Chapter 1 The Basics of Option Trading

OEX is the ticker symbol for the S&P 100 Index (Standard and Poors S&P 100 Stock Index). OEX options allow traders to speculate on the movement of the OEX. The OEX consists of the 100 top blue-chip stocks from diverse industry groups - they provide a good measure of the markets overall performance. The OEX is a subset of the S&P 500 index; the OEX is based on 100 of the 500 stocks of the S&P 500. OEX issues are not equally weighted - the larger a stock, the greater its influence on the total index. There are 100 top blue chip stocks in the world, such as Microsoft, GE, and IBM that are tracked as an index. This is called the Standard and Poors 100 (S and P 100). If an investor wanted to buy the actual stock index, equal number of shares of all 100 stocks, the stock symbol is OEF. Investors have been using OEX options (with American-style exercise) since 1983. More than one billion OEX options have been traded since then, making the OEX one of the most popular equity portfolio management tools in history.

Top 20 OEX Stocks

Seasonality defines which of the stocks are in the top 20, and the list may change, but these should provide you some good indicators. Microsoft (MSFT) Intel (INTC) General Electric (GE) Amgen (AMGN) Pfizer (PFE) Cisco (CSCO) International Business Machines (IBM) Citigroup (C)

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Wal-Mart (WMT) Johnson & Johnson (JNJ) Oracle (ORCL) Merck (MRK) Philip Morris (MO) JP Morgan (JPM)

Exxon-Mobil (XOM) American International Gp (AIG) Home Depot (HD) Bank of America (BAC) Proctor & Gamble (PG) PepsiCo (PEP)

These stock issues begin the index for the top 100 stocks that allows an investor to buy the stock options of the S and P 100. The stock symbol for this is OEX. Every day the OEX is tracked just like the Dow Jones average. In fact, they both run very close parallels. For example, the Dow (DJIA) may be 11,000 one day, and the OEX may be at 586.00, meaning the value of the OEX at that time is 586.00. During the day, just like the Dow, the OEX goes up and down based on the value of the top 100 stocks, and thusly the index options, themselves, change in price. These changes to the price (say from 586.00 to 588.00, or to 579.00) make the OEX go up or down in value, and the options on them change prices at the same time. If the OEX is at 586.00 there may be a stock option that looks like this: OEBDT- Apr590C- This is an April 590.00 call. 590.00 is the strike price. The option may show a bid price of 2.00, and an ask price of 2.40. This means there is someone that owns the option and is willing to sell it at 2.40, and there is someone that wants to buy the option and is willing to pay 2.00. The seller may have previously bought this option at 1.50, and is now trying to make a profit of .90 on the option. The buyer is interested in buying the option at 2.00, and thinks the option may go up in price. He/she thinks this because the current price of the OEX is 586.00 and the trader believes the index will go UP in value. The higher it goes, and especially if it strike price exceeds 590.00 the more the value of the option will be. The trader would like the option to become worth, say, 3.50, so that he can sell it for a 1.50 profit.

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Each of these options is a contract. One contract equals 100 shares. Thusly if a contract is available for sale at 2.40 and a trader buys one, he is spending 240.00. OEX options are popular for several reasons: 1. Investors can trade OEX options rather than analyzing and investing in any of the 100 top stocks individually. It takes less money for greater reward, at greater risk. 2. Purchasing S&P 100 options can be less risky than buying and selling numerous individual stocks Trading OEX options requires less capital than trading the options of individual stocks. The trader can leverage better. Lets make it clear. Heres the definition of an option: An Option is a financial instrument that gives you the right to buy or sell a specific stock at a certain price within a set time period of time. Financial instruments mean an investment that can be bought and sold. Options are flexible. They allow you to buy or sell to another at a profit or loss; that is, they give you the RIGHT to do so, but not an obligation. www.cboe.com A CALL makes money when the stock goes up, and a PUT makes money as the stock goes down. Straddles and Strangles are two types of Option positions. Simply put, they involve buying a CALL and a PUT at the same time. When you hold both PUTs and CALLs you are insured by something moving either way in the market. Your risk is reduced by holding both...smartly hedging a bet that you have bought right on one (no matter which way the market moves). Floor traders are important people doing a different job than you may see in the news or on TV. Companies hire Option Traders to sell their Options; they don't want them speculating. They are hiring them to trade the spread, limit the risk, and hedge against losses. This means Floor Traders make their profits on the spread. They have no bias, do not forecast the market well and don't want tothey are traders. They want to sell PUTs and CALLs and make their money, again, on the spread between Bid and Ask. This is the price you get between what the trader is offering the stock for (ASK) and what you and others are willing to pay (BID). With many stocks there is a spread between Bid and Ask that is the profit a trader makes and it can be large. Your goal is to be as close to what price you are willing to pay and what price the seller will let it go. We teach that the bid/ask are the current boundaries of the option, and nothing more. They should not be viewed as leading indicators. As an option trader you choose what you are willing to pay, and to sell for.
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The Rules of Engagement

To succeed at option trading you must have specific rules in place for every trade you make, in advance.

What The Rules Are

1. The capital available and the amount you are willing to RISK per trade 2. What profit goals you have, and when you will sell an option that is profitable 3. What stop loss rules youll make, knowing when to GET OUT of a trade

Clear Risk Methodology

Define what % of your available capital you are willing to risk to make a trade. This is called a reward to risk ratio. Successful traders pick a % of their trading capital that they define as the maximum exposure they will have per trade. You should define the specific percentage you are willing to risk, and hold to this.

REWARD TO RISK can be interpreted as: The total amount of your available trading capital that you will USE per trade Or The amount of your trading capital that you will RISK per trade (be willing to lose)

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Chapter 3 Learning About Yourself

Weve lost some serious money in the option market. Our blood is on the floor. In the prologue Confessions of an OEX Trader we found that learning about me was the key part of our successes. Most individual option traders, when honest with themselves, have really not made money. The slick ads and websites that offer 200% returns are merely snake oil salesman in disguise, part of the hype and wrong information about the real value of trading stock options. When you hear bad things about trading options, the lawsuits, manipulated markets, hipsters with email services promising 200% returns! And can prove it; they are all true. This is just when unscrupulous behavior taking advantage of novices is taking place. If youve done your homework, you know that you already buy options every day. Your car insurance is an option. Mortgages are options. You also know that trading options can be gambling, no better than bad blackjack in Las Vegas. Index options appealed to you because it can be an effective way to increase your net worth. If you have been the typical trader, you buy high, hold for too long, and sell low. You may set rules but seldom follow them, and second guess yourself with emotions and circumstances taking ownership of your discipline. As a typical investor you may try a variety of approaches, typically not for too long, and learn bits of pieces of everything, using little of it. What goes wrong with stock or option trading is simply FEAR and GREED, and lack of discipline. Period. The psychology of YOU is critical to successful trading. Maximum profits and minimal losses occur not by great mechanical trading systems, but by knowing your own emotions, trading knowledgeably reading the market, and having your own Rules of Engagement.

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Chapter 5 Choosing the Option to Trade

The Logic of Repetition
Trading is all about numbers. Some of it is fun, but the fun has a reason behind it. W.D. Gann is one of the greatest market gurus, who traded long before World War 1, and who has influenced and provided many of the classic tenets of trading. In our index and supply and demand studies we use Gann in many ways; Gann is complex and difficult to decipher, but the stop loss thinking, and use of counts we use in our daily signal directional bias, comes straight out of Gann logic. As you read the puzzles and thinking below, add the following to your OEX thinking from Gann: Changes in trend take place in Threes (3s)third month, six, nine, twelve, etc. Changes in overall trend also take place on the 10th of each month, and again on the 15th. On the 20th to 23rd of each month high and lows for a stock or option are also more likely to have been reached. If a trend is established already, count 10 days towards the bias, and begin watching the 11th thru 15th day as the primary LAST shift to the reverse bias. In other words, patterns of up or down do not typically last beyond the 12th or 13th day. Seven (7), historically important in many religious texts, Gann believed to have strength beyond all numbers.

From Benjamin Franklin, W.D. Gann, and mathematicians worldwide since time began, the theories of patterns, repetitions, and algorithms have been the basis of process. With index option trading we use the simplicity of patterns and math to define trends. Math patterns were analyzed from ancient times. W.D. Gann took much of
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