Understanding Options

Transcription

1 Understanding Options

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3 Introduction... 4 Option Contracts... 4 Call Options... 5 Put Options... 6 Using Leverage... 7 Pricing An Option... 8 Learning the Basics Understanding the Bid/Ask Spread Changing Sides Buying Vs. Selling Managing Positions at Expiration American Vs. European Cash Vs. Share Settlement Avoiding Major Pitfalls Choosing Your Position Understanding Implied Volatility Giving Up Your Edge on Entries Fibonacci Ratios Closing Statements

4 Introduction For many newcomers to the stock market, the possibility of making money by trading from the convenience of a laptop is intriguing, dangerous, and exciting. When the markets are closed, take the time to learn the facts presented in this collaboration. This collaboration specifically tells newcomers to the business how to use and understand option contracts. For those just entering the field, moving into the world of options can be somewhat daunting. For those coming from a stock background, the most simplistic form of understanding these methods would be buy low and sell high. In theory, this idea breaks it down so even the newest members can understand, but that doesn t mean it is always so simple. With options, however, there are many working parts which make the machine, as a whole, more difficult to understand, and even harder to master. That said, trading still invites newcomers to compete along-side lifelong professionals, unlike sports, where, for example, one could not sign up for the Masters after learning a basic golf swing, nor could an individual compete as a professional racecar driver after simply learning how to operate a manual transmission. If you feel like you ve just set foot inside the Endeavour spaceship, where hundreds of lights, buttons, and screens blink and beep in your direction, a sense of overwhelming tension can creep up, causing a clear disadvantage in the market. We overcome this disadvantage with a clear understanding of the market we re participating in, with a foundational knowledge of how each part works. This foundation begins by understanding what an option contract is, how it works, and how you can implement it into your specific trading techniques. For those who already feel overwhelmed, remember to take each working part one step at a time, breaking them down into pieces one-by-one, much like learning a dance, step-by-step, slowly mastering the entire process. Option Contracts An option contract, also known as an option, is defined as a promise that meets the requirements for the formation of a contract. Essentially, this is a binding contract between two parties. 4

5 An option simply means that the buyer has certain rights. The buyer is the optionee, or beneficiary, of the contract. This individual has rights, but not necessary an obligation, to long (or short) a stock from a predetermined price. There is a date until which this contract is good for called an expiration date. There are two types of options contracts calls and puts. Call Options Call options give the buyer a guarantee that the person who sold the option, will sell those shares at a predetermined price. That predetermined price is also known as the strike price. As a bullish bet, it is likely to go up in value. Bullish means that an investor believes a stock price will increase over time; similarly, investors who purchase calls are bullish on the underlying stock. Conversely, bearish indicates that an investor believes that the stock will decrease in value. A call option is a bet that the stock is going to increase in value. For instance, if one predicted that Apple s stock was on the verge of rising, that person would buy a call option. The higher Apple s stock climbs, the more the call option appreciates. The risk with options is that the option could expire worthless. If Apple s stock were hovering at $500 and one bought a $510 call, it would expire worthless and the premium paid would be lost by that unfortunate investor. What that seller managed to do is called writing an option. If a stock were going to go lower, one could sell those options to a third party who believes it will go higher. That is called writing premium, or collecting premium. Writing call options is among the riskiest of trade strategies. A particularly unfortunate scenario was illustrated when one individual sold hundreds of a $50 call option for approximately one dollar; when the stock price was $48. The call ended up expiring worthless, but that person had initially thought he would make $25,000 on the trade. The next day he received the news that the stock was up over $50 a share, as it was being bought out. The money he had invested was unable to be recovered. That is the risk associated with writing call options. When one purchases a call option, it offers the right to buy a given asset at a fixed price, also known as the strike price. If a call option is purchased at $5 and the underlying asset increases in value, the call will increase in value as well. At any time before the specified expiration date, the option writer (namely, the individual who created the option purchased) has a legal obligation to sell the asset at the strike price. Call options that have a strike price below the current market price of the underlying asset are said to be in 5

6 the money. If Apple were at $500, a $450 call option would be considered to be in the money, while a $550 call option would be out of the money. Those acronyms are common: ITM, OTM, and ATM, or at the money. Put options (discussed below) are the inverse of this. It is also critical to remember that an option price consists of both the intrinsic value and the time value. The former is the amount that the option is in the money. For example, if Apple s price was at $500 and there was a $490 call, $10 of that option price is intrinsic. Extrinsic (time) value has several variables that create that dollar value. Buying a call option is the least amount of risk that one could take. Selling a naked call option, on the other hand, is the riskiest endeavor. The downside is essentially unlimited. However, this should not indicate that buying will offer a constant stream of income; if one purchases the wrong stock option, no money shall be made. For instance, if a stock trades at $520 and there are options available at a strike price of $570, this would indicate a tidy profit if the stock were to rise in price. However, the stock could trade sideways, which would leave the trader with nothing as the option expires worthless. As an example, if Apple s March $515 call option was priced $ The option buyer had the right to purchase 100 shares of Apple stock at a strike price of $515 per share any time prior to the expiration date. If Apple was at $520 and one bought the $515 call option, and the price might rose to $550. Then an instant profit could be made because the stock is actually trading at $550. However, there is still the option of buying the stock at the price of $515. Some experts discourage the purchasing (assigning) of stock, which is uncommon but not unheard of. Generally the option is either bought or sold. Put Options Put options are the opposite of call options, and again, one can buy or sell a put option in the same manner as a call option. If Apple s stock were going to go down, one would buy a put option because as that stock descends, the put option will increase in value. These options give you the right to sell shares at a given strike price. Selling naked put options is a popular income strategy. For instance, if stocks keep rising, like days when Apple continues to rally, one would sell naked put options. If the stock keeps rallying and the put options expire worthless, the premium received could be kept as income. This is a more conservative option than selling naked call options because a stock can only fall to zero, and the 6

7 difference between the option strike and zero would be the maximum loss. One can also mitigate the risk by utilizing credit spreads. (more on this technique later) As mentioned earlier with an option being in or out of the money, with put options, the inverse holds true: if put options have a strike price above the current market value of the underlying asset, those would be considered to be in the money. If the strike price were below the current market value, those would be out of the money. The purchase of put contracts gives the buyer a bearish outlook on the market; meaning that they hope the value will actually go down. Therefore, we buy puts when we expect a market to drop and buy calls when we expect it to rise. While it seems that we could merely buy stocks rather than options, there is one reason why options are so important: leverage. Leverage means that a small amount of work can move a large force. Imagine using a pulley system to lift a heavy object, or using a crow bar to open a jammed door. Leverage can help small individuals move large objects. The leverage of options can help build a powerful portfolio. Using Leverage Leverage can actually allow traders with small accounts to grow exponentially while also allowing traders with large accounts to free up excess capital. It is imperative to maintain several different accounts with which to work. Some traders keep multiple accounts, each engineered for different work: short-term, long-term, day trading futures, swing trading options (swing means holding for more than 1 day), among others. Consider the example of RAX. Currently, RAX is trading for $31.76 in the market. A typical order of RAX may be 100 shares, for a total of $3, $31.76 x 100 = $3, A delta 1.00 call option (delta meaning the rate of change for an options price, relative to a one-unit change in the price of an underlying asset) will give you the exact same price movement as the 100 shares of stock, but it will only cost the buyer $800, rather than a price over three grand. Generally, one should aim for a delta value of 70 or higher. Gamma, additionally, is the rate of change of the delta. (more on this later) 7

8 In both of these examples, the buyer will receive $100 for every $1 that RAX increases. If both of these scenarios give the same movement, why not trade option to save on capital? Usually when something is too good to be true, it is. In this particular scenario, it s important to discuss the other moving parts that make the machine operate. Leverage does not come without a cost. Traders who overleverage themselves may not truly understand the risk involved. Imagine giving a fulcrum to children, or even adults who haven t been trained in operate the device, and then asking them to move a large object; risk is involved. Pricing An Option In terms of our machine s moving parts, this really only refers to how an option is priced. The most common method is the Black-Scholes Option Pricing Formula, which has been the premier method of valuating options since Fischer Black and Myron Scholes published their theorem regarding the subject in 1973: 8

9 To be fair, the formula above is a little overbearing and most traders will never actually have to use it. It s included, however, for those who would like to understand the fundamentals of trading. Specifically, this formula emphasizes the point that your options price is a moving target. Exercise comes back to being the buyer vs the seller. If you re long the option you can exercise [buy the stock] at any time. For beginners, the following variables should be noted from the formula above: 1. Stock Price 2. Strike Price 3. Time Until Expiration 4. Volatility Of the four variables listed above, volatility is perhaps the most critical. Implied volatility (IV) is one of the most important concepts for options traders to understand for two reasons: First, it shows how volatile the market might be in the future. Second, implied volatility can help you calculate probability. There are various indexes to watch on a daily basis: NASDAQ 100 options (the continental benchmark for securities and technology stocks), ETFs (exchangetraded funds), SPDRs (as said before, an abbreviated version of Standard & Poors depositary receipt), and others. There are even reverse-etfs, in which an exchange-traded fund, which is made by utilizing various derivatives, leads to a profit from a decline in the value of an underlying benchmark. These are ideal for traders who feel comfortable doing shorter-term work. Some individuals believe that market internals, or hourly updates from within the market itself, provide valuable information. While they do offer information and help situate a trader before buying or selling, the data is not the benchmark from which someone should measure. If the trading is to be done on SPDRs, then market internals will be valuable. Other times, market internals will indicate an overall downward trend while individual stocks are rising. With that in mind, IV can be measured as a deviation or variance between several returns within a security or market index. Essentially, the higher the volatility, the more risk involved. 9

10 Learning the Basics The image below can come off as a little daunting to newcomers, but remember to take each piece one at a time, and you will soon learn the entire puzzle. From left to right, each of the four working parts is presented above. Time Until Expiration is on the left, in red. On the upper right, Stock Price is listed with Strike Price and Implied Volatility sit underneath. This specific example comes from ThinkOrSwim.com, so not all programs will be designed, or presented in this exact way. 1. Stock Price 2. Strike Price 3. Time Until Expiration 4. Volatility In this example, the Time Until Expiration is presented in red, with exception to the third option. When red (in this example), these are generally weekly options. The strike price points to different numbers. These strike prices relate directly to the underline stock price. With options, it s important to understand what the stocks may be worth upon option expiration, to know if these stocks or bearish or bullish. 10

11 It s important to think of where the stock is trading. In many cases, 90 percent of lower priced options will not lead to success and will expire worthless. Instead, take time to study those options that sit within the money. In addition, think about options from their intrinsic standpoint. Implied volatility is the next step to study. Take a look at the numbers presented here, listed in black font on blue background near the Implied Volatility bubble. In this example, the numbers are relativity the same until April 14. When you see something like this (a jump from 15 to 25), this usually signals an earnings period for the company. Market makers (traders on the other side of your position) price the option to cover their risks. Essentially, rather than take the chance of losing any money, the price simply rises during earnings periods to make sure the stock doesn t take any large jumps or falls. Now, take a look at the four black rectangles. Apple is bullish, but it s also important to know when/how the stock might move. For example, if you expect the stock to move within 48 hours, you can examine how the stock has moved in the past. If the numbers will not add up in 48 hours, consider giving yourself seven days for the stock to move, knowing you will only pay an additional two dollars overall. In April 5, many of these numbers nearly double (presented in lower portion of graph). This is a direct impact of the Implied Volatility. This is crucial and relates back to the intrinsic value. For example, take a look at the 540 call. Take a look at the beige colors on the left side of the chart above (page 7). For this particular example, the beige strikes are in the money and the white strikes are out of the money. While the 540 call is in the money, it s only worth $2.55, with the remainder of the value being the juiced up volatility along with the premium, making profit difficult to attain. When an option expires in the money, it will be worth however far it is in the money. Meaning, if these options expired on Friday, then they would only be worth $2.55. When purchasing directional calls, timing is everything. Also, despite these numbers being presented in the form of decimal dollars, when buying, they actually represent hundreds of dollars. For example, if you were to purchase a 2.55 stock, this is actually $ and not $2.55, in real dollars. 11

12 This all comes down to intrinsic value, versus extrinsic value knowing what that option will be worth upon expiration. Imagine buying the 540 call, and doing so for only $15. Now, where will that set your break-even price? Paying 15 up front means that Apple will have to be sitting at 555 on the expiration date just for the buyer to break even. If the call was only $10, but sat at 550, then the stock would have to increase all the way to 560 just for the buyer to break even. For those not paying close attention, in this scenario, it s possible to take a large hit, losing money upon expiration. Once again, if this seems overwhelming, take some time to digest the chart above, allowing for the information to sink in. These four variables will come back again and again. 12

13 Understanding the Bid/Ask Spread Presented in red next to the stock price, the Bid/Ask spread is presented as two numbers. Unlike all other purchases, there is not a listed price. At your local grocery store, all items are priced and there is nothing more to discuss. The Bid/Ask Spread itself is the amount of money by which the ask price actually exceeds the bid. With trading, there is always a negotiation that takes place, much like how buying used to take place in the market place. The negotiation exists between the buyer and seller, along with hedge funds, floor traders, and those trading online. Using a Bid/Ask, there is no set price, but a variable that needs to be agreed upon. Let s take a look back at the Black-Scholes model to understand more. With theoretical pricing, take a look at the Mark, Volume, Open, Bid, and Ask. In the example above, using Theoretical Pricing, there is no Stock Price Adjustment or Volume Adjustment, which means that stock should (theoretically) trade at The Bid/Ask spread, indicated by the fifth and sixth columns, is 35 wide, sitting between 8.15 and In this sample, there were over 3,000 sold (Volume). The Bid is 8.15 and the Ask is 8.40, so (theoretically), the bid rests somewhere in the middle, in the case at 8.27, with sellers asking for more and buyers asking for less. When searching for equilibrium between the two, a sell can be made. Let s look at another example. 13

14 This option is not nearly as liquid as the previous option. Auto Zone traded 232,723 options that day, which is relatively thin. In this scenario, that will affect the numbers. Specifically, AZO doesn t trade weekly s (or weekly options, for which premiums can be extremely high; when dealing in weekly options, it is best to be a seller as opposed to a buyer), but they do trade monthly s, meaning there is not an option to sell a spread the following week. Lower volume stocks do not have weekly s. In this example, the Bid/Ask rests between and For newcomers, it s best to focus on liquid markets, such as the one illustrated in the first example. In the example above, looking under volume on the chart, only 1 single option was traded that day, on an interest of 88. That means that only 88 people have come into to purchase a fresh interest in the stock. The Bid/Ask spread specifically relates to what the market maker will ask for and what the buyer will pay. Much like an asking price at a car dealership, there is a sticker price (MSRP is theo price), but there is some leniency until the two parties reach an agreement. The agreed-upon price is the last price traded, or last. Keep it simple: an option is only worth what a buyer is willing to pay. 14

15 Changing Sides Once these ideas have become more understandable, buyers are more comfortable thinking of themselves as the market makers, or sellers. Imagine buying a car from a dealership, and then becoming an independent dealer. As a seller, you want to find the highest bidder in order to make the most money. Buying an option versus selling one is also a key factor in how the Greeks will affect your position. The main three to focus on are delta, theta, and vega (theta meaning the measure of premium decay, and vega indicating the measure of how much an options premium will increase or decrease given a change in volatility). Buying Vs. Selling Selling options can give you an edge in the market. Take a look at the 535 calls in Apple (APPL). In this scenario, we see a delta of.56, theta of -.22 and a Vega of.43. Disregard the positive and negative values until you actually take a position. This can be especially confusing when one number is negative and the other two positive. If we come in as the buyer of the option, then we will be focusing on the bid and the theo price. Once we enter our position, the Greeks will take a positive or negative stance. 15

16 In this example, we have one loan option that has fourteen days before expiration. The market price is 538 and the market change is -4. There are long deltas, which rest at 57.37, meaning that as APPL rises, the market will rise at that value. However, each day theta will fall , as theta moves exponentially rather than linearly, which is different from delta and vega. This means that if APPL opens up at 538 and doesn t move a penny, the buyer will still lose 21 dollars due to leverage. Therefore, our contract will react each day as we move forward in time, to each dollar the underlying rallies and how much the contract will gain or lose for each 1 percent change in the volatility of the underlying asset. If the seller of the option focuses on ask and theo price, then the Greeks will take their corrective positive or negative stances upon the position. In the above example, the stock was sold, reversing the values of the Greeks. So, if the individual sells, the seller will lose 57 dollars. Whatever hurts the buyer will help the seller. This occurs because theta is the only Greek that will absolutely move forward. Short options carry more risk (leverage), but it puts the constant variable of time in your favor the only real truth within the formula. It is always important (and always worth the investment) to pay more for time. Without time, the market will work the trader instead the trader working the market. 16

17 Managing Positions at Expiration The third Friday of each month is the monthly expiration. This is where all standard monthly equity options will stop trading and the buyer/seller will have to determine whether or not they are in or out of the money and what that value means to their overall portfolio. Some index options will vary on their expiration, but there are ways to better understand those issues. Remember; take options and their expirations one step at a time. American Vs. European American style options (MSFT, APPL) can be exercised anytime on or before the date of expiration. With European options (RUT, NDX), these can only be exercised at expiration. Cash Vs. Share Settlement Cash settled options mean that there is no way for the buyer/seller to be assigned shares of an underlying at expiration. The strike of the contract will be compared to its moneyness and the different will arrive in the account. If an individual expires in the money with APPL, for example, it s possible to be forced to take the shares, depending on the size of the account in question. If the stock opens flat, meaning it can be flipped on the same day to meet margin requirements, there is no harm. However, if there is a heavy margin, it s possible to take a loss, putting the individual back to square one. 17

18 One way to remind your-self, or verify that a market would be cash settled, is to look the volume for that ticker. In the case of SPX, this is cash settled because there are no actual shares of SPX or trade. It is simply a measure of the S&P 500 that gives us another instrument or trade. As the buyer, there is more flexibility than the seller, which is why most people begin as a buyer rather than a seller. As a buyer, there is no risk when action is not taken, which is untrue in the case of sellers. Note: in this example, the No Volume option has been presented using the Think or Swim website, which presents a flat-line for study. 18

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20 In these two images, there is a different between SPX, with SPX expiring early. Make note of the days left showing in your trading platform. These two images specifically show the difference of SPX against NDX, with NDX expiring a day earlier. These were taken together to show that NDX has already expired. These platforms can actually take a great deal of the difficult work out of the equation. 20

21 Avoiding Major Pitfalls First, choose your position size and manage risk accordingly. Understanding and managing risk based on the initial investment is perhaps the most important aspect in trading. Understanding implied volatility is another aspect of avoiding pitfalls. With earnings, the market will make an example of you if your actions aren t performed correctly, using all known information. Much like covering a spread, many buyers will assume that APPL will make money during earnings, which they usually do. However, even if they make money, they may not make enough for the buyer to make a profit, or even break even. This will lead to these buyers feeling as if market makers took advantage of them, when the truth is that they didn t understand the inner workings of the system. Finally, giving up your edge on entries is the last mistake to avoid. Choosing Your Position With options, there are countless variables to consider. Make sure to understand those variables, giving each their fair share of understanding. This will differ for everyone and is something each person must learn in order to make progress in the market. This will also vary depending on what type of goals each person has within their own specific portfolios. Many people do not understand the risk because they assume they are choosing a winner. Like gambling, do not risk more than you can afford to lose. As an example, let s say you re trading on a $100,000 account and you re focused on steady income and would like to limit drastic swings in the account. Meaning, you will sit around the 2 percent range, which is $2,000 to risk. While $100,000 may seem steep at first, it s a solid number for providing examples. Feel free to scale this number to better fit your needs after understanding the basics of the formulas. Sizing up a 2 percent risk ($2,000), will differ depending on the strategy being used. Directional calls are easiest to measure in this case since it is a debit transaction, meaning you can add up contracts until you reach your limit of $2,

22 For example, if an option is $5.00, you can buy 4, because that $5.00 actually equals $500, and four would equal $2,000. Situations where you sell a spread are different, but your risk has been defined. If you re selling a spread that is $5.00 wide and you take a $2.50 as a credit that means you have $2.50 of risk ($ $2.50 = $2.50). Then, using the max value, divide it by the dollar amount, meaning you could sell 8 of these options at $250 x 8 = $ For smaller accounts, focus on doing longer-term, directional plays. Buy options around 100 days out. When selling spreads, you must take into account the larger risk, or loss, possible. Look at risk with the attitude: What is the absolute worst case scenario for my position, and how much would I lose if that came to pass? Using this kind of risk control for your account does several things to help newcomers to the world of trading. First of all, you re never going to blow an entire account on a single trade, though there might be some considerable damage. There are certain traders who feel that the market (or the world) is against them. With this mindset, poor performance becomes acceptable, which is wrong. Know your risks. Next, you will have a more objective outlook on your position rather than being stuck focusing on the P/L (profit and loss). Put on the spread and know how much you are risking by keeping a strict limit on what you can afford to lose. Do not find yourself in a deer in the headlights situation, or, in a trade you can t handle. Meaning, do not tense up due to exceeding your risk. 22

23 Understanding Implied Volatility Implied Volatility is one of the Greeks previously discussed and is an enormous factor to give an edge in options trading. This is a computed value that has to do with the option itself rather than the underlying asset. Simply put, this states that the intrinsic portion of an option will always remain the same. The premium portion of that option, however, has the ability to change drastically depending on surrounding circumstances. If the stock is right before earnings, there might be an extra $20 of premium since the implied volatility jumps up 100%. The above is why some traders have trouble with straddles prior to earnings, which is an options strategy that has the investing holding a position in both a call and put, with the same expiration date and strike price. The first way to understand this is to look at a direct comparison with basic implied volatility. This indicator can be found on most trading platforms. Here, we have the clean price option and the basic implied volatility. In this example, we can see earnings as they arrive over the span of a year. These same earnings, which seem positive, can crush newcomers who do not understand earnings. If the implied volatility is approximately 20% or anything up to 40%, that is a deal that is safe and worth considering. If a deal is anywhere in the upper range anywhere near 80% or higher one should be extremely careful. There will be a large premium attached to that deal. 23

24 Take a look at the small icon on the upper graph. As APPL earnings arise, the lower graph falls tremendously. Buying high volatility in this example caused a big loss. While the numbers do arise towards the day of earnings, it will then fall and the pattern will continue to repeat itself. Now, let s split the implied volatility into thirds. While these values aren t exact, they can be used for traders as a general measure on whether they should be buying or selling options. The volatility analysis can help decide whether the numbers will rise or fall. By splitting these numbers into thirds, traders can compare the results of APPL to other numbers along the same line. Many traders will examine the results of Apple and then compare those numbers to Google, which is like comparing apples and oranges. Instead, use the graph above to compare Apple s numbers to Apple, extended over a period of time. This visual graph shows the highs and lows to better help traders understand the range. Draw a line at the highest point and the lowest point. Then, begin to think about your individual contract, helping decide when and how to trade. For Think or Swim users, there is also another way to analyze this value. 24

25 Check the Trade tab in Today s Options Statistics. This is essentially the same numbers as presented on the graph, but rather than an image, there is a numerical value assigned to each point. Therefore, when examining the two graphs, notice that the 17 percent represents the end of the green line of the graph above Today s Options Statistics. Meaning, Implied Volatility is at a low point, when compared to the possibility of 100 percent, which would be the highest point that the green line reached. The percentage comes from the highest and lowest point of the graph. 25

26 On this bar graph, it s time to once again consider the rule of thirds. The Buy Options represents 0-33 percent. The Buy or Sell represents the middle of the range, providing options to traders. With Sell Options, the IV range (or implied volatility range) is the highest. When the IV range is in the upper portion of Sell Options, it s not possible to buy options. Play volatility as its own independent trading instrument. With the spread, buy a long contract with the hope of not having to use it. Much like putting insurance on a home, it is something for safety that you hope not to use. 26

27 Giving Up Your Edge on Entries This is a lesson on discipline. With options, if you give up your edge, you can lose. When you first start trading options, or trading in general, there s a tendency to wait to get in until things look good. The problem with this is once you think things look good, so does everyone else. This is typically where professionals are waiting to unload their positions (selling them at the ask in the most lucrative examples) giving buyers a bad buy. To avoid these situations, just remember if it feels like you are chasing, then you are. Step back and wait for retracement. Know what you are willing to buy and if prices don t meet that point, wait for the next opportunity. Also, do not buy extensions. In regards to extension, prices above 100 percent of a given swing, typically percent and percent, these swing ratios are beyond this text, but simple enough to understand to get an edge in options. For those unsure of whether or not they are chasing, focus on extensions. Looking at SYK, the closing bar notes a new 52-week high, giving a bullish appearance to the chart above. This also depends on the amount of data pulled (meaning for ten days, it would be the high of ten days ). 27

28 This feature is especially useful to find a 1-year high or 5-year high. This data can help traders known when and how to make a purchase. However, on this chart, when these new highs are compared to the percent extension, traders can see that the risk to reward ratio is incomprehensible. These results from Fibonacci ratios and their existence in the market. Fibonacci Ratios Fibonacci ratios are a tool that technical traders use to identify key numbers. Developed from mathematician Leonardo Fibonacci, the sequence of numbers results in extreme points on a given graph. After levels have been identified, a horizontal line identifies support and resistance levels, as presented above. In the example above (page 23), the extreme high to the extreme low (swing high to swing low), the horizontal line represents 100 percent. The point at the end of the graph, the point represents percent, as it sits above the swing high. While fundamentals are important, the buy and hold era is coming to an end, so these ratios are crucial when it comes to risk and profit. 28

29 Meaning, in this example, if you choose to buy at 84.12, this essentially means that you can make a dollar, but you are willing to risk six dollars, which is foolish. We are trying to predict what will occur in the future, taking as little risk as possible. When everyone is trying to buy, the higher-ups are most likely about to dump, which can cause a loss to many newcomers within the market. Closing Statements Most individuals who trade options lose money. This is because the only approach utilized is that of purchasing options. There need to be other option strategies in place, and players need to remember that 80% to 90% of options expire worthless. The general public will buy options without paying attention to the fair value of the option and the implied volatility. This can lead to buying overpriced options and losing even more money. There are many beginners mistakes that can ensnare the unsuspecting trader, such as not diversifying strategies and not chasing out of the money options. However, a trader simply needs to purchase delta 70 options with an implied volatility that has not skyrocketed. Furthermore, do not chase a big move with an out of the money option. With a bit of time, practice and patience, sticking to this fundamental outline will increase returns, lower stress, and hopefully give you a relatively gentle introduction into the world of options. To learn more about options you need to bring theory into the real world. At Simpler Options we have a nightly options trading video newsletter service that will prepare you for the next trading day. Normally this is $79 per month, but as a reader of this e-book the first 30 days is only $7. If you would like to continue this Journey with Simpler Options for 30 days for only $7 visit us at: