requirements) of the contract if the option is exercised.

In the case of a call option on stock, the seller (writer) has given someone the right to buy the underlying asset. The seller of the call option will be obligated to sell the stock to the call option owner if the option is exercised. The owner of the options literally has the right to CALL the stock from you.

With a put option on a stock, the seller of the put option has given the right to sell that stock to another party. The seller of the put option is therefore obligated to buy the stock from the put option owner if the option is exercised. The owner of the options literally has the right to PUT the stock to you.

Option Examples

An option is a derivative. It derives or gets its value from an underlying asset. Did you know that you are using a form of options as part of your daily life? Have you purchased insurance as a safeguard against a fire in your home, a crash in your car, or large medical bills? Do you pay a premium for your house, auto, and medical insurance? Then you have purchased a type of option. The fact is, options are a part of our everyday life, and have valuable application in our trading and investing.

Auto insurance, health insurance, and homeowner's insurance are all examples of put options. These options transfer the risk of loss from the owner of an asset to the writer (seller) of the put. Insurance companies are basically put option dealers.

Leverage

Leverage is the term used to describe the profit or loss potential when a small amount of money controls a large amount of money. The owner of one call option has the upside potential of 100 shares of stock by investing a smaller amount of money than he or she would in purchasing the stock outright. If there is a 10% rise in the stock, the option can double in value.

A word of caution: leverage also increases risk. A 10% decline in the stock can result in the total loss of what we paid for an option.

Example

Purchase100 shares stock @ $32 for a cost of $3,200.00. If the stock climbs from $32 to $42 you would have a $1,000 gain, or a 31% increase.
OR
Control 100 shares of stock by purchasing the option at a premium of $3 per share for a cost of $300 (1 contract x 100 shares x $3 premium = $300). If the option premium rose from $3 to $11, the original cost was $300 and it is now worth $1,100. You have an $800 profit, but a 266% return!

When comparing the stock purchase to the option purchase, your stock purchase will have a moderately high dollar profit. But your option purchase will have a significantly higher percentage return.

Strategy Breakdown

Options Investing Strategies

Buying Calls (Bull Market) and Buying Puts (Bear Market)

Buying calls and puts is considered the most aggressive of these strategies. They are exposed to market directional risk and are considered speculative. They may be referred to as directional trading plays. As powerful as they are only allocate a small portion of your portfolio to them. When taking on directional risk of this sort, follow the most stringent money management guidelines. They are referred to as being Long positions. By purchasing a Call you will be considered long a call option and will have the right to buy and/or benefit from a rise in the underlying stock. By purchasing a Put, even though you have the right to sell and/or benefit from a drop in the underlying stock, you will be considered long a put option. Their use is only recommend after one has gained significant experience and confidence in the market and is successful trading stocks.

Covered Calls (Neutral Market, Use to sell stock, Income) and LEAPS (Bull Market)

This is when you write a contract and sell it (sell a contract you do not own). These strategies can be considered a form of hedging. You will have the obligation side of the contract. By selling contracts you will be considered Short. By selling a call contract, you are giving someone the right to force you to sell the underlying asset. For Covered Calls you must own the underlying stock. Depending on your mindset you can use these strategies to buy stock or sell stock at agreed-upon levels, and in effect get paid to do so. LEAPS (Long-Term Equity Anticipation Securities) are long-term options (more than 9 months). They are considered more conservative in nature due to their longer time frame and have a similar risk profile as owning stock.

Advanced Strategy – Selling Naked Puts (Bull Market, Use to buy stock, Income)

This is when you write a contract and sell it (sell a contract you do not own). These strategies can be considered a form of hedging. You will have the obligation side of the contract. By selling contracts you will be considered Short. By Selling a Put contract, you are giving someone the right to force you to buy the stock. For naked puts you must have the financial resources to purchase the stock if it is put to you. Depending on your mindset you can use these strategies to buy stock or sell stock at agreed-upon levels, and in effect get paid to do so.

Purchasing Options

Now that you understand some of the basic language and concepts of options, let's discuss some things about buying options.

Buying call and put options is risky. They are not recommended for the beginning investor.

If you are going to use them you should:

• Use strict money management guidelines.
• Use the same entry rules and exit rules you would for trading stock.
• Decide if you want to use the leverage of options in a position based on your assessment of the trade.

Your primary concern for evaluating a possible option trade should be based on the price action of the underlying asset. As an option buyer you have the choice on what to do with that contract: sell it to someone else or exercise it. The best choice is almost always to sell it, but just in case let's find out what it means to exercise a contract.

Option Exercise

When you take advantage of the right granted by your option, it is known as exercise. If you exercise a call, you buy the stock at the option's strike price. If you exercise a put, you sell the stock at the option's strike price.

American Style Exercise options, which are the vast majority of options traded in the U.S., allow the holder of the option to exercise anytime before expiration. In contrast, holders of European Style Exercise options can only exercise during a specified period of time just prior to the options'expiration.

In both cases, expiration usually occurs on the Saturday following the third Friday of the month. However, because the exchanges are not open on Saturday, trading actually stops on the preceding Friday, and in the case of some index options, the expiration is actually on the 3rd Friday of the month.

You should also note that different brokerage firms have differing policies regarding the automatic exercise of options In-the-Money at expiration. Contact your brokerage to know how your brokerage handles expiration and margin requirements if you do not have adequate cash in your account to perform the exercise.

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Options Education

Options Greeks

In this section, we're going to discuss some more advanced topics as we delve into the mathematics behind options pricing. Don't worry if you're not a fan of complex algebraic formulas and mathematical algorithms, the items we're going to discuss are all calculated for you automatically within the optionsXpress system. Our goal in discussing this information is to help you become familiar with some of the components that help determine the overall price of an option so that you'll be able to better anticipate price movements when they occur.

As a new options trader, you've probably heard people refer to "options Greeks." These are simply a number of different ingredients in the overall "recipe" that determines the value of an option. They're called "Greeks" simply because the different variables are named after letters of the Greek alphabet. Each has a place, and every one contributes to the equation.

There are two ways to locate the options Greeks information. The first is to simply click on the "Pricer" link in the Toolbox menu. The other method is to look up an option chain where you'll find the "Delta" and Implied Volatility values for the particular option strike price and expiration date.

Now, let's discuss the options Greeks individually, and explain how they're used to determine an option's value.

Delta

Delta is the variable that tracks the relationship between the change in the price of an underlying stock and the change in the value of the option contracts associated with it. Delta ranges in value from 0.00 on the low side, to a maximum of 1.00. An option with a Delta of 1.00 means that for every dollar the stock rises in price, the options will increase in value by one dollar per share. This becomes very important when you consider that most option contracts control 100 shares of stock. If the underlying stock rises $1.00 per share in value, the "Delta 1.00" contract just increased in value by $100.

Generally, an "at-the-money" option strike price will have a Delta somewhere between 0.50 and 0.75. For every dollar the stock rises, the at- the-money option will increase by 50 to 75 cents per share, or $50 to $75 per contract on a 100-share contract. The deeper in the money an option becomes, the greater the Delta, until the Delta reaches 1.00. Delta will never exceed 1.00 for a single contract, although the net effect can appear to be more than 1.00. Keep in mind, the higher the Delta, the more expensive the option contract. The reverse is also true - the lower the Delta, the less expensive the option.

Every once in a while, you may hear stories of novice options traders who are enticed to buy deep out-of-the-money options contracts thinking that they can get so much more for their money. While it's true, you can buy several deeper out-of-the-money options for the same price as one or two Delta 1.00 options, the value is nowhere near the same.

Sometimes it helps to think about Delta as an option's "horsepower." Here's an interesting example:

Let's suppose that you're considering buying call options on stock "XYZ." Let's further suppose that the current stock price is $92.35/share. As you consider which option to purchase, you take a look at the "Pricer" link under the Toolbox menu, where you find the following information (among other information) listed:

Notice that if the underlying stock price is $92.35/share, the $80, $85, and $90 strike prices are "in-the-money." This is also indicated by the shaded area of the table.

Suppose that you have $1120 to spend to purchase your options contracts (for the moment, we'll disregard commission costs.) Using the information found in the table above, which option strike price represents the best value for the money?

Well, let's consider the relative purchasing power you now have. You could purchase one contract of the $80 strike price options, (XYZ CP) with a Delta of 1.00. That purchase would cost you $1120. The advantage of this purchase, of course, is that for every dollar the stock price rises, your options contract will increase dollar for dollar (remember, however, that Delta works both ways - your options contract will lose value dollar for dollar with the falling price of the stock).

Let's consider something interesting here. If you can purchase a Delta 1.00 contract by buying the $80 strike price option for $1120, isn't the $85 strike price almost as good?

You could still only buy one contract of the $85 strike with the money you have available, but you still benefit from almost the same Delta, right? For every dollar the stock rises, your options contracts will increase $0.96 per share. One contract of the $85 strike price would cost you only $850, compared to $1120 and you get nearly the same Delta benefit! Let's consider the $90 strike price options.

How many of the $90 strike price (at-the-money) contracts could you buy for $1120? You could actually purchase two of the $90 strike price "at-the-money" contracts with your available funds. What's the Delta? It's 0.75 per share, PER CONTRACT. In other words, while Delta for any single contract will never be more than 1.00, the combined, or "Net Delta," felt by the increase in purchasing power available by buying the $90 strike price contracts is actually a "Net Delta" of 1.50. For every $1.00 the stock moves higher, your options contracts will have a net increase of $1.50 per share.

Keeping in mind that the further we move "out-of-the-money" the less expensive the options become, let's consider the purchasing power we could put behind the $95 strike price options. How many could you buy with $1120? If you take $1120 and divide it by the Ask price of the $95 strike price option ($2.25 per share), we could buy almost 5 contracts. Although you can't buy a partial contract, let's assume that we could buy 5 contracts. What's the "Net Delta?" The Net Delta is only 0.85. (5 contracts times a Delta of 0.17 per share.) Even though you could buy five times the number of contracts as you could if you bought the deep in-the-money $80 strike price options, the total combined Delta for the five $95 contracts is only $.85 on the dollar.

What about the $100 strike price contracts? You could buy 15 contracts of the $100 strike price options, but with a Delta of 0.00, you wouldn't see any increase in options value at all until the stock price crept closer to $100. By that time, the $90 strike price options would be approaching a Net Delta of nearly $2.00 per share for every $1.00 increase in the price of XYZ stock.

How is Delta like horsepower? Imagine if these five option strike prices were drag racers, each with the same potential horsepower. The light turns green, the deep in-the-money Delta 1.00 $80 strike price car leaps off the line instantly, using every ounce of available horsepower. The $85 strike price car is hot on its tail with nearly the same horsepower. Suddenly, the $90 strike price dragster zooms past 1.5 times as fast as the first two cars. The $95 strike price dragster is just pulling off the line, and won't hit its maximum power curve for several seconds. The $100 strike price dragster? It just stalled on the line. That is the power of Delta.

Gamma

Gamma is one of the least understood but most powerful of the options Greeks. Gamma is the variable that tracks the rate of change of Delta. In the previous example, we compared Delta to horsepower. Keeping with that same example, Gamma is the acceleration or rate of change of the dragsters. How quickly can each car make use of its available horsepower? That's Gamma.

Unfortunately, many options investors fail to recognize the effect that Gamma can exert upon the value of an option. In reality, knowing how the Delta changes can make a significant difference in the profitability of an option play. Here's an example:

Suppose that IBM is currently trading for $23.00 per share. Suppose further that a glance at the options Greeks showed that the current Delta for the $20 strike price option was .96. This means that for every dollar per share the stock price rises, the $20 strike price option will increase $0.96 per share. That's the current situation, but a quick check of the Gamma value for the $20 strike Calls is 0.04. This means that if the stock were to increase a dollar per share, the Delta would increase by 0.04, resulting in a Delta of 1.00. Once the stock price reaches the level of $24 per share, the $20 strike price options will increase dollar for dollar in value with any further increase in the value of the stock.

Now, suppose that you were faced with two different option plays. Each of the two plays have the same Delta, and each option costs the same to purchase. But suppose one of the options carried a Gamma of 0.01, and the other carried a Gamma of 0.05. All other things being equal, the option contract with the higher Gamma would generally result in a greater profit for a given period of time, when compared to the option with a lower Gamma. A higher Gamma often equates to greater acceleration in profitability with a given increase in the value of the stock.

Theta

Theta is used to track the rate of decay of the time value of an option. The time value of an option is the variable piece of the option's value. Here's an example: Suppose you identify a stock that is currently trading for $21.35 per share, and you decide to buy the $20 strike price Call options. Before buying the options, you note that the ask price for the $20 strike price Call for the current month's expiration is $2.50 per share.

There are two components in the price of the option at the $2.50 per share ask price. Those components are the intrinsic value and the time value. The intrinsic value of the option is simply the difference between the price of the stock ($21.35 per share) and the strike price of the option ($20.00 per share), using the example above.

If the ask price for the option is $2.50 per share, and we know that the intrinsic value of the option is $1.35 per share, then we can easily deduce the time value component of the option (take the ask price of $2.50 per share and subtract the intrinsic value of $1.35 per share). This gives us a time value component of $1.15 per share.

Now, suppose you consider the $20 strike price Call for the same stock, just one month further out in time. In that case the stock price hasn't changed, and it's still trading for $21.35 per share. The strike price is still the $20 strike price option, but now the ask price for the option is $3.50 per share. What's changed? The only difference in the price of the option is the time value. Since the options for next month are further away from expiration, we should expect to pay more for them.

As the option approaches its expiration date, the time value erodes more rapidly. Tracking the Theta as an option approaches expiration reveals the speed of the decay of time value. Try this: Compare the Theta for the at-the-money option for a particular stock as far out as you can go. Now compare the Theta for the at-the-money options for the next expiration month. You should notice that the Theta for the near-term options is much larger than the Theta for the longer-term options.

In addition to the Delta, Gamma, Theta previously discussed, investors also have access to another, lesser-known pair of options Greeks. These variables are primarily used by institutional money managers, but can be helpful in allowing us to forecast the potential return on our option investment, should a given price movement occur in the underlying stock.

Vega

Vega is the Greek letter used to track the change in an option's theoretical value, given a 1% change in the volatility for the underlying stock.

Here's one way that we can actually make use of the information: let's say there is sudden good news in a stock. When the news hits the wires, the market makers for the stock immediately begin to increase the price of the stock in anticipation of a bullish rally. If investors are willing to overlook the increase in price and purchase the stock regardless of its now overvalued Ask price, the historical volatility for the stock likely increases.

Armed with the current historical volatility figure for the underlying stock, we can calculate the effect of this change to the T-Val of the option. A 1% move in the historical volatility of the underlying stock has a very small effect on the theoretical value of the option, which is why this information is usually monitored only by institutional investors with millions of dollars under management. Individual investors seldom carry enough volume in a given option position to be affected by changes in Vega.

Rho

Rho is the Greek letter used to track the expected change in the price of an option given a 1% change in interest rates. Like Vega, changes in the Rho value of an option aren't greatly affected by changes in interest rates, and are used mostly by institutional investors.

Historical Volatility

Historical Volatility is a measurement of the price movement of the underlying stock over a 6-month period of time. This value can tell us what types of price fluctuations we could expect from a stock, helping us to identify stocks that fit our personal investment strategy. Highly volatile stocks are subject to wide, quick price movements. This isn't necessarily a bad thing, if we are prepared for the consequences. Highly volatile stocks have a greater potential for quick gains, however they can lose money just as quickly. Low volatility stocks are often more stable, and less prone to wild price movements. As a result, they aren't as likely to see heavy gains over a short period of time.

Volatility is expressed as a percentage, and represents the variance in the standard deviation of a change in the price of the underlying stock over a six month period. If that sounds like a little more than you would care to know, don't worry about it. The definition is simply included to satisfy the curious.

Here's what the Historical Volatility figures actually mean to us. If we have a stock with a Historical Volatility of 16%, it simply means that we should expect a stock with a price of $100 per share to fluctuate between a low of $84 per share, and a high of $116 per share over a 6-month period. As you can see, it doesn't matter whether the stock is trading at its low range or its high range, the volatility is the same. The volatility figure does not tell us the potential direction of the stock.

T-Val

The term "T-Val" is short for "Theoretical Value." This figure represents the fair market value for the option under ideal conditions. The value is actually calculated for us through the Black-Scholes formula, which we'll discuss in greater detail below. This formula represented a monumental breakthrough when it was published in 1973. It's still in use today as the standard pricing model for options. One way to think about the T-Val is to compare it to the Kelly Blue Book value for a car. The Blue Book value for a used car represents the price that current market conditions should support for the vehicle.

This doesn't mean, however, that we should only expect to pay what the vehicle is worth according to Kelly. For example, let's say that you have a 1972 Toyota Land Cruiser with a new engine, new tires, and new paint. The Blue Book suggests the value is $200 - $500 dollars, but some individuals may consider the vehicle to be a collector's item, willing to pay us $3000 or more. The fair market value isn't necessarily what we would have to pay to buy it, especially if what we're buying is in high demand.

Implied Volatility

As we discussed earlier, historical volatility is a useful measurement of the price movement of a stock over a given period of time. Historical volatility can be thought of as a sort of baseline standard for the price movement of a stock. The implied volatility, by contrast, is a kind of measurement of the expected price movement above or below that baseline standard.

Think of it this way: suppose you identify a stock with an average annual growth of 10% per year for the last five years. The stock has demonstrated a pattern of growth that forms the basis for an expected 10% annual return. Suppose that there is a very positive news announcement for the stock that may result in significant additional corporate revenues. Investors are likely to consider buying the stock, with the thought that the new opportunity may drive the stock price higher.

As you can imagine, investors aren't the only ones expecting the stock to increase in value over the next few months. The market makers for both the stock and the options will typically raise the price of their securities with the expectation that the bullish news will encourage folks to buy the stock or options, even if they're a bit overvalued. The market makers will seek to raise the price of their securities for as long as investors express a willingness to buy them. This increase in price is reflected in a higher implied volatility measurement.

By comparing the historical and implied volatility, we can see at a glance whether or not the market believes that the underlying stock is likely to increase in price, remain about the same, or drop in price.

Generally speaking, anytime the implied volatility is 20% or more above the historical volatility, the options are considered overvalued. Conversely, an option is usually considered undervalued if the implied volatility is 20% or more below the historical volatility. Many serious options traders will rely heavily on the implied volatility and even track it on a daily basis for a particular stock. If the implied volatility starts to increase, they may begin to look for bullish trades, believing the increased volatility may indicate a change in the market's perception of the stock.

Introduction to the Black-Scholes Model

In 1973, a talented economist named Robert C. Merton published a peer-reviewed paper discussing methods by which stock warrants and other financial instruments could be equitably priced. This paper presented the work of two mathematicians, Fischer Black and Myron Scholes. In what would thereafter be known as the "Black-Scholes" model, Merton described the relationship between the price-movement of the underlying stock, interest rates, and all of the "option Greeks," variables discussed previously.

In 2000, PBS station WGBH-Boston aired a fascinating program that featured the Black-Scholes model. The NOVA documentary entitled "Trillion Dollar Bet" discusses how the formula came to be, and its application within the world of finance. If you'd like to know more about the Black-Scholes model, and about the advantages and risks of financial models like it, you would likely enjoy finding a copy at your local library, or searching for it online through retailers like Amazon.com.

Here's the theory behind the formula: When a call option on a particular stock expires, its intrinsic value is either zero (if the stock price is less than the option's strike price) or the intrinsic value is the difference between the stock price and the strike price of the option. For example, say you buy a call option on XYZ stock with an option strike price of $100. If at the option's expiration date the price of XYZ stock is less than $100, the option is worthless. However, if the stock price is greater than $100—say $120, then the call option is worth $20. The higher the stock price, the more the option contract is worth. The difference between the stock price and the option strike price is the option's "payoff."

Obviously, it's very simple to figure out how much an option is worth at expiration. It's simply a question of subtracting the option strike price from the stock price at expiration. What if I want to know what my option contract is worth right now, or one or two weeks prior to expiration? Remember the two components to an option's value, the "Intrinsic Value" (stock price minus strike price) and the "Time Value."

The Black-Scholes model was created to calculate that "Time Value" component of an option's value at any time prior to the option's expiration date. Add together the "Time Value" and the "Intrinsic Value" and you know precisely what an option is worth.

In order to work, the model depends on a number of input variables. These include the price of the underlying stock, the exercise price of the option, the risk-free interest rate (the annualized, continuously compounded rate on a safe asset with the same maturity as the option) and the time to maturity of the option. The only unobservable is the volatility of the underlying stock price.

Armed with that information, the formula quickly identifies what the option is worth.

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Options Education

Options Trading Rules

Let's discuss some of the most important options-trading rules for successful investors.

Rule #1 - Trade with the Market, Sector and Stock

This sounds like a simple rule, but it's an easy one to forget. Most of the time, when we're ready to enter an option trade, we're familiar with the trend for the stock. This is usually what attracted us to the trade in the first place. Checking the trend of the stock isn't enough. Before placing an order for the stock or its options you must clearly understand the direction of the general market, and market sector for the stock. Be sure that the market and sector trends are moving in a direction appropriate to your strategy.

There are 27 market sectors, (the Banking and Technology sectors for example) comprised of 247 Industry Groups as determined by Standard & Poor's. Every publicly traded company falls into one of these industry groups. It's incredible to see just how much industry group performance can influence the price movement of a stock. Companies are lumped together into a given industry group based upon the products or services they offer. Often each of the companies in a given industry group sell to the same client base. This is the reason that bad news from one company will tend to drive down the price of other stocks in the same group.

An example of this was the Enron fiasco a few years ago. There were a number of healthy utility companies that shared industry group placement with Enron prior to the discovery of questionable practices within the company. Once word of the scandal reached the public, the entire group dropped like a rock. Investors didn't know whom to trust within the group. As a result, even the "good" companies were punished.

Before we enter the trade, check the trend of the general markets, the specific market sector, industry group, and the trend of the stock.

Rule # 2 - Have an Exit Strategy Prior To Entering the Trade

Before you ever enter a trade, you should prepare an exit. Not only will this prevent you from being paralyzed into inaction in the event the trade begins to go against you, it will also help you to recognize when you should be happy with the profits.

When should you be happy with the profits? If you answered, "Never!" you may have a problem. Try this: When you're ready to enter a trade, instead of buying one contract, buy two. That way, when you first feel excitement over a great trade, you can think, "Should I be happy with this profit?" If so, then consider selling one of the contracts, leaving the other contract to run until you see sell signals. The secret here is to remind yourself: "I'll never go broke taking profits off of the table."

Another strategy is to analyze the stock chart for patterns of support and resistance. Try and identify the average move when the stock rises. If the stock tends to rally 20 percent each time it has a breakout, expect this run to be no different. Plan to exit near the 20 percent level.

Ask yourself when "good enough" should really be considered "good enough." Set exit points relative to the average move in the price of the stock, and exit in a timely manner. Consider selling half when you're happy and let the other half ride until your exit point is met, or until you receive sell signals.

Rule # 3 - Beware of Upcoming Announcements

Life is full of surprises. Hopefully, your investments are as free as possible from the sorts of surprises that tend to lose money. Fortunately, there are specific announcements that are easy to plan for, such as quarterly and annual reports. Watch the news items for your stocks, and mark your calendars to expect announcements. If you know that the last earnings announcement for a given company was May 20th, plan that the next announcement will be three months later on August 20th. It may not actually fall on that day, but you will know roughly when to expect it. A quick bit of research to identify the fiscal year-end and reporting periods for a stock will go a long way towards preparing you for the unexpected. You can find the Fiscal Year-End and quarterly reporting periods for your stocks by clicking on the "Company Profile" link on the left side of the page from the Corporate Snapshot page. This information will show you when the stock closes its books for the year, but it doesn't tell you exactly when the results for that year or quarter will be announced. Check the news for that information. Most companies will let investors know when to expect the actual announcement.

Watch for patterns in other relevant news. For example, whenever the Chairman of the Federal Reserve speaks, reverberations are felt in the markets. If he were to hint at an increase in interest rates, ask yourself if the stocks or options that you are currently trading would feel the influence of his comments. Watch the reactions of the market. This is one of those times when running with the herd may be a good thing. If your holdings drop in value on his comments, protect yourself. Consider exiting the trade. Make sure that you have stop-losses in place prior to the announcement. An appropriately placed stop-loss is the next best thing to knowing the future.

Schedules for reports and events from the Federal Reserve are available on the Web at http://www.federalreserve.gov/calendar.htm.

Check to see when the stock reports its quarterly earnings. Look for an announcement three months later on the same day. This may not give you the exact date, but you can fine-tune the date by following the news. Check to see when key economic reports are due for release.

Conducting a nightly review of your holdings is imperative to investing success. If you would like to build your wealth, you simply cannot afford to ignore your investments. As part of your nightly routine, you should check the stock charts for each of your holdings, as well as the market news for each. Review the information. See if the charts or news items would direct you to sell your positions. This is also a great time to review the placement of your stop-losses. Conducting this analysis should take you no longer than 15 minutes each night. Armed with information regarding your positions, you can submit orders for action the next morning.

There is no excuse for being uninformed with the events of your stocks. If you begin to notice weakness in the chart patterns for your holdings, consider exiting your trades, unless of course you're using Bearish strategies! Review the placement of your stop-losses. Consider adjusting them in order to protect yourself from unexpected news.

Option Ticker Symbols

The ticker symbols for an option are built according to a recipe that serves to identify the underlying stock, the expiration month, and the strike price for each option. The first three letters of the ticker symbol are used to identify the underlying stock, although the three-letter symbol for the stock may be different than you're used to. Here's an example of the index symbol for S&P 100 is, of course, OEX. The three-letter designation for options on S&P 100 is OXB. Just remember that as far as the ticker symbol for the option is concerned, the first three symbols represent the underlying stock.
The last two symbols represent the expiration month, and the option strike price. The expiration month is represented by the letters "A" through "L" for Calls and "M" through "X" for Puts

The last two symbols represent the expiration month, and the option strike price. The expiration month is represented by the letters "A" through "L," with January represented by the letter A, February represented by the letter B, and so forth. Each individual option strike price is represented by a different letter as well. The lowest strike price offered for an option is $2.50. With most optionable stocks, option market makers will offer options in increments of $2.50 up to the $25 strike price, at which point strike prices advance in increments of $5.00 ($25.00, $30.00, $35.00, etc.).
Decoding the strike price can be a bit tricky, since there are more strike prices than letters. For example, the letter B might represent $10, $110 or $210.
The symbols for the strike prices progress as demonstrated in the table above. As option strike prices increase the letters advance, each letter representing a higher strike price.

Since the option symbols follow a recipe, they are recycled year after year. That's one reason why it can be difficult to find historical quotes for options. Once a particular option expires, the symbol will lie dormant for a few months, until the re-issue of that same option ticker symbol next year.

Levels of Options Trading Authority

Back in the early 1990's a technology revolution quietly began to change our lives. I'm sure you can recall the first time you dialed into your Internet Service Provider's system, and took your first tentative steps through the World Wide Web. About the same time you were learning to navigate through the Internet, an enormous effort was under way to make use of this new medium as a tool to make investors better informed, and to streamline the entire investing process.
This streamlining process allowed investors unparalleled access to their brokerage accounts. Unfortunately, this access simply gave uneducated investors a way to lose their money more efficiently. Back then, there were no levels of option-trading authority. People more or less traded as they saw fit. That is, until the first lawsuits began to surface.
optionsXpress, in compliance with SEC (Securities and Exchange Commission) rules, requires clients to document their previous trading experience, financial well-being, and risk tolerance prior to granting options trading authority. This is done to protect not only the integrity of your account, but to protect your overall financial security. Education is the key to successful options trades. Learning how to use options in order to expand your investing toolbox should be the goal of every investor. Understanding the risks should be a priority.
When you apply for an options trading account, you will be provided with access to an online booklet entitled "Characteristics and Risks of Standardized Options" published by the Options Clearing Corporation. It's important that you learn to recognize the risks of options trading, and never risk money that you can't afford to lose. In order to help you manage risk, optionsXpress has established five levels of options trading authority.
These are general definitions only. We'll discuss specific options trading strategies available within each level of options trading authority in another section.

Level 1 Options Trading Authority:

Level 1 authority is granted to accountholders seeking approval to trade Covered Calls. This is considered a conservative strategy, and is a great way to build your experience in the application of options.

Level 2 Options Trading Authority:

Grants approval to buy Calls and Puts, as well as the ability to write Covered Puts. Generally given to accountholders with some history of trading stocks and an understanding of the speculative nature of options trading. To increase your level of options trading authority within the optionsXpress system, simply click on the "Account" tab, and options-trading authority. You'll generally find this form in the "FAQ" section of your broker's Web site. If you aren't certain where to find the form, or how to complete the application, contact your broker.

Level 3 Options Trading Authority:

This level allows the accountholder to execute Spread trades.
Spreads are more advanced than simple Call and Put option plays in that they can result in a Naked Position. A Naked Position simply implies that you are selling an option to someone else, without owning the stock first. An example of a trade requiring this level of authority would be a Calendar Spread, which is simply a Covered Call on a LEAPS option. In this example, although you own the LEAPS contract, which gives you the right to purchase the underlying stock, you don't technically own the stock. This places more of your capital at risk, since you are basically naked in the trade. This is why your broker would require a higher level of trading authority for a Calendar Spread.

Level 4 Options Trading Authority:

This level involves the selling of Naked Equity Options.
As mentioned above, Naked Equity Options would result in selling an option without the ownership of the stock itself. This would be used when you are fairly certain that a stock isn't going to move above a certain point. We sell the Covered Call at a strike price above the point at which we expect the stock price to stop moving higher. This then enables us to reap the premium from the sale of the Calls, without having to extend ourselves to actually purchase the stock first. Since you do need to be prepared for the possibility of being called out, your broker will require a certain cash reserve within your account. The size of this margin is determined by the exposure in the position determined by the current price of the stock.

Level 5 Options Trading Authority:

Basically authorizes the investor to trade Naked Index Options.
Some Index Tracking Stocks (also known as Exchange Traded Funds) are quite unique in that investors can purchase the options, however there is no stock in which to take ownership. The OEX is a prime example of this. The OEX tracks the performance of the Standard & Poor's 100. The value of the OEX is tied to this composite; however, you can't actually purchase the stock itself. Since options are available on the OEX, however, you could sell the Call options, but you don't actually own the stock...you're just pretending you do. What would happen if you're called out? Since there is no stock to turn over, you're forced to settle the trade with cash. This could result in an outlay of tens of thousands of dollars, again dependent upon the price of the issue in question. The margin requirement for this type of trade is usually far greater than for Naked Equity Options.

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Options Education

The Basics of Options

Before you actually start investing with and trading options you need to understand the basic terminology (the language of options) and more about what makes them tick. For example, the factors that affect the prices or premiums, and how that relates to the price of the underlying stock.

Definition

An option is the right, not the obligation, to buy or sell a stock at a specific price on or before a specific date.

Two Types of Options

Call	Put
The right to buy	The right to sell
The obligation to sell	The obligation to buy

Contracts

A Call option gives the buyer or holder the right to purchase the underlying asset and gives the writer or seller the obligation to sell a set number of shares of the underlying stock at a specified price (strike price) on or before the date the contract expires (expiration date).

A Put option gives the buyer or holder of the contract the right to sell the underlying asset and give the writer or seller of the contract the obligation to buy a set number of shares of the underlying asset at a specified price (strike price) on or before the date contract expires (expiration date).

An option contract usually controls 100 shares of stock. However, if there has been a recent split in the stock this may not be the case. The buyer of the contract will pay a premium, while the writer or seller of a contract will collect a premium.

Option Contract

Strike Price

The price at which you have the right to buy or sell according to the contract.

Expiration Date

The third Friday of the month.

Premium

The Cost of the option

Example

Let's take a look at an example of how all of these factors go together. You are interested in building a golf course and have found a 1,000-acre plot of land in a potentially high growth area. However, it will take time to obtain the necessary financing and land-use permits in order to begin building. You want to secure the land while you put everything into place, but you don't want to lay out a hefty price to purchase the land outright just in case you can't ultimately build the course there.

Strike Price

• You go to the property owner and strike a deal that allows you to purchase the property for 2 million dollars.
• He agrees and you now have the right to purchase the property at the agreed upon price.

Your solution is to go to the landowner and create a contract that will give you the right to buy the land, but not the obligation. The contract will control all 1,000 acres. The price that you agree to is called the strike price. If you are not successful in obtaining the right to build a golf course, you can simply walk away from the deal and lose only the amount that it cost you to purchase the contract.

The contract is written with an expiration clause so as to protect the landowner from being obligated to sell his property for an unreasonable amount of time. It also will decrease the cost of the contract to you, because you will only be tying up the land for a short pre-determined period.

Expiration Date

• The expiration date offers some protection to the property owner by invalidating the contract after 6 months.
• Gives the buyer only a limited time to decide whether to ultimately purchase the land or not.

The landowner will expect to collect a premium for being obligated to sell you the property. The amount of money he expects will be determined by how long he will be under obligation and what the expectations are for the property to move up or down in value. The more time the land will be tied up, the more money he will expect. Likewise, the more likely the land is to increase in value during the duration of the contract, the more money he will expect.

Premium

• The landowner will collect a premium for being obligated to sell us the land for the agreed upon price.
• His price is based on how much the property might move in value during that period and how long he will have the obligation.
• The premium is $20,000.

Of course, your reasons for entering into this type of deal are fairly clear, but why would the property owner be interested in such an arrangement? For one thing, he gets to keep the premium paid for the contract no matter what happens, allowing him to make a little upfront money on a property he may or may not wind up even selling. In addition, the agreed upon sale price (strike) is likely to be much higher than he could obtain if he sold the property without the land-use approvals that you're working to obtain.

This example is very similar to what happens with a call option in the stock market. Stock options are contracts that have strike prices, expirations, and premiums. Rights are transferred and the parties to the contract take obligations.

Strike Price

This is the price per share at which you will have the right to buy or sell the underlying stock. For example, if you see May 30 calls, this means you have the right to buy stock at $30 per share. If you have written or sold a contract, the strike price will be the price at which you will be obligated to buy or sell. Strike prices are determined by the exchanges and are stated in even increments.

Strike Price Increments

Stock Price	Strike Increment	Starting At
$5.00 to $25.00	$2.50	$5.00
$25.00 to $200.00	$5.00	$25.00
$200.00 to $60,000.00	$10.00	$200.00

Expiration Date

Every option contract has a month in which it expires. For standard options, the dates can range from one to nine months, and contracts expire on the Saturday following the third Friday of the month. However, since you can't trade on Saturday, the third Friday of the month is considered the option expiration date.

Options are identified in part by their expiration dates. If you see a quote for May 30 calls, the May refers to the expiration month and the actual date will be the third Saturday in May. The option no longer trades at the close of the markets on the third Friday of May, and officially expires the next day. If the markets happen to be closed on that Friday, the last trading day will be on the preceding Thursday.

Option Premium

The premium is the amount the buyer pays to purchase the option; in other words, it is the option's price. The premium also represents the amount the seller of the option will collect for assuming on the obligation of the contract. When looking at an option, you will see a bid and ask price, just like you would with a stock.

Note that options in the U.S. are generally for 100 shares of stock. The premium, or price, is quoted for one share. If you see a May 30 call at $4, the price for one contract is 100 shares multiplied by $4, or $400. (1 x 100 x $4 = $400)

Three factors affecting premium

• Time
• The underlying asset price relative to the strike price
• The volatility of the underlying asset

The value of an option is highly dependent on the amount of time left before the option expires. Options are considered wasting assets because they have a limited lifetime and their value decreases as their expiration dates approach. Time value is the portion of the premium that is dedicated to time remaining until a contract expires.

When buying time, the purchaser of an option is buying the possibility that an option's value will increase before the expiration date. As the option approaches expiration, its time value decreases toward zero. In the last two weeks, the weeks just before expiration, their decline in value accelerates. This works in our favor when we are the contract sellers. At expiration, the option's value will be zero unless the option finishes In-the-Money.

In-the-Money, Out-of-the-Money, and At-the-Money

In-the-Money (ITM), Out-of-the-Money (OTM), and At-the-Money (ATM) are three terms used to describe the relationship between an option's strike price and the current price of the underlying stock.

A call option is considered to be In-the-Money (ITM) when the stock is trading higher than the option's strike price, Out-of-the-Money (OTM) when it is trading for less than the option's strike price, and At-the-Money (ATM) when it is trading at exactly or very close to the option's strike price.

For example, the OEX Mar 390 Call would be In-the-Money if OEX was trading for more than $390, Out-of-the-Money if OEX was trading for less than $390, and At-the-Money if OEX was trading for exactly $390. If an option is In-the-Money, it has intrinsic value (value if it were to be exercised).

Intrinsic Value

Intrinsic value is the difference between the stock price and the ITM strike price. In other words, it is the ITM portion of an option's price. For example, if a stock is trading at $37.50 and the strike price on the option is $35, the intrinsic value in the option is $2.50.

Intrinsic value can never be a negative number, but the option does not need to be ITM to have some time value (this is called extrinsic value). Interest rates and stock dividends, if applicable, can also play a small role in the premium.

The General Rule of the Option Pricing

In-the-Money options are more expensive, but their value also increases more quickly as the price of the stock goes up.

Out-of-the-Money options are less expensive, but their values increases more slowly as the price of the stock goes up.

Delta

Delta is one of the "Greeks", a collection of analytical tools used by options traders to measure risk (more in-depth discussion of the individual Greeks is available in Level 2). Delta is the term used to describe the relationship between option price movement and the movement in the price of the underlying stock. Delta is the amount of change in an option's price if the underlying stock price moves by 1 point.

For example, if the stock price on the left increases from $390.44 to $391.44, then the price of the 385 Call (Delta .5463) will increase from $5.50 to $6.04. Delta is positive for call options and negative for put options.

It is important to note that delta is not a fixed value. As an option moves further In-the-Money (ITM), its delta increases. Similarly, the further Out-of-the-Money (OTM) the option becomes, the further the delta decreases.

Why is this important? It will give us insight into why we would want to buy an In-the-Money or At-the-Money option, rather than an Out-of-the-Money option. It is also a concept that, along with the other Greeks, is put to greater use in more advanced options trading strategies.

Volatility

One of the most important aspects in determining the value of an option is the behavior of the underlying stock. Given the many different opinions among investors about how a stock might behave going forward, it stands to reason that individual option traders may also disagree about the value of any given option. This difference of opinion can affect the price of the underlying security dramatically.

This brings us to the important concept of volatility. Volatility is the measure of stock price movement, or how much a stock price moves up and down – the greater the up-and-down movement of the stock, the greater the odds that the option will be In-the-Money during its lifespan. Higher volatility – and the greater chance of being In-The-Money – increases the price of the option.

Volatility of the underlying stock is a key factor in determining the value of an option. As the volatility of a stock increases, an option's premium will likewise usually increase. The difficulty of predicting the behavior of a volatile stock allows the option seller to command a higher price for the additional risk assumed.

There are two types of volatility – historical and implied. Historical volatility is a measure of price movement based on how the security has behaved in the past. Implied volatility is a measurement of price movement as implied by the current market price. It is basically determined by running the model backwards. If our model stated that an options price should be $4 but it was trading at $5, we would plug in 5 for the price and solve for volatility. This number would be the market's opinion of what the future volatility of the underlying issue might be.

Putting it all together

Time and volatility are closely related. Together, they are generally referred to simply as Time Value.

An option can have no intrinsic value and still have worth. However, when nearly the entire value of the option is based on time, risk increases significantly.

• Option price = Intrinsic value + Time value + Volatility + Dividend
• $5.70 = $2.50 + $1.50 + $1.60 + $.10

As you can see, only part of an option's price is made up of intrinsic value.

• Option price = Time value + Volatility + Dividend
• $3.20 = $1.50 + $1.60 + $.10

Now that you know the basics what makes up an option, let's move on to some of the most important option-trading rules that all investors should know.

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Options Education

Intro to Options

Every day, options traders around the world profit from the rise and fall of equity markets. Even when the general markets are down, there is profit to be made if you simply know how to make options work for you. Options can become very powerful tools in the hands of the educated investor. They allow investors to make money regardless of overall market conditions, with strategies so diverse traders can tailor their approach to be conservative, to protect or "hedge" their positions, or even be aggressive with money they can afford to lose.

Options are so versatile they can be used in a wide range of investment strategies and goals.

For Example

• Options may be used to buy stock at a lower price than "retail".
• Options allow traders to participate in the ups and downs of a stock's price without even owning the stock.
• By executing certain strategies, you can potentially make a monthly income on stock that you currently own.
• You can protect a stock or even make money when the market goes down.

You have probably heard of the inherent risks in options and have been told they are primarily used for speculation. In reality, options can be very conservative or very aggressive, depending on the forecast you have for the stock and the strategy you want to employ.

In fact, some of the earliest option applications were used to reduce risk rather than increase it. For example, in the commodity markets, options are used to lock in fair or reasonable prices in a potentially volatile future.

Background of an Option (Historical Example)

You may have already heard of the Dutch tulip mania in the 1600's. When tulips gained popularity with those of royalty, the general demand increased for all types of bulbs. Tulips became a status symbol and tulip bulb prices rose dramatically. As bulb prices increased, Dutch growers and dealers began to trade tulip bulb options to lock in prices and insure profits. As public interest grew, greater numbers of people speculated on future price increases. In the beginning, this proved to be profitable. This situation only caused the speculation to increase and tulip bulb prices continued to soar even higher.

The bubble soon burst and as prices dropped, the buying frenzy became a selling panic. People lost their homes and their livelihoods, banks failed, and fortunes were lost. Although greed, reckless speculation, and the use of borrowed funds to invest caused the financial collapse, people blamed options. This was because tulip options were responsible for enabling people to speculate with small amounts of money and large amounts of leverage.

We should learn the lesson that leverage can work against a trader just as easily as it can work in his or her favor.

In America during the 1920's, the option market was unregulated and there were many abuses by underground option pools. During the congressional hearings to establish an oversight committee, which eventually became the Securities and Exchange Commission, the initial reaction was to make all options trading illegal. However, Congress gave the Put and Call Dealers' Association a chance to speak out.

The Association explained the difference between options where put-call dealers deal openly for a consideration and manipulative options secretly given for no fee. In other words, there were both good and bad options, but the lack of knowledge about the proper use of options and the heightened public awareness of option pools led many in Congress to conclude that all options were speculative.

The proposed bill read: "not knowing the difference between good and bad options, for the matter of convenience, we strike them all out." Members of the committee also expressed concern about the number of options that expire worthless. It was stated: "If only 12 ½ percent are exercised, then the other 87 ½ percent of the people who bought options have thrown money away?" The reply was, "No sir. If you insured your house against fire and it didn't burn down you would not say that you had thrown away your insurance premium." The committee initially saw expired options solely as a monetary loss rather that a means of insurance against potential loss.

This argument convinced the committee that options have economic value and when properly used, options can be valuable investment tools. The options business survived the hearings and the SEC assumed regulating authority under the Securities and Exchange Act of 1934. The SEC still regulates the options industry today.

What is an Option?

An option is a contract that derives its value from an underlying asset. That contract either gives the owner the right to buy the asset (call option) or the right to sell the asset (put option) at a predetermined price and within some predetermined time frame.

The key idea here is that the owner of an option has a right, not an obligation. If the owner of the option does not exercise this right before the predetermined time, then the option and the opportunity to exercise it cease to exist, the option expires.

Seller (Writer)

On the other hand, the seller (writer) of an option is obligated to fulfill the obligations (requirements) of the contract if the option is exercised.

In the case of a call option on stock, the seller (writer) has given someone the right to buy the underlying asset. The seller of the call option will be obligated to sell the stock to the call option owner if the option is exercised. The owner of the options literally has the right to CALL the stock from you.

With a put option on a stock, the seller of the put option has given the right to sell that stock to another party. The seller of the put option is therefore obligated to buy the stock from the put option owner if the option is exercised. The owner of the options literally has the right to PUT the stock to you.

Option Examples

An option is a derivative. It derives or gets its value from an underlying asset. We are already familiar with them. Did you know that you are using a form of options as part of your daily life? Have you purchased insurance as a safeguard against a fire in your home, a crash in your car, or large medical bills? Do you pay a premium for your house, auto, and medical insurance? Then you have purchased a type of option. The fact is, options are a part of our everyday life, and have valuable application in our trading and investing.

Auto insurance, health insurance, and homeowner's insurance are all examples of put options. These options transfer the risk of loss from the owner of an asset to the writer (seller) of the put. Insurance companies are basically put option dealers.

Leverage

Leverage is the term used to describe the profit or loss potential when a small amount of money controls a large amount of money. The owner of one call option has the upside potential of 100 shares by investing a smaller amount of money rather than purchasing the stock outright. If there is a 10% rise in the stock, the option can double in value.

A word of caution: leverage also increases our risk. A 10% decline in the stock can result in the total loss of what we paid for an option.

Example

Purchase100 shares stock @ $32 for a cost of $3,200.00. If the stock rises from $32 to $42 you would have a $1000 gain or a 31% increase.
OR
Control 100 shares of stock by purchasing the option at a premium of $3 per share for a cost of $300 (1 contract x 100 shares x $3 premium = $300). If the option premium rose from $3 to $11, the original cost was $300 and it is now worth $1100. You have an $800 profit, but a 266% return!

When comparing the stock purchase to the option purchase, your stock purchase will have a moderately high dollar profit. But your option purchase will have a significantly higher percentage return.

Diversification of Options

• The possible payoff of options can make them very appealing – even seductive – for many investors.
• Those potential returns come from leverage.
• That leverage can also bring greater risk.

A ten percent increase in the underlying asset can potentially double your money in the options market. On the other hand, a ten percent loss in the underlying asset and you could go broke. Too many amateur investors or beginning traders do not take enough time to think about the potential downside before jumping in with leverage.

In the end it is all about control and choice. By having knowledge of options we are no longer limited to the buy and hope strategy. We can now make money in any type of market situation. We can be very aggressive or we can be conservative depending on our investing personality and objectives. There are several strategies you can implement with options. They can be broken down into basically two groups: trading strategies and investing strategies. Since the primary focus here will be on investing strategies, let's take a look at the breakdowns to get the big picture.

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Secret Head And Shoulder Pattern

Secret Head And Shoulder Pattern

-Initiated by the uptrend
-There are 3 pieces top
-Peak of the middle called the Head
Peak left-called left shoulder
Peak-called right of right shoulder
-Top of head should be higher among the three
-The line that connects "the two lowest point in the formation" called Neckline
-The closing price below the neckline is a validation.
-Target is determined based on the projected closing "the vertical distance the top of head to the neckline".

Ideal volume on the pattern Had And Shoulder
-Volume on Head should be thinner than left shoulder
-Most importantly, the volume on the right shoulder is the thinnest volume when compared to the head or left shoulder
-Volume increases during breakout
-Volume thinning when (if it occurs) pullback
-Volume again increased during continued downtrends after pullback.

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Head And Shoulder JSX.JK (IHSG)

Head and shoulders

Head and Shoulders pattern is one of the patterns reversal most popular and reliable. Head and shoulders pattern is the parent of the other patterns within patterns charts. Head and shoulders many technical experts say the pattern has the strongest and highest accuracy.
Figure above shows JSX.jk (JCI) was formed head and shoulders pattern which is initially formed from a up trending charts. The Basics (A, C) and peak (B, D) looks more and more high (higher lows and higher-high). Until the uptrend seen here is still normal, then gradually began to show signs of losing momentum since the last peak (F) is not able to reach the previous peak level (D). Peak B is called the left shoulder, peak D is higher referred to as the head, was the top F is called right shoulder. Straight line drawn by connecting points C and E is called the Neckline. Notice in the image above JCI (JSX.jk) shows that has not penetrated Neckline (position 2288.5), likely a few more days will happen efflux neckline line. If it happens the neckline line penetration, then the reversal signal is said to have a validation. Furthermore the minimum price objective is often called the target can be determined. The trick is to project the "vertical distance between peaks Head (D) with a neckline" to "breakout point on the neckline, looks at the position of the target 2016.33.

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