Option Investor
Educational Article

TIME FOR SOME Q&A

HAVING TROUBLE PRINTING?
Printer friendly version

I welcome questions from our beginning option readers. It's very important to grasp the fundamentals of options trading before you trade. In subsequent columns, I will discuss a number of advanced strategies - including the non-directional strategies that I use in my Couch Potato Trader. But, let me request that, if you have questions beyond the basics, you direct those questions to the Couch Potato Trader. I'll answer them as soon as I can.

Question: Dear Mike -- Excellent outline of the nuances of the put option. The mechanics of how it works and the example you used is the best I've seen. Clear, simple and easy to understand. Congratulations! I suppose the same can be done if you are short selling a stock and it happens to go in the opposite direction, i.e. UP. Would you then purchase a protective call option to protect yourself if there is such a thing? Thanks, T.R., Houston, TX

Answer - Tom, I'm glad you're enjoying the columns. In response to your questions, yes. If you are short a stock, you can simply buy a "protective" call as insurance - just as you would buy a put to protect a long stock position. All the same principles apply.


Question: Mike -- I've always read about how you can buy a straddle of a company at-the-money just before an earnings announcement. The theory is that one leg of the straddle will outgain the losing leg and you will still make money (more if there is a greater than 10% move). However, in real life, right after the earnings announcement, the option premium usually depreciates on both legs so you actually end up losing money on both sides. What is your take on this? Mike M.

Answer: Dear Mike M, you're getting ahead of things. We're learning about option basics here. In the future, questions about more advanced strategies should be sent to the attention of my Couch Potato Trader column, where I will answer them.

The straddle is a more advanced strategy. But, you have a basic grasp of the dynamics of a straddle position. (In a straddle, you buy a call and a put at the same strike price). The premium that you hope to make when trading a straddle, comes from the uncertainty about the announcement you're waiting for. There are people making bets in both directions. Then, once the announcement is made, the uncertainty is gone - and along with the uncertainty goes the excess premium.

When trading a straddle, you have to be there to babysit the position. You can't go to the movies, to the cleaners, or even to the bathroom. When the announcement hits, people will be rushing to buy or rushing to sell - depending on whether it's a positive or negative announcement. You have to be there to take advantage of the huge spike (up or down). The spike may last five minutes of two days. You never know which. If you miss it, then there's a good chance you will lose what you have risked. You can put in sell orders, but you lose control of the trade and may not get filled if the asset doesn't reach the trigger point.


Question #2 -- Also, in a iron condor on a index option such as SPX, DJX, OEX, MNX, if you are short the index at expiration, is it true that you settle as "cash"; since they are European-style options? Will you ever be assigned the stock by your broker?

Answer -- Again, we're getting far ahead of ourselves. But, yes, the indexes above settle as cash. You will see the adjusted figures in your brokerage account on Monday morning. The SPX, DJX, and MNX are European style options. European style options stop trading on the Thursday prior to expiration Friday. However, their settlement number is calculated based on the Friday morning opening of all the stocks in the index. OEX is an American style option. There is a very small risk of a short option being exercised.


This Is Good Stuff Just a reminder that, if you're new to options, these basic articles are very valuable. Print these articles out so you can reference them at your leisure. This is your bible for the options basics. This is information you need to know before you risk your hard earned dead presidents - and it may very well become a collector's item. What better reasons can there be?

Mike Parnos - A Little Knowledge Goes A Long Way The outspoken Mike Parnos has been writing Option Investor's very successful "Couch Potato Trader" column for over four years. He's been trading and teaching options for over 15 years - and knows what you NEED to know to trade options profitably.

Many foolish traders jump into the more advanced option strategies without having a good fundamental understanding of options, how they work, and how they are meant to be used. The results? Say goodbye to your money. That is why there such a stigma attached to options. People lose money because they simply don't know what they're doing -- and that's a recipe for disaster.

If you have more money than you know what to do with, losing $5,000 or $10,000 is no big deal. However, if you've worked hard for your money, and you appreciate the value of a dollar, you should make every effort to learn everything you can about options before you put your money at risk.

Mike tells you "like it IS", not how you "hope" it will be. As you read through the columns, feel free to send him your questions. As you read through the columns, feel free to send him your questions at support@optioninvestor.com with "Options 101" somewhere in the subject line. Who knows? You might end up in next week's column.

Options 101 Archives