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.