All options are priced through a complex calculation called the options pricing model. I call it a ‘machine’ because it’s so exact and so dependable! (The markets are so efficient.) The OPM works like this:

It takes the six market variables — the current price of the underlying stock, the strike price of your option, the number of days to expiration day, the current interest rate, the current dividend rate and the current implied volatility and runs them through the very complex, highly mathematical, Nobel prize-winning formula to come up with the current value of an option.

Of special note to options traders is that while the price, the interest rate and the dividend rate are what they are. Furthermore, the strike price and days until expiration are of your picking. But the IMPLIED VOLATILITY is a made into a crucial ‘wild card’ of which ALL OPTIONS TRADERS MUST BE AWARE.

The reason is that this variable to the OPM is ‘manipulated’ or, perhaps I should say, ‘calculated’ by the market makers depending upon the current supply and demand on that particular option.

For example, if a certain option, for what ever reasons seen from the perspective of traders, is highly desired and begins to have lots of people buying it, the market maker will increase its implied volatility and, EVEN THOUGH HE CAN’T TOUCH THE OTHER FIVE FACTORS, CAN,IN EFFECT, CAUSE THE VALUE (price) OF THE OPTION TO INCREASE.

Likewise, if the market’s desire for a certain option decreases, he will decrease the IV (implied volatility) and cause the price to respond, along with its responses to the other five factors, to decrease in value.

The bottom line, for options traders, is that the implied volatility variable is a significant consideration when searching for an option and in determining whether to buy or sell it. 

The following scenario, as a matter of fact, is common:

A trader performs his market analysis on a stock and chooses to have a bullish bias, meaning that he thinks that it is going to go up in price (value). It’s at $30 and he buys the option at the $30 strike price for, say, $2.00.

[Note: Each option represents 100 shares of stock. The prices shown on the options chain, which we'll discuss soon, are of individual shares. Thus the option described above represents 100 shares @ $30 or $3,000 in stock value. Since its price is listed as $2.00, he actually places 2.00 x 100 or $200 at risk in this trade.]

Then the price of the stock DOES slowly increase in value and a week later, the new price is now $31.50. He thus proceeds to sell the $30 strike price option that he owned and finds, to his chagrin that, even though he predicted the stock increase correctly, he actually LOST money on the trade!

Incredulously, our hero calls the trade desk of his broker to complain and to find out what happened. That’s when he learns, the hard way, that while the PRICE of the underlying did go up, as he had predicted, two of the other factors – passage of time and implied volatility drop – overrode the increases in his option value that arose from the stock price increase to the point of taking a loss.

In other words, he failed to realize that in ANY MARKET MOVEMENT some of the five variables of the OPM will work FOR you, to make your trade profitable and some will work AGAINST you, to make you suffer a loss. Whichever side achieves the most will decide the overall outcome of your trade.

More next time………..

Recall that options are of two types, calls and puts. We’ve already covered their definitions, so we’ll proceed to the next step.(All of options learning is sequential! That means that it’s best to learn ONE section at a time and know it well before proceeding to the next step.)

Every option has an ‘open’ order which must be followed by a ‘close’ order.

When you SELL an option, you want its value to decrease so that you can buy it back cheaper and put the difference in your pocket. When you BUY an option you want its value to increase so that you can sell it back for more money than you paid for it, which represents your profit.

So the process is STO (sell to open)/BTC (buy to close) or BTO (buy to open)/STC (sell to close).

However you approach an option, you do so based on how you believe the market is going to move.

Summary of these two points:

If you think the stock you’re looking at is going to go up, you might BUY a call option that will increase in value when the underlying stock does so. Or you could SELL a put that will decrease in value when the stock goes up.

If you think the stock is going down, you could BUY a put that will increase in value when the stock does so. Or you could SELL a call that will decrease in value when the stock goes down.

Confusing? Of course it is! This is only ONE example of why NO ONE SHOULD TRADE OPTIONS WITHOUT GETTING THE PROPER TRAINING and have plenty of experience in PRACTICING the trading of options before putting real money into them!

But, back to the point…….

The point is that whether we make money or lose depends on how the VALUE of the options changes once we made placed our trade.

But how are those VALUES calculated (thus how is it determined that you make a PROFIT or suffer a LOSS on a trade)?

Here are the six factors that determine, through a fancy and complex calculation, what the new value of the option is:
(the original calculation won a Nobel prize!)

1. The current price of the underlying stock
2. The strike price of your option (recall that all options are contracts that have, as one of their stipulations, the price at which the transaction will take place; that’s the ‘strike price’ of the option)
3. The number of days to expiration day (again, recall that all options’ contracts have a time limit, i.e., a date at which time, if the transaction has not occurred, the options expires worthless)
4. The current interest rate
5. The current dividend rate
6. The current implied volatility (here I’m introducing a new term – volatility. There are volumes written on this subject, but at this point, just know that it is basically a measurement of the amount of fear and uncertainty that exists in the market at this point. The more fear there is, the more erratic and unpredictable price movements tend to be.

In the next section, I’ll cover how all of these comes together to form the new option value.

You may not have noticed…………….but, this trading stuff is risky.As a student of trading, I have to admit, publicly, that I found the truth to the above statement the hard way. (Is there any other way?)

Here’s what I was recently told, by my mentor:
“Winners focus on RISKS.
Losers focus on PROFITS.”

NOW he tells me! (In Texas, we call it closing the barn door after the horse has gone.)

As I look back on my beginning trading and as I speak with many starter students of trading, I see a definite pattern: They are thinking of making a PROFIT, they look at how much they could MAKE on a trade and they are not REALLY aware of the full RISKS that they are taking on, especially in relationship to their portfolio size.

How does this happen?

Here’s my take on the matter:

Many students want to make more money than is reasonable for their portfolio size. Likewise, they want to make it faster than is reasonable and realistic.

Thus they make several mistakes:

1. They ignore the fact that there are PORTFOLIO MANAGEMENT RULES which are well-documented, established and proven thousands of times to hold true.

They make the common error of thinking, “I’ll be different” or “Yes, but my situation calls for more aggressive action.” I’m sorry to say, ladies and gentlemen, but both are death knells and lead to NON-survival of the learning curve. They lead to action and attitudes that are more gambling than trading. They somehow, deep within their minds, rationalize that those rules do not apply to them. But they do. They DO!

2. They don’t know how to correctly analyze a potential trade for the true risks involved.

They don’t consider the fact that ‘anything can happen…and will!’ They don’t learn how to place the trade on a risk graph and to SEE, not just LOOK, at how much exposure they’re taking on. And, worst of all, they don’t consider the ‘Black Swan.’ The Black Swan is defined as being the worst possible thing which can happen, the thing that no one believes will happen and that, when it happens, pundits say, ‘It was easy to see it coming!’

As another example, suppose the trader forgot about a put option he had sold and it ended up, on expiration day, in-the-money? Would he be shocked if the next Monday morning, he looked at his screen and found that he owned hundreds of shares of stock and his account had been debited for thousands of dollars?

3. They attempt to fix a defined risk trade with an unlimited risk ‘adjustment.’

This is where they might place a spread, for example, a short call vertical (bear call), the market rallies, so they sell a put to offset the loss in the vertical. What happens, in this case, is that they have UNLIMITED downside exposure that could lead to ‘sudden death’ to their portfolio.

Here’s my trading psychology on placing a trade:

a. Ask what the Black Swan RISK is and EMBRACE that odiferous bird, i.e., be sure you’re financially, mentally and emotionally comfortable with that much loss.
b. Define what your MINIMUM profit level is so that, when that’s hit, you can GET OUT and take your RISK off the table as soon as possible.
c. If the trade goes against you, FIRST consider simply reducing your RISK in the play.

The committee of ‘they’ says, “Focus on RISK reduction, avoidance and minimization. Eventually, you’ll actually start to see some profits!”

I concur.

Let’s survive our learning curve together by watching our risk at every turn!

Is trading easy?It can be categorized as ‘simple,’ but, of course, that doesn’t mean that it’s easy. Simple is herein defined as being CLEAR.

You see, my dear fellow students of trading, there are two kinds of simplicity.

The first attracts the trading students who might be looking for easy, quick, pat answer to all of their trading questions. This person is of the opinion, consciously or subconsciously, that if he takes enough courses, reads enough books, finds the right trading system, does enough market analyses he’ll be able to solve the puzzle of successful trading and reap huge financial benefits, multiplying his current portfolio size.

While each one of those items is worthy of our attention, he might overlook the fact that all of those are OUTSIDE OF OURSELVES.

The second kind of simplicity includes all of the above activities but BEGINS with these four crucial ingredients:

a. A deep journey within OURSELVES to look objectively at how we think, how we perceive the world, how we react to people, events and things around us,

b. A forgiveness of OURSELVES for past shortcomings and a true acceptance that we are worthy of success,

c. A total release of any attempts to CONTROL people, events and things around us, and

d. A total release of any TIME CONSTRAINT or expectation of how long it will take to become a successful trader. (This means denying our ego that is begging for quick gratification.)

Then, when the day comes when we have reached that elusive level of financial, mental and emotional wealth that we have desired, we can consider ourselves as having earned the right to return to viewing trading as ‘simple.’

Then we’ll know that seeking simplicity directly is not the right path.

It’s only simplicity on the other side of complexity that is of true value and fulfillment.

BTW, after it becomes ‘easy’ to us, then we’ll say, ‘It was simple!’

All students of trading, especially those that are serious about surviving their learning curve, need a trading manager.This is a person whose brain is a like a Montana bear trap, whose blood is cold as Texas tea and who walks around, in the office, wearing a steel- faced helmet and shield. Also, she has a machete hanging from her belt.

Her job is simple:

1. Disallow you to trade until you have a written set of trading rules on each and every strategy that you employ. You must write them, but they must be passed through a Review Board of her sisters. The board will perform a critical review of these rules and must approve them before you can trade with real money.

2. Disallow you to place a large position size. This includes not only the size of your long trades (debits), but the risk you accept on your short trades (credits), the size of your margin requirements and, finally, the Black Swan risk you take on any single trade or any group of trades within the context of your portfolio. (She will also enforce, under most cases, the rule that only defined- risk trades will be allowed.)

3. To look over your shoulder every moment that you’re executing a new trade, making an adjustment to an existing trade or exiting a trade. With checklist and red pen in hand, she’ll watch to see if you do all the above in the exact same sequence and manner that you did on the last ten such trades.

The services of this trading manager from Hades are invaluable to us traders because she forces our EGO and our THINKING to get out of the way of our trading success.

So long as we dutifully and cheerfully comply with her ‘suggestions,’ she’s as sweet as a Southern Bell, with a flower in her hair and a soft, honey-dripping demeanor.

But if you dare cross her on any of these rules…… Well, it’s not a pretty picture. You don’t want to KNOW what she’ll do, all for your own good!

My fellow trading students, you cannot trade successfully without this trading manager!!

Hire her.
Marry her.
Adopt her.
Be her.
Do whatever it takes to bring her on board.