Learn Options
Option Trading

eBook

Written By - Adam Beaty


Table of Contents

BACK TO BASICS

3

HISTORY OF OPTIONS

3

WHAT DOES AN OPTION LOOK LIKE?

4

COMMON OPTION DEFINITIONS

5

7 FACTORS THAT AFFECT AN OPTION'S PRICE

8

OPTION STRATEGIES

12

LONG CALL

12

LONG PUT

14

SHORT CALL

16

SHORT PUT

18

COVERED CALL

20

COLLAR

22

BULL CALL SPREAD

24


BEAR PUT SPREAD

26

BEAR CALL SPREAD

28

BULL PUT SPREAD

30

LONG STRADDLE

32

SHORT STRADDLE

34

LONG STRANGLE

36

SHORT STRANGLE

38

LONG COMBINATION


40

SHORT COMBINATION

42

RATIO VERTICAL SPREAD WITH CALLS

44

RATIO VERTICAL SPREAD WITH PUTS

46

BACK SPREAD WITH CALLS

48

BACK SPREAD WITH PUTS

50

LONG CALENDAR SPREAD WITH CALLS

52

LONG CALENDAR SPREAD WITH PUTS

54


DIAGONAL SPREAD WITH CALLS

56

DIAGONAL SPREAD WITH PUTS

58

LONG BUTTERFLY SPREAD WITH CALLS

60

LONG BUTTERFLY SPREAD WITH PUTS

62


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IRON BUTTERFLY

64

SKIP STRIKE BUTTERFLY WITH CALLS

66

SKIP STRIKE BUTTERFLY WITH PUTS


68

INVERSE SKIP STRIKE BUTTERFLY WITH CALLS

70

INVERSE SKIP STRIKE BUTTERFLY WITH PUTS

72

CHRISTMAS TREE BUTTERFLY WITH CALLS

74

CHRISTMAS TREE BUTTERFLY WITH PUTS

76

LONG CONDOR SPREAD WITH CALLS

78

LONG CONDOR SPREAD WITH PUTS

80

IRON CONDOR

82


ADVANCED TOPICS

84

THE GREEKS

84

THE GREEK CHEAT SHEET

89

USING OPTIONS TO PICK UP STOCK

90

TOP 8 MISTAKES PEOPLE MAKE TRADING OPTIONS

93

(SET) AND INDEX OPTION EXPIRATION

99


Back to Basics

History of Op ons
The US op ons exchange started with the founding of the CBOE (Chicago Board Op ons
Exchange) in 1973. At the beginning there were a total of 16 equi es that had only call

op ons. In 1977 they began to trade put op ons. There are now over 5 different exchanges
ac vely trading op ons.
In 1975 the SEC (Securi es and Exchange Commission) approved the OCC (Op ons Clearing
Corpora on) with the sole purpose of clearing all US based op ons. A clearing firm’s job is to
facilitate execu on by transferring funds, assigning deliveries, and guaranteeing the contracts.
Op ons were a hit when they first appeared. In 1975 18 million contracts traded. By 1978 that
number had more than tripled to 60 million contracts. The increase in contracts con nued to
climb un l the 1987 stock market crash. A er the stock market crash investors were s ll
uneasy. In 1991 only 2/3 of the peak level contracts were traded. In 1983 we saw the first
op ons traded on an index, the S&P 500. This was a big development since it was from this
that led to the forma on of the VIX. The VIX is the vola lity index, fear index, based on the
prices of S&P 500 op ons.
Enthusiasm for the op ons market didn’t return un l the 1990s. During these mes we saw
the introduc on of LEAPS (Long-term An cipa on Securi es) which allowed investors to buy
op ons that expired over a year. We also saw the forma on of the OIC (Op ons Industry
Council) which is a non-profit organiza on developed to educate people on the risk and
benefits of op ons.


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What Does An Op on Look Like?
An op on gives the buyer the right to buy or sell the underlying at a specified price and
me. At the same me, the seller has the obliga on to take the opposite side and fulfill the
op on upon exercise. That means that the buyer can choose if they want to exercise the
op on, but the seller has to live up to the contract if the buyer does exercise.
A typical op on:

Let’s analyze:
XYZ is the underlying instrument. This can range from equi es (companies), indexes, futures,

and currency. In this case we are using the company XYZ.
January is the expira on month and sets the life of the op on. Expira ons are always given in
terms of a month. It is understood that op ons expire on the third Friday of every month. In
this example, a er the third Friday in January this op on will no longer exist.
170 is our strike price. The strike price sets the price of the underlying if it were exercised. This
is not the price you would pay to buy the op on.
Call specifies if this is a call or put. A call is the right to buy or call the stock away from someone
else. Too long a call you are making a bet the underlying will appreciate in price.
A put is the right to sell or put the stock to someone else. Too long a put you are predic ng
deprecia on in price.
A put and call can be traded long and short or also in combina on with other puts/calls to
create spreads (more informa on on combina ons to follow).


Back to Basics

Common Op on Defini ons

In-the-Money (ITM): For a call op on this means that the underlying is trading above the strike
price. For example ABC is trading at 30 and the call op on has a strike price of 25. This call
op on is ITM. For a put op on this means the underlying is trading below the strike price. For
example ABC is trading at 45 and the put op on has a strike of 50. This put op on is ITM.

At-the-Money (ATM): This indicates the underlying price is around the strike price. For
example ABC is trading at 50 and the op on strike is 50. This goes for both puts and calls. If
you cannot tell which strike is closer than look for the strike with a delta closer to .50.

Out-of-the-Money (OTM): For a call op on this means the underlying is trading below the
strike price. For example ABC is trading at 15 with the call op on strike at 20. This call op on is
OTM. For a put op on this means the underlying is trading above the strike price. For example

ABC is trading at 75 and the put op on has a strike of 70. This put op on is OTM.

Intrinsic Value: The amount the op on is in-the-money. Only In-the-Money (ITM) op ons carry
intrinsic value.

Time Value: Sets the value of me ll expira on. An op on that is Out-of-the-Money (OTM)
only has me value. If an op on is In-the-Money (ITM) it is made up of both Intrinsic Value and
Time Value.

Exercise: To exercise an op on contract means you are fulfilling the contract and closing it
out. If you exercise a call op on you are buying the shares at the strike price. If you exercise a
put you are selling the shares at the strike price.


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Assignment: An op on assignment is the other side of the op on being exercised. In this case
you are not the buyer of the op on instead you are the seller or writer of the op on. When a
buyer exercises an op on the writer gets assigned. If you are a writer of a call op on that gets
exercised then you have to give the buyer your shares. If you are a writer of a put op on
then you will receive the shares when assigned.

Op on Chain: An op on chain displays all the necessary informa on for the underlying
asset. The op ons are listed by the expira on month and then broken down by all the strikes
available. Usually Calls are listed on the le side and Puts listed on the right side. Op on
Chains can provide a wide variety of informa on from something basic such as the bid/ask to
more specific informa on such as the op on Greeks.


Back to Basics


Example of an op on chain:


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7 Factors That Affect An Op on's Price
1. Stock Price
If a call op on allows you to buy a stock at a certain price in the future than the higher that price
goes the more the op on will be worth.
Which op on would have a higher value:
A call op on allows you to buy The Op on Prophet (sym: TOP) for $100 while it is trading at $80 OR
A call op on allows you to buy TOP for $100 while it is trading at $120
Obviously no one is going to pay $100 for something they can buy on the open market for $80, so
our op on in Choice 1 will have a low value.
What is more appealing is Choice 2, an op on to buy TOP for $100 when its value is $120. In this
situa on our op on value will be higher.

2. Strike Price
Strike price follows along the same lines as stock price. When we classify strikes we do it as in-themoney, at-the-money or out-of-the-money. When a call op on is in-the-money it means the stock
price is greater than the strike price. When a call is out-of-the-money the stock price is less than the
strike price.
A TOP call has a strike of 50 while TOP is currently trading at $60, this op on is in-the-money.
On the flip side of that coin a put op on is in-the-money when the stock price is less than the strike
price. A put op on is out-of-the-money when the stock price is greater than the strike price.
A TOP put has a strike of 20 while TOP is currently trading at $40, this op on is out-of-the-money.
Op ons that are in-the-money have a higher value compared to op ons that are out-of-the-money.


Back to Basics


3. Type Of Op on
This is probably the easiest factor to understand. An op on is either a put or a call and the value of
the op on will change accordingly.
A call op on gives the holder the right to buy the underlying at a specified price within a specific
me period.
A put op on gives the holder the right to sell the underlying at a specified price within a specific
me period.
If you are long a call or short a put your op on value increases as the market moves higher. If you
are long a put or short a call your op on value increases as the market moves lower.

4. Time To Expira on
Op ons have a limited life span thus their value is affected by the passing of me. As the me to
expira on increases the value of the op on increases. As the me to expira on gets closer the
value of the op on begins to decrease. The value begins to rapidly decrease within the last thirty
days of an op on's life. The more me an op on has ll expira on, the more me the op on has to
move around.

5. Interest Rates
Interest rates have a very small effect on an op on's value. When interest rates rise a call op on's
value will also rise and a put op on's value will fall.
To drive this concept home let's look at the decision making process of trying to invest in TOP while
it is trading at $50.
We can buy 100 shares of the stock outright which would cost us $5,000.
Instead of buying the stock outright we can long an at the money call for $5.00. Our total cost here
would be $500. Our ini al outlay of cash would be smaller and this would leave us $4,500 le over.
Plus, we will have the same reward poten al for half the risk. Now we can take that le over cash
and invest it elsewhere such as Treasury Bills. This would generate a guaranteed return on top of
our investment in TOP.



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The higher the interest rate the more a rac ve the second op on becomes. Thus, when interest
rates go up calls are a be er investment so their price also increases.
On the flip side of that coin if we look at a long put versus a long call we can see a disadvantage. We
have two op ons when we want to play an underlying to the downside.
You can short 100 shares of the stock which would generate cash into the brokerage and allow us to
earn interest on that cash.
You long a put which will cost you less money overall but not put extra cash into your brokerage that
generates interest income.
The higher the interest rate the more a rac ve the first op on becomes. Thus, when interest rates
rise the value of put op ons drops.

6. Dividends
Op ons do not receive dividends so their value fluctuates when dividends are released. When a
company releases dividends they have an ex-dividend date. If you own the stock on that date you
will be awarded the dividend. Also on this date the value of the stock will decrease by the amount of
dividend. As dividends increase a put op on's value also increases and a calls' value decreases.

7. Vola lity
Vola lity is the only es mated factor in this model. The vola lity that is used is forward vola lity.
Forward vola lity is the measure of implied vola lity over a period in the future.
Implied vola lity shows the "implied" movement in a stock's future vola lity. Basically it tells you
how traders think the stock will move. Implied vola lity is always expressed as a percentage, nondirec onal and on an annual basis.


The higher the implied vola lity the more people think the stock's price will move. Stocks listed on the
Dow Jones are value stocks so a lot of movement is not expected, thus, they have a lower implied
vola lity.

Growth stocks or small caps found on the Russell 2000, conversely, are expected to move around a lot so
they carry a higher implied vola lity.


Option Stategies
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Name: Long Call
Descrip on: The long call gives the buyer the right to buy the underlying at the strike
price. The long call is used to simulate buying the underlying since you try to profit from the
underlying going up in price. Unlike buying the underlying outright the long call gives you a cap
for losses since you can only lose the price of the call. Be careful though, it is easy to
overleverage yourself using calls.
Setup: Buy (long) a call
Bias: Bullish
Break-Even: Strike A + Price paid for call
Max Profit: Unlimited: Looking for the underlying to go as high as the sky


Option Stategies

Max Loss: Limited: Price paid for the call
Margin: No margin needed since call is bought outright
Time Decay: As me passes the call will drop in value. To offset rapid me decay typically call op ons are
purchased 60-150 days from expira on.
Implied Vola lity: Over the life of the op on you want implied vola lity to increase, thus increasing the
price of your op on. A decrease in implied vola lity will lower the price of your op on.
Notes: Purchasing calls deep out-of-the-money because they are cheap will typically result in losses.



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Name: Long Put
Descrip on: The long put gives the buyer the right to sell the underlying at the strike price. This is the
equivalent to selling a stock short. The buyer of the long put will profit if the underlying drops in price.
Unlike selling stock short, which can have unlimited losses, a long put has a cap on the losses since you
can only lose the price of the put.
Setup: Buy (long) a put
Bias: Bearish Break-Even: Strike A - Price paid for put
Max Profit: Limited: Underlying cannot fall below $0.00
Max Loss: Limited: Price paid for the put
Margin: No margin needed since put is bought outright


Option Stategies

Time Decay: As me passes the put will drop in value. To offset rapid me decay typically put op ons are
purchased 60-150 days from expira on.
Implied Vola lity: Over the life of the op on you want implied vola lity to increase, thus increasing the
price of your op on. A decrease in implied vola lity will lower the price of your op on.
Notes: Purchasing puts deep out-of-the-money because they are cheap will typically result in losses. The
purchase of puts is also used as protec on against long stock. If you are currently long stock and want to
protect or lock in gains from future decline you can purchase a put that will cover any downward
movement below the strike price.


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Name: Short Call
Descrip on: The short call obligates you to sell the stock at the strike price. If the underlying finishes

below the strike price your call will expire worthless allowing you to keep the credit. This play carries
unlimited risk so cau on is advised when pu ng this play on.
Setup: Sell (short) a call
Bias: Neutral to Bearish
Break-Even: Strike A + Credit received for the sale of the call
Max Profit: Limited: To credit received
Max Loss: Unlimited: If the underlying rises above your strike price - loses will occur as long as the
underlying con nues to rise


Option Stategies

Margin: Short call requires no cash outlay so margin is used. Margin is calculated by taking the greater
of:
25% of the underlying security value minus the out-of-the-money amount plus the premium
received or
10% of the underlying security value plus the premium received
Time Decay: As me passes the call will drop in value which is what you want. You want your short call to
lose value so it expires worthless or allows you to buy it back (close it) for a lower price.
Implied Vola lity: Over the life of the op on you want implied vola lity to decrease, thus decreasing the
price of your op on. An increase in implied vola lity will increase the price of your op on.
Notes: Short calls can profit no ma er which direc on the underlying moves. Losses will only occur
above break-even. Selling deep out-of-the-money calls can return high probability plays


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Name: Short Put
Descrip on: The short put obligates you to buy the underlying at the strike price. If the underlying
finishes above the strike price your put will expire worthless allowing you to keep the credit. This play

carries high risk so cau on is advised when pu ng this play on.
Setup: Sell (short) a put
Bias: Neutral to Bullish
Break-Even: Strike A - Credit received for the sale of the put
Max Profit: Limited: To Credit received
Max Loss: Limited: If the underlying falls below your strike price losses will occur - but are limited due to
the fact the underlying cannot fall below $0.00


Option Stategies

Margin: Short put requires no cash outlay so margin is used. Margin is calculated by taking the greater
of:
25% of the underlying security value minus the out-of-the-money amount plus the premium
received or
10% of the underlying security value plus the premium received
Time Decay: As me passes the put will drop in value which is what you want. You want your short put
to lose value so it expires worthless or allows you to buy it back (close it) for a lower price.
Implied Vola lity: Over the life of the op on you want implied vola lity to decrease, thus decreasing
the price of your op on. An increase in implied vola lity will increase the price of your op on.
Notes: Short puts can profit no ma er which direc on the underlying moves. Losses will only occur
below break-even. Selling deep out-of-the-money puts can return high probability plays. Short puts can
also be turned into cash-secured puts. This is setup by holding enough cash to buy the shares if the
underlying falls below the strike price. This is a good way to pick up shares at a reduced price. For
example if the underlying is currently trading at $65 and you are willing to purchase the stock at $60
then you could sell the put on the 60 strike. If the underlying falls below 60 you will be assigned the
shares and now have a long stock posi on. This is more typical for picking up long-term holdings.


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Name: Covered Call
Descrip on: A covered calls means you are buying or already own shares of the underlying and you are
going to sell a call on it. People will do this because this posi on is rela vely safe. If the underlying
increases in price you will sell the shares and keep the premium. If the underlying drops then you will
keep the premium.
Setup: Sell (short) a call and Own or Buy (long) equal amount of shares
Bias: Neutral to Slightly Bullish (If the underlying sky rockets in price you will be forced to sell at the
strike price missing out on the extra gains)
Break-Even: Underlying Price - Credit received for the sale of the call
Max Profit: Limited: To credit received; if the underlying price goes above strike price then profit
increases to premium received + sale of the underlying


Option Stategies

Max Loss: Downside risk happens only if the stock price falls to low
Margin: The short call is covered by the purchase or ownership of the stock - no margin needed
Time Decay: As me passes the call will drop in value which is what you want. You want your short call
to lose value so it expires worthless or allows you to buy it back (close it) for a lower price.
Implied Vola lity: Over the life of the op on you want implied vola lity to decrease, thus decreasing the
price of your op on. An increase in implied vola lity will increase the price of your op on.
Notes: Covered Calls are typically referred to as beginner plays because the op on cannot take a loss so
the posi on is rela vely safe. Selling calls on shares already owned is a good way to increase/boost profit
on long-term posi ons. Only establish covered calls if you are comfortable with ge ng assigned, if you
are okay with losing the shares because they are called away. Pu ng on a covered call when you are not
willing to give up the shares will only bring headaches and future losses.


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Name: Collar
Descrip on: This strategy creates security around your underlying posi on. When you long the put you
use the short call to pay for it. With this play you have protected your downside movement and capped
your upside poten al.
Setup: Own the stock and Sell (short) a call and Buy (long) a put
Bias: Neutral to Slightly Bullish (If the underlying sky rockets in price you will be forced to sell at the
strike price missing out on the extra gains)
Break-Even: Two breakeven points could exist:
If the play is established for a net credit (cash inflow) the break-even is the current
underlying price - the credit received
If the play is established for a net debit (cash ou low) the break-even is the current
underlying price + the debit paid


Option Stategies

Max Profit: Limited: The strike of the short call - the current underlying price + the credit or - the debit
paid
Max Loss: Losses will equal the current underlying price - the strike of the long put + the debit paid or the credit received
Margin: The short call is covered by the purchase or ownership of the stock - no margin needed
Time Decay: As me passes the call will drop in value and the put will also drop in value. This is a
neutral effect.
Implied Vola lity: Movement in implied vola lity will also be neutral.


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Name: Bull Call Spread or Ver cal Spread
Descrip on: The bull call spread has the same intent as the long call. However, instead of just buying the

long call you also short a call. This short call reduces your cost, reduces your risk, but also reduces your
profit poten al.
Setup: Buy (long) Strike A call and Sell (short) Strike B call - same expira on month for both
Bias: Bullish with a target at the short strike
Break-Even: Strike A + debit paid
Max Profit: Limited: Strike A - Strike B - Debit Paid
Max Loss: Limited: Equal to the debit paid Margin: No margin required