Book Review Series: The Rookie’s Guide to Options – Chapters 2-5

By July 2, 2014Book Review

This book is a REALLY quick read which is great because it means I’ll get to the implementation part soon! This break down of The Rookie’s Guide to Options will cover a host of topics ranging from answering the question plaguing every options student, “What is an option?” to defining the value of an option. Let’s get started!

Chapter 2 – Exactly What is an Option?

When I first started learning about options, I was confused as hell. At first I thought I was buying the underlying stock and some sort of “thing” which would let me do something with it in the future.

Boy was I wrong!

Options give one person the right, but not the obligation, to buy or sell the underlying security (i.e. stock). That’s it…plain and simple.

There are lots of parts and pieces to an option, like strike prices and expiration dates, which Wolfinger does a great job of defining simply. But boiled down to their most basic element options give one person the right to buy or sell while obliging another person to do the opposite.

Wolfinger does make a point to highlight his belief it is almost never a good idea to exercise, or use, an option, except in specific instances. This means he believes it’s better to sell or buy the option, depending on your situation, to close out your position and I tend to agree.

Option traders are there to trade options. Investors which use options as insurance for other investments may have a need at some point to exercise their option, but for the most part I can’t see a scenario in which I would need to exercise an option.

I almost aced the quiz at the end of this section, however sneaky #6 caught me off guard and denied me a perfect score…I’ll extract revenge in the next round! On to buying and selling options!

Chapter 3 – Trading Options

This is what you and I are here for, trading options. Everything else we learn through this book leads up to this point and helps us either do it more efficiently. At the end of the day though, what do options do for us and why would you trade them instead of stock, ETFs or some other investment vehicle? Great question!

Options give the trader leverage over the security, stocks in my case, they are derived from. For example, I trade Cliff Natural Resources (CLF) options. Each option contract covers just one share, however you’re only allowed to trade in lots of 100 contracts, so essentially I can control 100 shares of CLF for each trade I make. If today CLF is trading for $15/share, but I can buy an option for $100 which controls 100 shares, then I’m gaining control of $1500 of CLF with only $100…pretty awesome!

This is for buying only. You can sell options too, which seems to be Wolfinger’s future plan with us.

If you check back in my income reports you’ll see I’ve sold a multitude of CLF options over the past few months and learned some valuable lessons in the process. If you decide to sell options instead of buy them, the payment you receive is called “premium”. You’ll often hear this referred to as “selling premium”.

There are both buyers and sellers of options in the world and both have their benefits and limits when it comes to trading strategies, of which I’m sure will be covered in future chapters.

Chapter 4 – The Nuts and Bolts of Trading

This chapter covers the basics on how to trade options and what tools you need to do so. The most important of which is access to a broker. The world of brokers changed much over the evolution of options trading. Nowadays you can trade easily through your phone or just about any other Internet capable device.

I use OptionsHouse as my trading platform. It’s a discount broker, which means their commission for each trade is low, though they may not offer all the really cool tools which other brokers provide.

And this is perfectly fine for me. I’m not a bells and whistles kind of guy. For the type of trading I’m doing currently I don’t need access to a ton of analysis, and frankly I wouldn’t know what to do with most of it anyway.

This may and probably will change over the course of my trading lifetime, but for now I just need the basics.

Chapter 5 – Figuring Out the Value of an Option

This is the first chapter I really learned something new.

Setting a value on options is tricky. Their worth is derived from a variety of factors which includes the price of the underlying security and a host of other items Wolfinger points out.

The golden nugget in this chapter concerns the two relationships between options/interest and options/dividends. Wolfinger does a great job of explaining the relationship between options/interest, but it boils down to the fact that increased interest rates hurt the value of put options. This can be significant if your strategy focuses on selling put options. High interest rates could definitely hamper the premium you receive.

Dividends, for those of you that don’t know, are payments companies make to stock holders on a recurring, usually quarterly, basis. As an example, CLF currently pays me $.15/share per quarter. Right now with 200 shares that equates to $30/quarter. Not a lot, but it never hurts to get paid for doing nothing!

Dividends, however can help or hurt the pricing of options. If your underlying stock is on or past it’s ex-dividend date, the date by which you must own the stock to get paid the dividend, then the option will take into account the dividend rate in its pricing. This negatively impacts call options and helps puts.

Above all, however, Wolfinger says volatility is the most important factor in valuing an option. If you’ve glanced across the Internet’s variety of options trading resources you’ll see this rings true with just about everyone. Volatility, however, is the one element in an option’s value which isn’t known and must be forecast. This is where the variability on the value of an option can begin to creep in as various people predict volatility at different levels.

This is a topic for another time. In fact, volatility gets its own chapter which I’ll cover in my next post!

Today you learned a TON about options. What they are, how they’re valued and traded and how interest rates and dividends can help or hurt their value. If you’re just getting into options trading I highly suggest picking up a copy of The Rookie’s Guide to Options to get you started. I’ve already learned a lot of new information and it’s opened my eyes to how I look at the value of options.

Join my growing community of followers by entering your email above on the right which will notify you when I discuss volatility. Also, it would be great to hear from you what you think about this book review series!

Join the discussion 2 Comments

  • Gene Alvin says:

    Hi, I stumbled into your site while searching for information on Options Journals and spreadsheets. Great site! I’ve been studying the Market and have focused on position trading. Not long ago I found a site called Dough that is all about options and I like it but I think that your site is superior in that it deals with the day to day option trading routines that beginners, like me, can follow and understand. I am considering purchasing the Trading Journal Spreadsheet. I see that you use it. Seems like a step in the right direction for me. Again, great site, I’ll be following it from now on.
    Regards

    • Patrick says:

      Gene,

      Thanks for the kind words! I’m finishing up an article on rolling options which features lots of material from Dough’s parent company TastyTrade. They’re a great resource and full of info for new traders.

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