Today, I present a labor of love reading list for the options trading enthusiast.
With July 4th just around the corner, summertime offers an opportunity to lather on the tanning oil and brush up on your options trading knowledge. Not that I wouldn’t reach for the latest Jack Reacher novel, object to the suggestion of Grisham’s courtroom intrigue or deny the deal making put forth by Trump.
But as someone who writes about and actively trades options, I belong to the camp that believes options are a valuable investment tool that, when properly utilized, can both boost returns and reduce risk. So instead, impress your neighbors, annoy your family and study yourself into a well-deserved siesta with some of the best books and resources on options. It may lack the drama of reading about Greece or central banks’ interventionist policies, but I promise the long term benefits are greater.
That said, I acknowledge the validity of many of the arguments made against options trading. Perhaps pointing out the most common pitfalls, rather than proselytizing on the benefits, is the best approach to bring some evenhandedness to the subject.
I’ll tee up a few topics and offer some reading suggestions for those that want to delve deeper and don’t mind being spotted on the beach thumbing or swiping through an options book or tablet.
Operation Manual
As with any tool, before using options, make sure you are familiar with the basic rules and guidelines that govern their behavior.
For starters, make sure you know the contract specifications the product you are trading. Items such as margin requirements (pay special attention to leverage), the exercise and settlement procedures, and what strikes and expirations are currently listed for trading are important to know.
For example, you should be aware that index options, such as for those on the S&P 500 or SPX, can only be exercised on expiration day and are cash settled; also note that SPX options actually cease trading on the third Thursday of the month, a day earlier than equity options, though they officially expire on the third Saturday.
By contrast, equity options, including those on the Spyder Trust (SPY), can be exercised at any time during the life of the contract. This is especially important when trading options on stocks that pay dividends.
This information and more can easily be found at exchange websites such as the Chicago Board of Options Exchange (CBOE) page. Another great source of knowledge is the Options Industry Council.
A terrific book that covers all the basic concepts and strategies is Options as a Strategic Investment by Lawrence McMillan.
For more sophisticated techniques, try Option Volatility and Pricing: Advanced Trading Strategies and Techniques by Shelton Natenberg.
Dealing in Dividends
If you own in-the-money calls on Exxon (XOM), make sure you know when the ex-dividend date occurs — you will need to exercise your calls if you want to qualify for the payment. Likewise, if you are short an in-the-money call on a dividend-paying stock, be prepared for assignment and being short the actual shares the day before it goes ex-dividend.
Most ETFs pay dividends. Some, like the Spyders, pay out on a quarterly basis. For some reason, the ex-dividend date often falls on the Thursday prior to a quarterly expiration. Meaning many people have failed to exercise an ITM call and lose out on the dividend while others or are unwittingly assigned puts and forced to pay.
Others, like the Dow Jones Diamonds (DIA) make monthly distributions. The point is, knowing the basic rules by which the various vehicles operate will help you avoid surprises such as an early assignment on an in-the-money call.
Jargon Slashing
Option traders, like other professionals, love to use industry jargon. Talking the lingo serves several purposes: it connotes a high level of knowledge and expertise in one’s specific field, it accurately conveys complex concepts in a concise manner, and it just sounds so cool to say things like, “I’m long vol up the ying-yang and bleeding theta,” which basically means one owns options that are suffering from time decay.
The downside of lingo is that sometimes it’s used to purposely conceal the true level of understanding, or is simply a means for the speaker to bolster his self-esteem and get the upper hand in a conversation or negotiation.
This can be very off-putting to the layperson put in the position of deferring to the expert because he is reluctant to ask a stupid question. So with that in mind, while it’s not important to know all the jargon, it is imperative to understand the concepts so as not to make a needlessly costly error.
Or that scalping gamma is a fancy way of saying “I’m trying to buy low volatility and sell higher volatility as the price of the underlying stock moves back and forth within a trading range.”
Some basic concepts of option pricing models such as Black-Scholes and “the Greeks”, especially, delta and theta, mean and how they measure options’ value.
For deeper dives into this, there are plenty of good books out there. One of my favorites on harnessing Vega and Gamma is Options Volatility Trading: Strategies for Profiting from Market Swings by Adam Warner.
A great site for finding and analyzing current and historical volatility, along with an amazing amount of free tools, is http://www.ivolatility.com/
Some of the best option books I’ve ever read come from Charles Cottle, whom I’ve had the pleasure of sharing a panel with on several occasions. His Options Trading: The Hidden Reality blew my mind the first time, and I had to go back and read it again. I still only understand half of what he was saying.
That one will both enlighten and put you to sleep. Enjoy the weekend.
For some lighter fare, and the best and quickest, and cheapest, way to get an introduction to options trading is through my free e-book The Ultimate Guide to Trading Options.
If you have topics or questions you’d like me to address in coming weeks, e-mail me at stevesmith@yolopub.com. We can whip up some margaritas and talk about options trading until the sun goes down.
