Trading Options for Potential Income in a Volatile Market

Trading Options for Potential Income in a Volatile Market Dan Sheridan Sheridan Mentoring & Brian Overby TradeKing TradeKing is a member of FINRA & SIPC October 19 & 20, 2011 Disclaimer Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained by calling TRADEKING at 877-495-KING, visiting www.tradeking.com/odd or by asking a TradeKing representative at this event. System response and access times may vary due to market conditions, system performance, and other factors. Market timing is a complex investment strategy which involves risk and may incur additional commission costs. Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult a tax advisor. Any strategies discussed and examples using actual securities and price data are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results. Consider the following when making an investment decision: your financial situation, your risk profile and transaction costs. This event is provided for educational and informational purposes only. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. TradeKing provides selfdirected investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products. 1

Disclaimer The projections or other information generated by TradeKing's tools regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. The calculations do not take into consideration all costs, such as commissions and margin interest which may impact the results shown. It is the user's sole responsibility to select the criteria to enter in the TradeKing's tools, or to choose among the predefined screens, and to evaluate the merits and risks associated with the use of the tools before making any investment decisions. TradeKing is not responsible for any losses that occur from such investment decisions. The material presented by Dan Sheridan is a product of SheridanMentoring.com and as such, is solely responsible for its content. TradeKing maintains a business relationship with SheridanMentoring.com. TradeKing charges $4.95 for equity and option trades, add 65 cents per option contract. Trade more than 8 contracts, and we'll automatically lower your cost to 15 cents per contract plus $8.95 per trade. TradeKing charges an additional $0.35 per contract on certain index products where the exchange charges fees. See our FAQ for details. TradeKing adds $0.01 per share on the entire order for stocks priced less than $1.00. See our Commissions + Fees page for commissions on low-priced stocks, option spreads, and other securities. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility. Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security. Gamma represents the consensus of the marketplace as to the theoretical rate of change of Delta relative to the underlying security. Theta represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract. There is no guarantee that these forecasts will be correct. Crash Course in the Greeks TradeKing is a member of FINRA & SIPC 2

The Black-Scholes Formula C(S, E, t, r, σ) d = [ ln(s/e) 1 d 2 S E r δ t σ N() = d 1 σ = e δt SN(d ) Ee 1 + (r δ + σ 2 /2) t ] / σ t rt N(d = current price = strike price = continuously compounded risk-free interest rate = continuously compounded dividend yield = time to expiration of the option = rate of return volatility on the stock = cumulative normal density function t ) 2 Example: Let S = 40; E = 40; r = 8%; σ = 30%; t = 91 days; δ = 0 The Black-Scholes price is 2.78 5 The Greeks Delta: The amount a theoretical option's price will change for a corresponding one-unit (point) change in the price of the underlying security. Gamma: The amount a theoretical option's delta will change for a corresponding one-unit (point) change in the price of the underlying security. Theta: The amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract. Vega: The amount a theoretical option's price will change for a corresponding one-unit (percentage-point) change in the implied volatility of the option contract. Rho: The amount a theoretical option's price will change for a corresponding one-unit (percentage-point) change in the interest rate used to price the option contract. 6 3

Delta Example I Delta: The amount a theoretical option's price will change for a corresponding one-unit (point) change in the price of the underlying security. Stock @ 50 Strike is 50 3 Month Call $3 3.50 51 4.10 52 Non-Textbook Definition iti The delta is the probability of the option being in the money on expiration. 7 Delta Example II Delta: Non-Textbook Definition The delta is the probability of the option being in the money on expiration. Stock @ 50 51 Call Strike is 50 1) One Day to Expiration Δ.50.90 2) Sixty Days to Expiration Δ.50.60 8 4

Gamma Gamma: The amount a theoretical option's delta will change for a corresponding one-unit (point) change in the price of the underlying security. Gamma is highest for the near-term ATM strike, and slopes off toward the ITM and OTM strikes. 9 Delta Example II Delta: Non-Textbook Definition The delta is the probability of the option being in the money on expiration. Stock @ 50 51 Call Strike is 50 Gamma 1) One Day to Expiration Δ.50.90 2) Sixty Days to Expiration Δ.50.60 10 5

Graph of Gamma ATM Calls 0.10 0.09 0.08 15-Day 85 Strike Call 45-Day 85 Strike Call 0.07 Gamma 0.06 0.05 0.04 0.03 0.02 0.01 0.00 80 85 90 95 Stock Price 11 Theta Theta: The amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract. 12 6

Time Decay of ATM Call Option 2 173 1.73 Option Premium 1 1.41 1.00 0 90 60 30 0 Days to Expiration 13 Vega Vega: The amount a theoretical option's price will change for a corresponding one-unit (percentage-point) change in the implied volatility of the option contract. The more time premium, the higher the Vega is for an option. By that rational, longer term options will have a higher Vega number then shorter term options. Option ATM $4 Vega.10 IV was 60 and went to 59 1% move Option is now trading for $3.90 in theory. 14 7

Position Greeks Lets look at some position deltas XYZ at 103.27 Long 1 XYZ May 105 Call at 3.60 Position Delta Equals 46.00 Long 2 XYZ May 105 Call at 3.60 Position Delta Equals 92.00 Long 5 XYZ May 105 Call at 3.60 Position Delta Equals 230.00 15 Phone Numbers: (877) 495-KING E-mails: theoptionsguy@tradeking.com Brian s Blog: The Options Guy http://optionsguy.tradeking.com TradeKing s Trader Network: http://community.tradeking.com Check out OptionsPlaybook.com Today! Social Networks: Twitter.com/TradeKing Youtube.com/TradeKing Facebook.com/TradeKing 8

Dan Sheridan Managing Potential Income Trades Sheridan Options Mentoring, Inc. www.sheridanmentoring.com Disclaimer Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation at www.theocc.com. The information in this presentation is provided solely for general education and information purposes. Any strategies discussed, d including examples using actual securities i and price data, are strictly for illustrative and educational purposes. In order to simplify the computations, commissions and other transaction costs have not been included in the examples used in this presentation. Such costs will impact the outcome of the stock and options transactions and should be considered. Multiple leg strategies involve multiple commission charges. Investors should consult their tax advisor about any potential tax consequences. No statement within the presentation should be construed as a recommendation to buy or sell a security or to provide investment advice. Supporting documentation for any claims, statistics, or other technical data is available from Sheridan Options Mentoring at www.sheridanoptionsmentoring.com. Chicago Board Options Exchange, Incorporated (CBOE) is not affiliated with Sheridan Options Mentoring or OptionNet. This presentation should not be construed as an endorsement or an indication by CBOE of the value of any non-cboe product or service described in this presentation. Page 18 9

Running an Options Business Page 19 Portfolio Plan Income Strategies Speculative Strategies Long Term Strategies Page 20 10

Portfolio Plan Calendar Spreads Double Calendar Spreads Double Diagonals ATM Butterflies Condors Long Calls/Puts, Diagonal Spreads OTM Butterflies Vertical Spreads Directional Calendars Long Straddles Collars LEAPS Covered Writes/Straddles Long Stock Long Term Calendars Page 21 Credit Spreads Page 22 11

How to Find Credit Spread Vehicles? 1. Stocks you would buy in retirement account? 2. Stocks over $65 3. Stocks with option implied volatilities 20-40 Page 23 May NFLX Credit Spread Date: 4/4/2011 NFLX Price: $244.72 Page 24 12

May NFLX Credit Spread Date: 4/4/2011 NFLX Price: $244.72 Page 25 Plan for Credit Spread Date: 4/4/2011 NFLX Price: $244.72 Page 26 13

Stock Drops from Original Price of $244.72 Date: 4/8/2011 NFLX Price: $234.86 Page 27 Stock Drops from Original Price of $244.72 Date: 4/8/2011 NFLX Price: $234.86 Page 28 14

Adjustment #1 Roll Down Credit Spread Date: 4/8/2011 NFLX Price: $234.86 Page 29 Adjustment #1 Roll Down Credit Spread Date: 4/8/2011 NFLX Price: $234.86 Page 30 15

Adjustment #2 Buy a Long Option Date: 4/8/2011 NFLX Price: $234.86 Page 31 Adjustment #2 Buy a Long Option Date: 4/8/2011 NFLX Price: $234.86 Page 32 16

Adjustment #3 Debit Spread Date: 4/8/2011 NFLX Price: $234.86 Page 33 Adjustment #3 Debit Spread Date: 4/8/2011 NFLX Price: $234.86 Page 34 17

Adjustment #4 Turn Into Butterfly Date: 4/8/2011 NFLX Price: $234.86 Page 35 Adjustment #4 Turn Into Butterfly Date: 4/8/2011 NFLX Price: $234.86 Page 36 18

Adjustment #5 Condorize Date: 4/8/2011 NFLX Price: $234.86 Page 37 Adjustment #5 Condorize Date: 4/8/2011 NFLX Price: $234.86 Page 38 19

Adjustment #6 Diagonal Adjustment Date: 4/8/2011 NFLX Price: $234.86 Page 39 Adjustment #6 Diagonal Adjustment Date: 4/8/2011 NFLX Price: $234.86 Page 40 20

Adjustment # 7 Condorize in Puts Date: 4/8/2011 NFLX Price: $234.86 Page 41 Adjustment # 7 Condorize in Puts Date: 4/8/2011 NFLX Price: $234.86 Page 42 21

Adjustment #8 Reduce Size Date: 4/8/2011 NFLX Price: $234.86 Page 43 Adjustment #8 Reduce Size Date: 4/8/2011 NFLX Price: $234.86 Page 44 22

Calendars Page 45 Why do calendars? Page 46 23

Why Do Calendars? Time Decay Limited risk Easy to understand- same risk as long option Two legged spread versus 3 and 4 legged spreads, butterflies and calendars Commissions are typically lower on two leg spreads than 3 or 4 leg strategies. Page 47 Finding Calendar candidates Page 48 24

Finding Calendar candidates Good stocks you would own in retirement Implied volatility between 14-30 Stocks over $60 Page 49 Finding Calendar Candidates NDX HPQ SPX XOM RUT NSC PG IBM WMT AAPL CL CVX GOOG QCOM CAT AMZN BA Page 50 25

VIPES Process for filtering candidates Page 51 VIPES ( Calendar Filtering System ) Volatility- Long option of calendar in lower end of IV range Industry- Is this a whacko industry? Price- Channeling or Trending? Looking for speed! Earnings- Stay out of earnings month Skew- Positive skew greater than 3 investigate, Negative skew more than 2 back off News- keep up! Don t like words like buy back or takeover ( Beware of descending IV pattern) Page 52 26

Consistency? January $500 September $ -1000 February $500 October $500 March $300 November $300 April - $800 December $500 May $500 Net profits for 12 June $500 months = $1500 (30%) July -700 capital $5000 August $400 target 10% ($500) Page 53 What is a Calendar? Date: 6/15/2011 SPX Price: $1265.42 JUL(30) AUG(65) Options Pi Price IV Trade Pi Price IV Trade 1265 Calls $26.15 17.9% 1 $37.65 17.5% +1 Delta 0.5 Gamma -0.2 Theta 14.5 Vega 68.1 Debit 1,150 At July Expiration: Max Risk: 11.50 Max Gain: Limited & Unknown Commission: $6.95 at TradeKing Page 54 27

What is a Calendar? Date: 6/15/2011 SPX Price: $1265.42 Page 55 Finding Calendar Candidates Stocks you would buy in retirement account Stocks over $60 Implied Volatility levels between 17-31 Beta s less than the market Good solid candidates Indexes RUT, MNX, SPX Stocks like IBM, MCD, WMT, AAPL Page 56 28

Executing Calendars Depends on Vehicle, compare Index vs Stock Mid Prices Entering versus exiting Time of Day Contingent and market orders Page 57 Calendar Adjustments Page 58 29

Adjustments Date: 6/3/2011 RUT Price: $808.13 JUL(42) AUG(77) Options Pi Price IV Trade Pi Price IV Trade 810 Calls $21.80 20.7% 2 $31.30 21.6% +2 Delta 2.0 Gamma -0.4 Theta 12.22 Vega 77.3 Debit 1,900 At July Expiration: Max Loss: 9.50 Max Gain: Limited & Unknown Commission: $7.55 at TradeKing Page 59 Adjustments Date: 6/3/2011 RUT Price: $808.13 779.79 843.43 Page 60 30

Why Adjust? Date: 6/8/2011 RUT Price: $788.04 5 Days in Trade Original RUT Price: $808.13 JUL(37) AUG(72) Options Pi Price Entry Pr IV Trade Pi Price Entry Pr IV Trade 810 Calls $11.20 $21.80 20.0% 2 $20.45 $31.30 21.2% +2 Delta 11.9 Gamma -0.4 Theta 9.9 Vega 86.3 Debit 1,900 Loss 50 At July Expiration: Max Loss: 9.50 Max Gain: Limited & Unknown Commission: $7.55 at TradeKing Page 61 Why Adjust? Date: 6/8/2011 RUT Price: $788.04 780.72 842.04 Page 62 31

Adjustment #1- Turn into Double Calendar Date: 6/8/2011 RUT Price:$788.04 5 Days in Trade Original RUT Price: $808.13 JUL(37) AUG(72) Options Price Trade Adjust New Price Trade Adjust New 810 Calls $11.20 2 +1 1 $20.45 +2 1 +1 790 Puts $24.95 1 1 $35.25 +1 +1 Before Adjusting Delta 11.9 Gamma -0.4 04 Theta 9.9 Vega 86.3 Debit 1,900 Loss 50 After Adjusting Delta 7.1 Gamma -0.4 04 Theta 13.5 Vega 82.6 Debit 2,005 Loss 50 Commission to adjust $7.55 at TradeKing Page 63 Adjustment #1- Turn into Double Calendar Date: 6/8/2011 RUT Price:$788.04 767.28 842.04 780.72 834.48 Page 64 32

Adjustment #2 Re-Position Date: 6/8/2011 RUT Price:$788.04 5 Days in Trade Original RUT Price: $808.13 JUL(37) AUG(72) Options Pi Price Trade Adjust New Pi Price Trade Adjust New 810 Calls $11.20 2 +2 $20.45 +2 2 790 Puts $24.95 2 2 $35.25 +2 +2 Before Adjusting Delta 11.9 Gamma -0.4 04 Theta 9.9 Vega 86.3 Debit 1,900 Loss 50 After Adjusting Delta 2.2 Gamma -0.4 04 Theta 17.2 Vega 78.9 Debit 2,110 Loss 50 Commission to adjust $9.55 at TradeKing Page 65 Adjustment #2 Re-Position Date: 6/8/2011 RUT Price:$788.04 757.20 842.04 780.72 826.08 Page 66 33

Adjustment #3 Diagonalize Date: 6/8/2011 RUT Price:$788.04 5 Days in Trade Original RUT Price: $808.13 JUL(37) AUG(72) Options Price Trade Adjust New Price Trade Adjust New 810 Calls $11.20 2 +2 $20.45 +2 +2 795 Calls $17.80 2 2 Before Adjusting Delta 11.9 Gamma -0.4 Theta 9.9 Vega 86.3 Debit 1,900 Margin 1,900 Loss 50 After Adjusting Delta -11.4 Gamma -0.5 Theta 16.4 Vega 72.1 Debit 580 Margin 3,542 Loss 50 Commission to adjust $7.55 at TradeKing Page 67 Adjustment #3 Diagonalize Date: 6/8/2011 RUT Price:$788.04 748.80 817.68 842.04 780.72 Page 68 34

Adjustment #4 Add More Calendars Date: 6/8/2011 RUT Price:$788.04 5 Days in Trade Original RUT Price: $808.13 JUL(37) AUG(72) Options Pi Price Trade Adjust New Pi Price Trade Adjust New 810 Calls $11.20 2 2 $20.45 +2 +2 790 Puts $24.95 2 2 $35.25 +2 +2 Before Adjusting Delta 11.9 Gamma -0.4 Theta 9.9 Vega 86.3 Debit 1,900 Loss 50 After Adjusting Delta 14.1 Gamma -0.8 Theta 27.1 Vega 165.2 Debit 3,960 Loss 50 Commission to adjust $7.55 at TradeKing Page 69 Adjustment #4 Add More Calendars Date: 6/8/2011 RUT Price:$788.04 767.28 780.72 Page 70 35

Adjustment #5 Add Long Options Date: 6/8/2011 RUT Price:$788.04 5 Days in Trade Original RUT Price: $808.13 JUL(37) AUG(72) Options Pi Price Trade Adjust New Pi Price Trade Adjust New 810 Calls $11.20 2 2 $20.45 +2 +2 680 Puts $1.85 +1 +1 Before Adjusting Delta 11.9 Gamma -0.4 Theta 9.9 Vega 86.3 Debit 1,900 Loss 50 After Adjusting Delta 5.3 Gamma 0.3 Theta -1.9 Vega 116.1 Debit 2,085 Loss 50 Commission to adjust $5.60 at TradeKing Page 71 Adjustment #5 Add Long Options Date: 6/8/2011 RUT Price:$788.04 780.7272 781.56 Page 72 36

Dan Sheridan +1-630-835-4691 dan@sheridanmentoring.com Sheridan Options Mentoring, Inc. http://www.sheridanmentoring.com/ Page 73 37