Trading Basics and Mechanics Wall Street is Always the Same; Only the Pockets Change

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Timothy Gaines
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1 Chapter 4 Trading Basics and Mechanics Wall Street is Always the Same; Only the Pockets Change Trading in the financial markets should be approached as a business, and few businessmen are successful over the long term without a written mission statement and a business plan. Most people would see this as mere common sense. However, it seems the same logic does not apply to many new traders. Rather than planning how and where their capital is to be allocated, new traders often plunge head first into a trading career with little to no regard as to their risk and profit objectives. By failing to have a trading plan, a trader will not know what to do when the market goes in their favor, or worse still, when it moves against them. Without the structure that a trading plan provides, you will find yourself not only at the mercy of changing market conditions but also of your own conflicting emotions a sure recipe for disaster. In this section we ll use screen shots from the thinkorswim trading platform. Most online brokers will show similar price quotes, option chains, and all other financial data in a relatively similar fashion. There will be slight variances across most data provides, but so long as you know how to read and interpret the information being presented, you ll be able to start virtual trading immediately. Let s get started. Reading Stock Price Quotes One of the first requirements for a new trader is learning how to read quotes from their trading screen. Though each quote vendor will provide tools for translation of their options quotes, it is useful to know the methods that the exchanges use. Consider this thinkorswim quote screen for Apple Computers, ticker AAPL. This box displays quotes and volume statistics on the underlying security. Figure 1: Price quotes on Apple Computers (AAPL) through thinkorswim. Last Price: The last price that a buyer and seller traded the underlying stock for. Net Change: This reflects how much the stock is up or down compared to the prior day s closing price. Bid: The price that you would get if you sold shares of stock. Ask: The price that you would pay if you purchased shares of stock. Size: The amount of shares on the bid, versus the amount of shares on the ask. Volume: How many shares have traded on a particular day. Open: The first printed price of the trading day. High: The highest price recorded on the day. Low: The lowest price recorded on the day. Reading Option Quotes As we transition into options trading, you will want to become more familiar with how options are quoted as well. We won t get into the basics of options yet, we ll just touch on how to read their price quotes. Let s start with a basic options symbol, which has three parts: Base symbol for the underlying stock Expiration month symbol Strike price symbol The base symbol for options is never more than three characters in length and is usually the same as the stock symbol. The three characters or less system works well for most listed stocks, but NASDAQ listed stocks are normally four characters in length. For options in these companies, the CBOE has created three character symbols for the options of these companies. Trading Basics and Mechanics Page 1

For call options, the letter A stands for January, B stands for February, up to L for December. For put options, the letter M stands for January, N is for February and so forth, up to X for December.

2 The second part of an option symbol is the expiration month code. Expiration month codes are one character symbols that serve a dual purpose. First, expiration month codes identify the expiration month of the option. Second, they designate whether or not the option is a call or a put. For call options, the letter A stands for January, B stands for February, up to L for December. For put options, the letter M stands for January, N is for February and so forth, up to X for December. The letters Y and Z are not used for expiration month codes. The chart below illustrates how the symbols are used. Figure 2: Option Symbols Expiration month codes. The third and last part of an option symbol is the strike price code. Strike price codes are also one-character symbol that identify the exact strike price for an option. A stands for $5, B stands for $10, on up to S for $95, and T for $100. If the strike price exceeds $100, then A could stand for $105, B for $110, and so on. Below is a chart illustrating the strike price symbology. Figure 3: Option Symbols - Strike price codes. Activity: Below are a few examples of how option symbols are constructed. See if you can follow along with the tables above to match the symbols with months and strike prices. Examples of Option Symbols IBM IBM IBM July 200 call IBMGT Cisco CSCO CSCO April 20 put CYQPD Ford F Ford March 10 call FCB General Motors GM GM December 25 put GMXG Now that we have the basic framework in place to read option quotes, we ll move into the options chain. With option symbols it s important to know that you won t need to memorize this, rather just understand how it works. An option chain will help simplify reading option prices, and depending on the platform, you might not even see the option symbol. Option Chain As we learn to read and interpret price quotes and market data, the next area we ll transition into is the option chain. The option chain is very similar to reading stock price quotes. The biggest difference is that there can be a tremendous number of options available on a stock, and several months of expiration to select from. Trading Basics and Mechanics Page 2

3 Take a few moments to examine the graphic below. This is a snapshot from the thinkorswim trading platform. Most option brokers present an option chain in the same layout, so chances are if you use another trading platform, it will look similar to the graphic seen below. Here are the basic details: Call options are listed on the left side of the chart, put options are listed on the right. Strike prices are listed vertically down the middle of the chart. Horizontally, you can expand a specific month of expiration to view the listed options. Figure 4: Option chain on Ford (F) through thinkorswim. With some option specific brokers, you can customize the above layout. For example, the data being displayed for each individual option includes the bid, ask, volume, open interest, and last price. You can typically change this data to other items such as intrinsic or extrinsic value, open, high, low, or close, as well as option Greeks such as Delta, Gamma, Theta, Vega, or Rho. Get familiar with the option chain so that you can quickly get to the correct expiration month, know how to locate the particular strike price of a call or put, and quickly be able to identify the bid/ask price for this option. The more familiar you become with these mechanics, the less likely you are to make mistakes such as trading the wrong option, selling instead of buying, etc. The last items we will review in this module are the mechanics of placing a trade. We ll discuss basic order types, as well as discussing in better detail the concept of risk and reward. This is an important step as it is a critical part of a trading plan. Order types If you re new to trading, it s important to outline the different order types that exist and how they can be used in taking positions. Each of the order types below can present advantages or disadvantages depending on the underlying issue or strategy. 1) Market Order A market order instructs the broker to get the next best available price as soon as the order hits the floor. When the order executes, it is said to be filled. Market orders are typically the default order type and are used often because they offer an immediate fill at the next available price without restrictions. 2) Limit Order A limit order instructs the broker to buy or sell at a specific price or better. Limit orders are typically used in options and less liquid stocks. Since options and illiquid stocks can at times have wide bid/ask spreads, a trader will want to specify what price they want to pay as opposed to taking a chance on a bad order fill. 3) Stop Order A stop order is typically a defensive order used to protect a position. A stop order is set at a particular price and once that price is hit, the order then becomes a market order to sell at the next available price. Buy/Sell stops can also be used to initiate a position once a price is hit. With option orders, every order must specify the following information: Buy or Sell Opening or Closing Transaction Trading Basics and Mechanics Page 3

Quantity Option Description Price Order Type Let s quickly review how a trade is placed. Let s assume you are bullish on Caterpillar (CAT) and have decided to by a December 82.5 call.

In the image above, you will see the December 82.5 call highlighted in yellow. Assuming you ve decided to purchase this option, you would click on the ask price, which has been highlighted in red.

4 Quantity Option Description Price Order Type Let s quickly review how a trade is placed. Let s assume you are bullish on Caterpillar (CAT) and have decided to by a December 82.5 call. To place the order, type in CAT in your trade screen to bring up the option chain. Here is a look at the option chain on CAT: Figure 5: Option chain on Caterpillar (CAT) through thinkorswim. In the image above, you will see the December 82.5 call highlighted in yellow. Assuming you ve decided to purchase this option, you would click on the ask price, which has been highlighted in red. Later down the road when you decide to sell it, you would then click on the bid price. After clicking on the ask price of this option, the order screen should come up. A typical option order might look like the following: Using the thinkorswim platform, the order description above is a limit order to buy a quantity of 10 contracts of the December 82.5 Calls for a price of $2.71. This order is good for the day, meaning if the order price is not hit and doesn t fill before the close of trade, the order then cancels. Once you click send you will get one final screen, reviewing all the details of the trade, such as your max gain, max loss, total cost, etc. If the details of this order look correct, submit the order. That s it! Activity: Take a moment to access your virtual trade account and walk through the process of placing an order if you haven t already done so yet. In the beginning, we should be most concerned with properly executing trades, error free. Place less emphasis on generating returns in the early stages of virtual trading. Once you have the mechanics down, we ll worry about the trade itself and generating returns as we practice our systems, entry points, and trade signals. The Concept of Measuring Risks and Rewards While we are on the topic of placing trades, we ll quickly discuss the concepts of understanding how to calculate a risk/reward ratio. Everyone who has traded before understands the concept of buying low and selling high. A companion to this basic premise is to let your profits run and Trading Basics and Mechanics Page 4

5 cut your losses short. The number one consideration in successful trading in any market is being able to balance risk versus reward. Part-time traders often have a false perception that professional traders rarely lose money; thinking that trading is skewed in favor of the pros. There are few superstars such as Warren Buffet who would fit this profile but this is far from the norm. Instead, most good professional traders lose money on 4 out of every 10 trades (possibly more) that they get involved in. The critical part of their trading success is that these traders are much better than average at limiting their risk and getting out of losing positions. In other words, most successful traders are often human on their attempts to sniff out value in a particular market but have a knack for knowing when not to get in at all, or when to get out with a relatively small loss. New traders often don t take time to fully understand their risk exposure and become too focused on the possible reward. It is recommended that every potential trade be examined first by its risk/reward ratio. To illustrate, let s assume that Trader A makes an average of $500 on every winning trade he enters into the market and that he has been profitable on 70% of his trades. Trader A s losing trades average $1000. Trader B makes an average of $500 on every winning trade but also enjoys a success rate of only 50%. Trader B does, however, limit his losses to $250 on average, per trade. After ten trades, here are the individual results before commissions: Trader A Trader B 7 winning trades $3,500 5 winning trades $2,500 3 losing trades -$3,000 5 losing trades -$1,250 Net P/L $500 Net P/L $1,250 Consequently, the trader who controls his risk better will be more successful than traders who are right in their views but do a poor job of managing risk. If one takes a realistic view that their views on the market will be correct only 50% of the time, it will take a risk/reward of at least 2 to 1 to be successful long-term. Under this type of trading plan, a potential trade must have a potential reward twice that of the amount of money put at risk, or the trade is not prudent and shouldn t be acted upon. Most successful traders will not enter a trade unless the risk/reward ratio is at 2 to 1 and will probably steer towards opportunities with a 3 to 1 risk/reward ratio to improve their comfort level. To illustrate this concept, let s look at the underlying stock. Assume MSFT is trading at $26 per share and the trader s view is that the market can rise to $30 in the next six months. Major support is believed to be at $24 per share and should provide a floor for MSFT. If the trader s bias is correct, his potential reward for buying MSFT stock is $4 per share. A major floor for MSFT is $2 below the current market price, but there is no guarantee that prices will sink to that low before MSFT rallies to $30. If the trader were willing to risk $2 in an effort to make $4 in MSFT, the risk/reward ratio would be 2 to 1. MSFT Price = $26 Risk Price = $24 Reward Price = $30 Current Price Risk Price $26 - $24 = $2 Reward Price Current Price $30 - $26 = $4 Reward/Risk $4 / $2 = 2 to 1 Risk/Reward Ratio In reality, traders are looking for trading opportunities that exceed a 2 to 1 risk/reward ratio; especially option traders. Most traders look for a 3 to 1 or a 4 to 1 risk reward ratio for their trades. Activity: Take a few recent virtual trades you have placed and go back and review them to determine what the risk/reward ratio was. Take the fill price and subtract your stop price to determine risk, then take your target price and subtract your fill price to get your potential reward. Set a goal moving forward to always consider the risk reward ration prior to taking any trades, and aim for a minimum of a 3 to 1 risk/reward ratio. Trading Basics and Mechanics Page 5

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TradeOptionsWithMe.com 1 of 18 Option Trading Glossary This is the Glossary for important option trading terms. Some of these terms are rather easy and used extremely often, but some may even be new to