Bernie Schaeffer - Option Advisor - Top Gun Trading Techniques

Option Advisor: Top Gun Trading Techniques

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Welcome to the Crash Course in Options Trading:

Top Gun Trading Techniques

Dear Subscriber:

Bernie SchaefferAt A Glance

Thank you for subscribing to The Option Advisor! You have made a wise investment decision, and you'll find my unique trading strategy to be both rewarding and easy to apply.

As promised, listed below are links to your Crash Course in "Top Gun Trading Techniques". Please review the course materials in the following order to maximize their educational value to you:

1. Characteristics and Risks of Standardized Options - This guidebook should be called "Everything You've Always Wanted to Know About Basic Option Trading But Were Afraid to Ask".

2. Your Step-by-Step Guide to Making Your First Successful Option

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Trade - Executing a successful option trade has never been easier. You'll learn exactly what to do when you pick up the phone to make your first option investment.

3. The 6 Most Dangerous Errors Made by Amateurs When Trading Options - Substantially reduce your investment risks by understanding what the most common errors made by novice option traders are, and how to avoid them.

4. 25 Amazingly Profitable Ways to Trade Options - This special guide reveals 25 inside techniques and strategies for boosting the success and profitability of your option trades.

5. How to MAXIMIZE Option Trading Profits - This in-depth audio presentation reveals the specific fundamental, technical and strategic factors that contribute to an ideal option trade.

6. Brokerage Firms That Go the Extra Mile for Option Investors - This exclusive report gives you all the important details for selecting exactly the right brokerage firm for your specific option investing needs.

In short, the Flight Pack contains all the information you need to start making successful option trades right out of the gate.

We will notify you via e-mail of every Option Advisor Hotline update along with its web address. However, you may also access Hotline updates by calling: (513) 674-9741. Telephone Hotline updates are available every Monday at 7:30 p.m. Eastern Time, and at noon Eastern Time the day following a +/- 100-point close on the Dow.

And, in addition to your monthly Option Advisor newsletter, you will also receive Special Bulletins at times when there are unusual profit opportunities.

The Option Advisor is published on the fourth Friday of each month. You can also act immediately on my recommendations by calling my telephone hotline message on the Thursday before publication (once every month) after 10:00 p.m. Eastern Time, or by accessing the Option Advisor website. This way, you can implement my recommendations on Friday.



Customer Service Help LineWe never leave you stranded. If you don't understand a strategy...if you need terminology clarified...if you have an important question...if anything at all seems confusing, simply call Customer Service Help Line toll-free at (800) 327-8833 for immediate clarification. My representatives are ready and willing to assist you with any subscription-related question you may have.

I again welcome you as a subscriber, and I look forward to serving you well in the years ahead!

Sincerely yours,

Bernard G. SchaefferSenior Editor

P.S. -- Remember, you can access our Telephone Hotline Number and our Option Advisor website at any time. All "between issue" hotline updates are made on Monday evenings at 7:30 p.m. Eastern Time. And, on the Thursdays before publication, the hotline messages begin at 10:00 p.m. Eastern Time. We will notify you via e-mail of these updates.

Note: The copyrighted Option Advisor Top Gun Trading Techniques and Option Advisor recommendations are specifically intended for your personal and confidential use as a subscriber. For your protection, any other usage or dissemination of the above mentioned materials or information is prohibited.



Top Gun Trading Techniques - Characteristics and Risks of Standardized Options


Top Gun Trading Techniques Table of Contents

Welcome:Introduction to The Option Advisor Flight Pack by Bernie Schaeffer

Section 1: Characteristics and Risks of Standardized Options

Section 2:

Your Step-by-Step Guide to Making Your First Successful Option Trade

Section 3:

The 6 Most Dangerous Errors Made by Amateurs When Trading Options

Section 4:

25 Amazingly Profitable Ways to Trade Options

Section 5:

How to MAXIMIZE Option Trading Profits

Section 6:

Brokerage Firms that Go the Extra Mile for Option Investors

Characteristics and Risks of Standardized Options

Before you begin trading, it is important to understand that options involve risk. Prior to buying or selling an option, an investor must have a copy of Characteristics and Risks of Standardized Options.

You can access and download the booklet on The Options Clearing Corporation's (OCC) website at:

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Top Gun Trading Techniques - Characteristics and Risks of Standardized Options

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This link reference is provided as a courtesy and does not imply that the OCC is endorsing Schaeffer's Investment Research or its products. This booklet is also available for free from your broker or from any of the U.S. options exchanges or you can call SIR toll-free at (800) 327-8833 and we'll be happy to send you another one.

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Top Gun Trading Techniques - Making Your First Successful Options Trade




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1. Before trading options, you must set up an options account through a brokerage house. (THE OPTION ADVISOR recommends using a discount broker. That way, you keep your costs to a minimum.)

2. Once you select the options you want to trade (THE OPTION ADVISOR makes this easy and dependable with clear, precise

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recommendations), tell your broker which options you want to buy and/or sell. Your order will sound something like this: "I'd like to buy the XYZ Corp. September 60 call (or put) option." Translation: you want to purchase the right to buy (or sell) XYZ Corp. stock at $60/share (the strike price). This right expires on the 3rd Friday of September (the expiration date). As the purchaser of an option, you are not obligated to either buy or sell the stock. You can choose to close out your position at any time, or you can let your option expire.

3. Always give your broker a maximum entry price (sometimes called a "limit" order) for the option. This price is the most you will pay for each option on an underlying stock. By entering a "limit" order, you protect yourself from overpaying. (THE OPTION ADVISOR lets you know precisely the highest price you need to pay for every recommendation.)

4. Your broker will give you the current price of the option and ask how many contracts you want to buy/sell. Important: each standard option contract is based on 100 shares of the underlying stock; thus an option quoted at 2 would cost you $200 before commissions. (THE OPTION ADVISOR suggests you use only your trading capital for options trading. Never buy puts or calls with money needed to pay bills. Intelligent trading decisions are rarely made when "scared money" is involved.)

5. THE OPTION ADVISOR recommends that you place a "limit order" at your maximum entry price or below (1) for the day only, or (2) good-till-canceled. These ensure your order being filled at or below your maximum entry price. The "day" limit order expires at the close of the market that day if not filled. This is advantageous if the underlying stock should move against you the following morning. Day orders should be re-submitted 20 minutes after the market opens the following day. Good-till-canceled limit orders are best for those who don't have the flexibility to call their brokers each morning. However, a good-till-canceled order will be held by your broker until you cancel it.

6. Your broker will confirm when your order is filled. This should be done over the telephone and/or through the mail.

7. You can also place an exit price at this time, using a good-till-canceled sell order. (THE OPTION ADVISOR provides a target profit



for every recommendation, and a table to help you determine the exit price.) Setting an exit price now will eliminate emotions from your trading, letting you "take the money and run" to the next trade.


Top Gun Trading Techniques - The 6 Most Dangerous Errors Made by Amateurs When Trading Options




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Have you ever lost money trading options before, or has someone told you that options are a losing game? That's probably because the methods being used to trade options were faulty or overly simplified. I've identified six reasons why the majority of option players fail to make money, and in turn, why I've been able to be so successful in my Option Advisor newsletter recommendations.

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1. Inappropriate short-term selection methods

Selecting the right stock (and the best corresponding option) is the first step in successful option trading. Some option traders will take a situation they just read about in the news as an option play. Others tend to look at longer-term measures like a stock's valuation as an indication of a stock's short-term potential. This mismatching of timeframes is one of the biggest mistakes made by those who trade options. My staff and I sort through the entire universe of stocks with listed options, in order to pinpoint only those situations which look most attractive for sharp short-term movements. The Option Advisor uses a methodology based on not one, but all of the key short-term factors that drive stock prices -- technical, fundamental, monetary and sentiment.

2. Betting against trends

Trends in prices, whether up or down, have a tendency to last longer than people expect. Most traders lose the bulk of their money betting against trends. I've specifically developed my indicators to tell me not only the nature of the trend, but also the investing public's view of the current trend. What I've found is that a prevailing disbelief of an existing trend gives a confirmation that the trend will continue, since there's money on the sidelines that will eventually be convinced to buy into the trend before it ends. Thus, my approach in buying options with the trend allows you to trade on the right side of the market.

3. Inability to take a loss

Sure, everybody loves to hear about gains and profits, as this is what we all seek to achieve. While "loss" has negative emotions attached to it, the key is not to be emotional in trading, but rather to stay objective in all trading decisions. If the market is not validating my analysis, I have specific exit rules that get my subscribers out of option purchases before their expiration, so that big losses can often be avoided and capital can be preserved for future trades which are likely to be more profitable.

4. Lack of discipline

Many option traders fail because even when they do have gains, they let them slip away by not knowing when to get out and take a profit. Often, you should be taking a profit when the position is moving most obviously



in your favor. What I've been able to teach option traders is that a mechanical system for entry and exit prices must be in place before the trade is initiated. I pre-determine the highest price that should be paid to enter the option, and the subsequent price that, when reached, will automatically force profits to be taken. This allows traders to prevent profits from slipping away, and enforces the discipline necessary in any successful trading approach.

5. Poor money management

Every smart option trader knows that even with a winning approach, money management is crucial in building an account's value. The primary consideration is how much to invest in each trade every month. Often, amateur option players come into the business and make some nice gains right off the bat. Then, thinking this is a simple way to riches, they let all their capital (including all their profits) ride on a subsequent trade that wipes them out. Then they vow to never trade options again. The answer here is to first know the rules of the options game: there is great upside on winning trades, while you can also lose all of your investment in a particular option trade. Clearly no matter how good your approach, you will never win 100% of the time, and you should not allocate all (or even the majority) of your trading capital to any particular trade. How much do you invest? Each month, I tell Option Advisor subscribers how much of each portfolio's cash reserves should be devoted to the recommendations in a particular newsletter. And my Handbook describes money management in great detail, so traders can trade confidently with the proper commitment of their financial resources.

6. Consensus thinking

Amateur traders tend to bet with consensus thinking, which is a sure way to lose in option trading over time. Whether it's an article in a national publication, a hyped new product or a "tip" you're betting on, Wall Street has a way of already discounting such news before it becomes widely disseminated. By that time, smart traders are looking for opportunities to bet opposite from the conventional wisdom. I've learned that you can use options very successfully in contrarian bets. Understand that a contrarian does not always "zig" when others say "zag," but rather looks for extreme viewpoints which are apt to spotlight the key turning points in stock prices. That's what defines true contrarians, and that's a major reason why I've been so successful for those who subscribe to The Option Advisor.




Top Gun Trading Techniques - 25 Amazingly Profitable Ways to Trade Options




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1. Options Trading and Your Financial Situation

Trade options in accordance with your financial situation. Never risk funds that you cannot comfortably afford to lose. Although trading options can yield huge profits, there is always the risk of a loss. If you are trading with funds that may be needed for other purposes, the axiom,

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"You never make money with scared money," may well apply. Your buy/sell decisions might be based on factors external to the market, which can severely decrease your chances of being successful.

We recommend that you devote about 20 percent of the funds that you would have invested in common stocks in The Option Advisor recommendations and invest the remaining 80 percent in riskless instruments such as Treasury Bills. Use The Option Advisor to maximize your chances for profits on your risk capital.

2. Options Trading and Your Temperament

Trade options in accordance with your temperament. Even if you are trading with your risk capital, you may be the type of individual who prefers to sacrifice some profit potential to reduce the chances of a total loss. In this case, more conservative strategies, such as covered call writing, are more suitable for you. On the other hand, if you prefer to maximize your profit potential and are willing to take an increased risk of large losses to achieve this objective, your strategy would be to purchase individual puts and calls outright. The Option Advisor maintains three separate portfolios (the Aggressive, LEAPS, and Put Selling Portfolios) to accommodate investors with these different risk/reward preferences.

3. Diversify!

A major advantage of trading in options is truncated risk, whereby your loss is limited to your initial investment, yet your profit is theoretically unlimited. Diversification will allow you to use truncated risk to its maximum advantage. While some of your positions will inevitably be unprofitable, each profitable position can offset several unprofitable trades. For example, assuming equal dollars invested in each of five option positions, a bottom line profit will be achieved if three of the positions yield profits of 100 percent, even if the remaining two positions result in total losses.

Diversification should be two-dimensional. This is accomplished by purchasing calls and puts (see below for a discussion of puts.). You are then insulated from the impact of overall market movements. The



Option Advisor strives to provide you with the most attractive call and put situations every month. Further details on truncated risk and two-dimensional diversification can be found in The Options Handbook.

4. Put Options

Trade in puts as well as in calls. Many people believe that the only way to make money in the market is to take a bullish position on an advancing stock. This orientation is compounded by the general fear of selling short, where one’s loss is theoretically unlimited. You can take a bearish position by buying a put, yet enjoy the advantage of limited risk offered by all options.

Remember also that ex-dividend stock price adjustments help put owners, while they are a negative for call owners (see #24 on page 12 for a discussion of ex-dividends.) Each month, The Option Advisor researches numerous attractive put and call situations to provide you with the most potentially profitable option opportunities.

5. Target Your Profits

Set your profits objects in advance. You should calculate your target exit point at the time you make your option purchase. By doing so, you will avoid the consequences of one of the major stumbling blocks to achieving trading profits - greed. It is virtually impossible for most investors to set reasonable profit goals once an option has advanced substantially in price. That "extra point" or "extra half-point" becomes a moving target with each advance in the option’s price. It is not surprising that, more often than not, the target is not achieved, and the investor is forced to panic out at tumbling prices (thereby becoming a victim of stumbling block number two - fear).

The Option Advisor gives you all the information you need to easily calculate your target exit point for each option position. You merely use the target profit percentage included with each recommendation. Once you make your option purchase, set your price objective and do not deviate from it, regardless of the temptation. Further detailed explanations of target exit points and profit objectives, as well as a table of pre-calculated target exit points, can be found in The Options


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Handbook.

6. Protect Your Capital

You can protect your trading capital by using the appropriate asset allocations listed in each month’s newsletter. Also, aggressive traders should always establish a closeout date to exit a position that has not achieved its profit objective. For instance, in The Option Advisor Aggressive Portfolio, this date should be one to two months prior to option expiration. By establishing a closeout date, you protect your trading capital by avoiding the accelerated deterioration in option premium (time decay) that occurs in the final month of trading. (Our Put Selling portfolio, on the other hand, is designed to take advantage of this time-erosion component of options.)

7. The Best Broker for Instant Executions

Use a broker who has voice contact (i.e., a direct telephone connection) to the options trading floor. This is not the only factor in choosing your broker, but in the fast-moving options market, a voice contact broker offers instantaneous connection to the options trading floor. This gives you a better chance of entering a trade at or below the maximum entry price that we use in our recommendations.

8. Keep Your Commission Costs Down

Shop around for attractive commission rates. Of course, commission rates should not be the only factor involved in selecting a broker. However, since options trades are of very short duration, the cost of a "round-trip" commission can have a significant impact on your bottom line. Many of the discount brokers have sharply reduced the cost of trading options. Also, a number of traditional full-service brokers are willing to discount their full ticket commissions for active options accounts. It never hurts to ask.

Discount brokers advertise regularly in Barron’s, Investor’s Business Daily, and The Wall Street Journal. We also provide a list of brokers who go the extra mile for options traders.




9. When to Ignore Your Newspaper

Don’t be misled by the closing options prices as listed in your newspaper, as many of the less-active options do not trade throughout an entire market session. In fact, the many of these less-active options will often have their last sale early on in the trading day. (For that matter, it’s entirely possible for an option to not trade at all on a given day.) Naturally, if the underlying stock makes a significant move later in the day, the closing options prices could be far out of line. Since complete option volume figures are not generally published, it is not possible to use printed volume as a gauge for the timeliness and accuracy of the closing price.

Solution: Use the "Options Quotes" feature at SchaeffersResearch.com to get the closing bid/asked quotation and the volume for each option you are following (or have your broker do this for you). Either way, you will have a big head start in the next morning’s trading over those who base their trading decisions on the prior day’s "closing prices."

10. Interpreting Options Quotes

Don’t be confused by apparent discrepancies between an option’s last sale and the bid/asked quotation. The options market is very fast moving, and adjustments are made quickly in response to price movements in the underlying stock. These adjustments are most quickly reflected in the bid/asked quotation. For example, if an option is quoted at "2 bid, 2-1/8 offered" with the last sale occurring five minutes ago at 1-15/16, be assured that the "true current market" is reflected in the bid/asked quotation. Be sure to incorporate the proper option pricing information in your trading decisions.

11. Be Careful at the Opening Bell

Never place an order to buy or sell an option "at the market" on the opening. Even the more actively traded options are not very liquid in early trading, so market orders are likely to be executed at unfavorable prices.

12. Beware of Market Orders


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Confine your market orders during the day to the most actively traded options, such as index options. In most cases, you will get better executions with limit orders. If you are in a hurry to execute, buy at the offering price or sell at the bid price. As a compromise, you can give your broker discretion to execute your order at a price 1/16 or 1/8 of a point away from the current market. This protects you from sudden changes in the market, and eliminates the "anything goes" possibility inherent in market orders.

Note: The options exchanges have introduced automatic execution procedures that provide much better executions for market orders on many option series. If you are trading an option on automatic execution, a market order is a viable approach. Check with your broker.

13. The 4:00 p.m. Trap

Never put yourself in a situation where you must close (or feel you must open) a position right before the closing bell. Most options are not very liquid late in the session and, like the situation at the open as described above, market orders will likely get filled at unfavorable prices. You’re better off waiting for the following trading day.

14. Maximizing Your Liquidity

Use volume and liquidity data to help determine the proper size for each option position. If every option were characterized by large trading volume and small "bid/asked" price spreads, the amount you invest in each option would be based almost solely on your financial situation and temperament, as well as by the need to diversify. Unfortunately, this is not often the case.

For example, let’s say you wanted to buy 10 contracts of a particular call option, but discovered that an average of only three contracts per day were traded over the past few weeks. In checking with your broker at midday, you learn that the option is bid at 10, offered at 11-1/4, and that no contracts have traded as yet. This presents a very difficult situation for the potential buyer of 10 contracts. You may be able to purchase all 10 contracts at 11-1/4, but this is a very large premium (12.5%) over the bid price. Worse yet, you may only be able to buy two or three contracts



at 11-1/4, with the remainder at 11-1/2 (or more). If you conservatively decide to place a bid at 11 (or even 11-1/8), your order may not execute for days (or at all, if the underlying stock price rises). Even if you ultimately buy all 10 contracts, it could be in separate transactions of one, two, or three at a time, thus costing you significant additional commissions. Furthermore, the stock price may have moved against you while you were acquiring the options, making your option purchase price unattractive.

Solution: Avoid such options unless you are buying one or two contracts (this, however, results in relatively high commission costs). If you are very interested in the underlying stock, try to find an option on the same stock with a different expiration date and/or striking price that has greater volume and liquidity.

Or: Perhaps there is a comparable stock in the same or similar industry with more attractive options. The short-life and longer-term options recommended by The Option Advisor are typically more active and liquid than average. The Option Advisor also publishes unique data on volume and liquidity for every recommended option to greatly simplify your decisions concerning the proper size of your position.

15. Use Limit Orders Intelligently

Watch your limit orders carefully (or have your broker watch them for you). You cannot walk away from limit orders the way you can with stocks. Since the true value of an option directly depends upon the price of the underlying stock, your "bargain bid" of 15 minutes ago may eventually be executed at a very disadvantageous price. For example, take a stock at 50 with a call option bid at 6 and offered at 6-1/2. You bid 6, the stock drops quickly to 48, and you are the proud owner at 6. Unfortunately, you shouldn’t have paid more than 4-1/2 at a stock price of 48.

The moral: You should be in constant contact with your broker on outstanding option limit orders to check whether they should be revised or canceled.

16. Avoid the Thundering Herd



Don’t stampede into an option. Options often take a little while to get rolling once the underlying stock starts a big move. The ideal time to buy the option is in this "percolating stage" just before the public rushes in. If you wait much longer, you will find yourself "stampeding with the herd" and paying "retail plus" for your option. Even if you are very enthusiastic about the underlying stock, it is usually best to stand aside at this point and wait for more favorable price relationships. Amid the enthusiasm and euphoria of the moment, ask yourself whether you really should be buying an out-of-the-money option that has already advanced a full point on a move of 1-1/4 points in the underlying stock!

17. How to Handle a Partial Execution

Don’t be overanxious on a partial execution. After you have placed an order to buy 10 options at 8-3/4, your broker make get back to you saying, "You bought five at 8-3/4, it’s your bid at 8-3/4 for the remaining five, the option is offered at 9-1/4." Instead of immediately paying the extra 1/2-point for the five options to fill your total order, wait a while. Since it is "your bid," any options that come in to be sold at the market or at 8-3/4 (or less) will be yours (up to a limit of five, of course). Your chances are pretty good as long as the underlying stock remains in a reasonable trading range. Of course, you and your broker should remain in close contact so that adjustments can be made in your order to respond to significant movements in the stock.

18. Demand Reasonable Executions

Don’t be afraid to question what appears to be a bad execution. For example, you may have entered a "buy at the market" order for an actively traded option, where the bid/asked spread was "10 bid, 10-1/2 offered." If your broker reports that you purchased your options at 10-3/4, while the current bid/asked spread remains unchanged and the underlying stock has traded in a narrow range, you are entitled to an explanation. Your broker can obtain from the trading floor a sequential listing of all trades in that option before and after your execution. If the execution still appears out of line, it can be appealed to the exchange itself.

Two important points to remember: The best way to help avoid this



situation is to place limit orders through your broker. Also, try to be objective about the overall quality of your executions—it is usually the excellent ones we forget very quickly.

19. Percentages and Bid/Asked Spreads

Don’t lose track of the concept of percentages when looking at bid/asked spreads. Always look at the spread as a percentage of the bid price. It is one thing to decide to pay the offering price when the bid/asked is "15 bid, offered at 16." You are paying 6.7 percent more than the bid price (1÷15) to achieve an immediate execution. It is quite another thing, however, to "pay asked" when the spread is "3 bid, offered at 3-5/8." That "mere" 5/8-point extra translates into a premium of 20.8 percent more (5/8÷3) than the bid price. Although this does not mean that you should never pay the extra 5/8, you should definitely factor these percentages into all of your trading decisions.

20. How to Understand Option Pricing

An options trader must be aware not only of the expected direction of the underlying stock, but also the expected magnitude of the movement (volatility) that the options market assumes to price the option. For example, if the options market is pricing for a 10-percent gain in the stock over a given period, and you correctly project a 20-percent gain over the same period, you will make money buying calls on that underlying stock. Thus, options traders will have a major edge if they have a method to determine the likely price change of a stock over a given period and then can assess the relative attractiveness (or unattractiveness) of the option premiums. This is important not only in the Aggressive portfolio, but doubly so in the LEAPS portfolio because of the added time for a stock to move. Volatility considerations are of primary importance for options players when the focus is on the magnitude of a move, rather than the move’s direction.

21. Option Expirations and How to Handle Them

Be aware of option expiration dates and times. Options cease trading on the third Friday of the expiration month. If your option is in the money, it would still be possible to exercise the option if you notify your broker



prior to 5:30 p.m. eastern time (you should always alert your broker in advance in these situations). Exercising a call would involve purchasing the shares of the underlying stock at the exercise (or striking) price, while exercising a put would involve delivering the shares of the underlying stock in exchange for consideration equal to the number of shares delivered times the exercise price. We do not recommend exercising your equity options, due to the large cash outlays and relative high commission costs involved. Instead, we recommend selling your in-the-money options prior to expiration.

22. Profit from Index Options

Profit opportunities abound in index options. These options allow the investor to take a leveraged position on the movement in the overall market. Index options can be used in a number of different ways to maximize your profits and reduce your risk. One of the most exciting ways to use index options is very short-term trading, with holding periods of one day to two weeks. While short-term index option trading has tremendous profit potential, many traders are unsuccessful due to buying overpriced options, inaccurate market forecasts, and trading on a hunch or emotion. The key to successful index option trading is having a disciplined, unemotional approach that can reduce risk while maintaining the reward potential. Our QQQ Speculator and OA Wealthbuilder services help traders overcome the problems that plague many novices who trade index options. For further information on this exciting area of investment, call your Schaeffer’s Investment Research account representative at (800) 448-2080.

23. Keep Your Eye on the Bottom Line

Investors trade options to achieve worthwhile bottom-line profits in a relatively short time frame. The big advantage in options trading involves truncated risk - you can never lose more than your original investment, but your potential profits are theoretically unlimited. Successful options traders almost always have more losing trades than profitable trades, but they still achieve substantial bottom-line gains. How? Their winners yield far more dollars per trade than are lost in their losing trades. It only takes two $2,000 profits in five separate $1,000 investments to achieve a minimum 50-percent bottom-line gain, assuming that all three remaining


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positions lose 50 percent each. Never look for perfection from your option trades. A reasonable "batting average" will still yield large profits. Just as in baseball, a ".400 hitter" in options trading is very rare indeed.

24. Ex-Dividends and How to Handle Them

Keep careful track of ex-dividend dates. On the day a stock trades ex-dividend, its price will be adjusted downward by the full amount of the dividend. As this date approaches, options premiums reflect the upcoming "automatic decline" in the stock’s price. To the uninitiated, put option premiums will appear inflated and call option premiums deflated, particularly if the stock pays a large dividend. For example, if a $50 stock is going ex-dividend for $1 the next day, the closing options prices will reflect a stock price of $49. An analysis of option premiums based upon the $50 price would be inaccurate and possibly quite costly to the uninformed investor.

Solution: Ex-dividend information for all stocks can be found in Barron’s, Investor’s Business Daily, The Wall Street Journal, and Daily Graphs chart books. Or, ask your broker.

25. How to Handle Stock Splits and Stock Dividends

Keep careful track of stock dividend/stock split dates. On the day a stock dividend becomes effective, all option striking prices are adjusted. For example, if XYZ stock is selling at $100 and has declared a 100-percent stock dividend (or a "two-for-one" stock split), the option with a striking price of 100 will have a striking price of 50 on the effective date of the stock dividend. Furthermore, a holder of 10 contracts with the 100 striking price will become a holder of 20 contracts with a new striking price of 50. In the case of an odd stock dividend of less than 100 percent (for example, a 50-percent stock dividend or "three-for-two" stock split), new odd striking prices will be created. In the case of our $100 stock, the 100 striking price will become 66-5/8 and will be listed in the newspaper as XYZ o 66-5/8. The o indicates that this is an old or pre-split contract. In the case of a stock dividend of less than 100 percent, the post-split contracts are adjusted differently. In our "three-for-two" example, a holder of 10 contracts prior to the split would still own 10 contracts, but each contract would represent the right to purchase 150 shares rather than 100 shares. The true premium of such a contract would be the



published premium increased by 50 percent. Upcoming stock dividends/splits will have a significant impact on the terms (or quantity) of your outstanding options contracts. Complete information on stock splits and stock dividends for the stocks underlying all recommended options can be found in Barron’s, Investor’s Business Daily, The Wall Street Journal, and Daily Graphs chart books. You can also ask your broker.


Top Gun Trading Techniques - How to MAXIMIZE Option Trading Profits




Section 1:


Section 2:


Section 3:


Section 4:


Section 5: How to MAXIMIZE Option Trading Profits

Section 6:


"How to Maximize Option Trading Profits," an audio lecture by Bernie Schaeffer

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Click Here To Listen To Bernie Schaeffer's Lecture

The following is a transcript of Bernie Schaeffer's lecture:

I'm Bernie Schaeffer, senior editor of The Option Advisor, and Chairman of Schaeffer's Investment Research.

For the next half-hour or so I will be pinpointing those factors that contribute to what I call the ideal option trade. I've grouped these factors into three categories - technical, fundamental and strategic. I'll close by giving you four conditions that should be immediate trade killers as well as ten major mistakes to avoid.

The first technical principle is to buy calls on stocks in uptrends and buy puts on stocks in downtrends. This may sound very trite, but this rule prevents you from trying to pick a bottom in a weak stock or pick a top in a strong stock - a very dangerous tactic when you're trading options.

While "the trend is your friend" is overdone as a trading rule, it is preferable to the "sticking your head in front of a freight train" approach of trying to pick tops and bottoms. Remember, an uptrend isn't going to stop dead in its tracks just because you decide to buy puts. You might ask how you determine if the stock is in an uptrend or downtrend. The easiest way is with moving averages. If the stock is above its 50-day and 200-day moving averages, for example, it is clearly in an uptrend. It should be at least above its 50-day if you are buying calls.

The second rule from the technical standpoint would be to buy calls at support levels and buy puts at resistance levels. An option trader needs to have the odds tilted in his favor to the greatest extent possible. To do so you must develop a trader mentality. Traders buy pullbacks and short rallies because the odds strongly favor this strategy, despite the natural inclination of the speculator to want to do just the opposite. So when an uptrending stock pulls back to support, conquer your emotions and consider buying some calls.

The third rule would be to look for confirmation in the industry sector. If IBM and Digital Equipment are weak, and Compaq Computer and Hewlett-Packard are strong, a decision to buy Apple Computer calls is not made any easier. But if most of the key stocks in the sector are rising in tandem, your decision to



play on the call side has greater validity. In fact, most good option trades are based on a sector viewpoint first, and on an individual equity viewpoint last.

Finally, you should opt for steady non-volatile trends in the underlying equity, rather than spectacularly volatile ones. A smooth, low-volatility uptrend will keep option premiums low, and allow you to score big profits on calls if the trend continues. The volatile spectacular gainer probably has very high option premiums to match, making it very difficult to profit, even if you're right on the direction. I know these stocks can be very tempting, but you're going to be subject to whipsaws all over the place if you confine your trading to them. Remember, with high option premiums you must be very right to make big profits.

Look at the fundamentals. Normally the fundamentals are not very important for a short-term approach like option trading. In fact, one of the biggest mistake novice options traders make is to trade off a fundamental research report. The time horizons just don't mix. But there are two fundamental factors a sharp options trader can take advantage of.

The first factor would be earnings surprises. A stock whose earnings report was better than Wall Street's expectations usually rallies on the news. But that's not all. First, the rally usually goes further than the initial move, and second, the more favorable the earnings report the more likely the next report will also be a positive surprise (even though analysts will adjust their expectations for the better earnings).

You as an options trader can profit from these situations in two ways. First, if you are really nimble, buy short-term calls as soon as the positive earnings surprise is announced, and close out a week or two later. Remember, by positive earnings surprise, I mean that the report exceeded Wall Street's expectations, not simply that this year's earnings exceeded last year's.

The second way to profit would be the longer-term play. You can buy four, five or six month calls, or even the longer-term calls (known as LEAPS) if they exist for that particular company. Close out a week or two after the next quarterly earnings report.

Everything I've said here can also be applied to negative earnings surprises, by playing puts. If you use a full-service broker, he should be able to provide you with his firm's earnings estimate for a particular company, so you can



determine if the surprise occurs, real time. Three other sources would be The Wall Street Journal, which now prints a list of positive and negative earnings surprises every day, Value Line, which shows quarterly earnings estimates by company, and Analyst Watch, published by Zacks, Inc., which also provides earnings estimates for individual companies.

The second factor from a fundamental standpoint that you can play, would be to consider buying options on stocks that are about to split - if you have a strong bullish or bearish opinion. Since lower-priced stocks have greater volatility and volatility determines a good portion of the price of an option, option premiums often jump after a stock split. For example, if your sixty dollar stock has a 60-strike call selling for 3, post-split the 30 strike call may sell for 1-3/4 instead of 1-1/2. Since you would have two 30 strike calls, you would end up with two times 1-3/4 or 3-1/2 in premium, instead of the 3 you started out with.

Several caveats here. First, this doesn't always work. Sometimes pre-split premiums get bid up in anticipation of the split. Second, try to pick a strike that will be an even strike after the split. Odd strikes, like 27-1/2, for example, often lack liquidity. And third, don't do this purely to play the split. Be sure you have a strong opinion on the stock in addition, so you don't have to close out the option if you don't get a volatility pop in the split.

My next segment involves the all-important concept of trading strategy. The first principle of trading strategy would be to take your profits based on price, and limit your losses based on time. I've heard stock option traders bemoan the fact that certain exchanges, at certain times, were not taking stop orders. In my opinion, they are doing these people a favor. The very worst strategy when trading equity options is to use stops, for the following good reasons.

First, options are cheap vehicles to which you are committing a small amount of capital. You know your risk is limited to that small dollar amount. So why use stops and potentially eliminate a big profit? The way to limit your losses is to buy a 3-month option, and close it out automatically after one month. In other words, you are using a time stop to prevent your losses from running too far, or from going into expiration and potentially losing all of your premium.

The second reason not to use stops in your options trading is that with the wild swings in the equity options market and in the stock market, your chances of getting stopped out are very high, even if the floor practice of "gunning the



stops" didn't exist. Take advantage of these wild swings by targeting a price on the upside of at least a double, and putting in a "good 'til cancelled" order with your broker to sell at that price. You might find that you will hit your target with a smaller-than-expected movement in the underlying stock, once you have your order out there in advance.

The second trading strategy principle: never trade with more than a fraction of your capital, and always diversify when you trade. This is the one factor that is the downfall of most option traders. Typically, someone with a hundred thousand dollars in investment funds that has been devoted to stocks and mutual funds will take fifty thousand dollars, invest it all in one three-week option, blow their entire investment, and swear off options forever.

In this example, they should have taken ten thousand dollars at most and bought options on four or five different underlying stocks, preferably some mix of puts and calls. I say preferably because a mix of call and put positions should be taken a majority of the time. However, the market does go through obvious trending phases and a portfolio of all calls or puts is one way to maximize returns in such trending phases, which occur only about 10-15% of the time. Remember, options are cheap, and the advantage of something that is cheap is it allows you to diversify, and it allows you to participate with a small investment relative to your total trading capital.

My final trading rule might come as a surprise to some of you - go light on index options unless you have access to professional advice. I know index options are very popular. And everyone seems to have the "I knew exactly what the market was going to do but my stock went the wrong way" mentality at some time or another. Whereupon, they promptly go bust trading index options. Why? First, market timing is a sophisticated combination of science and art that most investors don't have the time and resources to be successful at.

Second, you are by definition undiversified when you trade indices. Either you're right or you're wrong. As an individual speculator, you're much better off buying a package of different equity options and keeping your risk manageable. And finally, index options are very expensive compared to equity options, which means they tend to be priced above their true volatility. There are, however, options strategies to take advantage of such expensive options such as holding trades for very short time periods. And to reiterate, those who seek to trade index options should heed the advice of a professional in this



area. Only those with sophisticated pricing models will be capable of sorting through the index options to find those index options which are not richly priced. This overpricing has been particularly true over the past several years with index puts. So, even if you're right, you've paid so much in initial premium that your profits are often sub-par or non-existent. One index option trading method with which I have found particular success with is a strategy called a credit spread. This strategy involves selling an out-of-the-money option and protecting this naked sale with the purchase of a further out-of-the-money option, for a net collection of premium. By utilizing this strategy, you take advantage of the premium decay that often kills your average index option buyer.

I now want to get into the factors that I consider to be trade killers. I think that if one could pick up anything about trading options, it's the principle that you don't have to be in there all the time. You don't have to be trading unless the situation is just right. The fact that there are many, many hundreds of equity options from which to choose allows you to walk away from a trade which is not properly configured. And, I'll give you four negative factors, any one of which should possibly kill a trade.

First, if there is heavy, out-of-the-money call open interest, and you're considering a call trade; or if there is a heavy, out-of-the-money put open interest and you are considering a put trade, you should forget it! Why? First, the fact that there are so many speculators that agree with your assessment should be an immediate red flag for you. Option speculators, I must say, are usually wrong, and when they agree in large number, they are even more wrong than they usually are. You don't want to be part of the crowd when you're speculating in options.

Second of all, the options trading floor is going to be on the other side of this open interest. And since we're all big boys and girls, we realize that they have an incentive to try to cap or floor the stock by trading it. While this is not admitted to in equities, this is an open practice in futures options. Very often you will hear on the newswires that oil futures closed below a certain level because there were a lot of open call positions that the trading floor didn't want to see expire with any value. This is something that you at least have to be aware of. So, from a contrary opinion or sentiment standpoint, and in terms of the options floor being on the other side of your trade and wanting your trade to be unsuccessful, you've got to avoid those situations where there is heavy open interest.



How do you determine what this heavy open interest is? First of all you have to have the source for picking up the open interest in the various options contracts. Again, by open interest, I mean the number of positions that being held overnight in particular options series. It's really a summation of all the trading volume that takes place from the inception of that option to date of positions that were not closed out in-between. You can pick up open interest by strike from the Barron's options section, for example, or from the Daily Graphs Stock Option Guide, where it's displayed next to each chart. You can convert the open interest at the most active out-of-the-money strike to an equivalent share volume very easily. Just take the open interest, and multiply it by a hundred. If that resulting open interest is at least twice the average trading volume of the underlying stock, I would consider that to be heavy.

Now you have to be a little bit careful in the so-called cycle month, for example, the January, April, July, October months for IBM and the February, May, August, November months for Hewlett-Packard. These cycle months tend to have a lot of covered call options written in them. A lot of that open interest can be covered calls, which is not particularly a negative for putting on a speculative trade. You can usually note the situations that involve a lot of covered calls because the average daily option volume is pretty low compared to the open interest, often less than five percent or so of the open interest. But, if in doubt, avoid those situations where the open interest is heavy on the side in which you are looking to put the trade on.

The second trade killer: if there is chart resistance at your call strike, or if there is chart support at your put strike, don't do the trade. By entering a trade under these circumstances, it puts you in the position of betting on a breakout. While the rewards are great if you are correct, the odds are too low to be playing this with options. If you want to play a situation like that, play it with a stock, so you have the staying power to wait until the breakout actually occurs rather than watching your options expire before the breakout happens.

Another trade killer would be if earnings per share are due in the next week or two, particularly for the high-PE stocks or tech stocks. This becomes just too much of a flip of a coin. In these situations, the actual earnings are often way off the estimates, and the shares react violently when the earnings come out. If you're lucky that day you may make money, and if you're unlucky you'll get killed. This is not the kind of approach you want to take in options trading. It's the kind of approach you want to take in a casino.



Finally, the last trade killer. It involves implied volatility. If the implied volatility on the option you are looking to trade is far in excess of what the historical volatility of the stock is, particularly if the recent share volatility has not been high, do not do the trade. I might add, it is OK to pay up on volatility if the recent share action has been far more volatile than it's been historically, because those option prices are simply reflecting some new information that has occurred recently, particularly if you expect this high volatility to continue. For example, I remember a situation with Dillards Department Stores way back in the last half of 1990. The stock's historical volatility was very low, the recent volatility picked up, and the options looked expensive on a historical basis. But then what happened was the stock went from 80 to 60 to 90 in a matter of less than three months, so in retrospect those options were not very expensive. They were just continuing the more recent trend of high volatility.

But then there are other examples of where the high volatility is based purely on expectations, and you just want to avoid these situations like the plague. For example, just before the January 15th, 1991 war deadline in the Middle East, the put options on Homestake mining were bid up to very high levels even though the recent volatility on the stock was not very high. People were expecting all kinds of things to happen after the war deadline. Well, the stock plunged, along with gold on January 17th. But if you bought out-of-the-money puts on Homestake, you didn't make any money that day. You don't want to be right and not make money on your options trade. There are enough situations where you're wrong and you lose money. You don't want to lose money on situations where you're right.

So the rule of thumb would be - avoid options where the implied volatility is greater than one and one half times a measure of the historical volatility. And if you don't have access to options software to determine these volatilities and comparisons, I would strongly suggest The Daily Graphs Stock Option Guide, which provides all this information in a nice readable, tabular form.

Okay, now I'm going to go ahead and give you the ten major mistakes to avoid. First, don't buy too little time. Once you have selected an attractive stock, you will find there are a number of option expiration months from which to choose. Most of you should avoid options that expire in just a few weeks or days. I'm sure many of you have had experience with these. The typical investor is not geared for such an extremely short time frame. Professionals are ones that thrive in a market like this. The time value decay, as you know, in the final weeks is extreme. I suggest the average option player buy options with about



three months of life and close out your position no later than four weeks prior to option expiration, so you avoid the black hole, so to speak, in the decline in option premium in that final month, if the position doesn't move or moves against you. My experience in trading front-month options has been quite good, but realize that analyzing options is my full-time occupation.

Second rule: stay away from options more than two strike prices away from the current price. Such out-of-the-money options are generally lower-delta plays meaning it takes a big move in the stock to create a small increase in the value of the option. In turn, this increases the risk-to-reward ratio of purchasing this position.

And I'll add an additional rule for you beginning option traders; and that would be, you should consider sacrificing some profit potential and lowering your risk by buying in-the-money options. Under no circumstances should beginning option traders purchase out-of-the-money options without professional advice, no matter how tempting the low premium looks to you.

The third rule: and I have alluded to this earlier; and I'll say it again, don't confine yourself to call options; trade in puts as well as in calls. This rule applies to trading-range markets, which occur about 85-90% of the time. A particular mistake of beginners is to believe that the only way you can make money in the market is to take a bullish position on an advancing stock. And this orientation is usually compounded by the general fear of selling short, of unlimited risk and all the bugaboos about selling short. But with the widespread trading of put options, you can take a bearish position by buying a put, enjoy the advantage of limited risk offered by all options, and also benefit from the fact that very often puts are pretty cheap in comparison to calls. The indices are another story all together, as many of you know, where actually put options can become more expensive than calls.

My fourth rule: again I will restate, don't over-commit your funds. As I said earlier, sound money management is vital to successful options trading. You can't trade options as you would stocks and mutual funds. You have the possibility of multiplying your option stake many times over and that's very tempting, but you also face the possibility of losing your entire investment. So, the first step toward intelligent money management in options trading is to trade with only the portion of your capital with which you can comfortably - and I emphasize comfortably - devote to speculation. By limiting your exposure you can act rationally and sleep soundly, neither of which is possible when your



nest-egg is at risk in the options market.

The fifth major mistake to avoid: don't put all your eggs in one basket. Diversify your options positions in a two-dimensional way. Number one: you should have at least two option positions on different stocks, three would even be far preferable to two. And number two: invest in calls and puts, and if you are concerned about a short-term decline in an uptrending market, remember that you can add a put or two to your portfolio as a hedge.

Number six: don't pyramid your option trading profits. Never risk your entire trading capital on a single trade. This rule holds regardless of how successful you've been previously, and regardless of how attractive that next trade appears. There will always be losing trades, so by compounding your capital after a few profitable trades, you are exposing yourself to some potentially painful dollar losses once that loser comes along. The analogy here is sitting at a Black Jack table and just letting your money ride with every winning hand. No doubt, you're going to have a loser. Always keep a large portion of your trading capital in reserve. You'll then have the staying power to ride out the losers, so you can ultimately profit from the winners, including those winners that show paper losses early, but are eventually closed out for gains. Those situations happen all the time. This is also why we avoid stops. I would suggest that you commit to no more than 10-20% of your total trading capital devoted to options to any single equity option trade.

Another rule: option trading isn't for perfectionists, and the rule says don't expect perfection. You trade options in order to achieve a worthwhile bottom-line, and the emphasis is on bottom-line profits in a relatively short time frame. The big advantage in options trading involves truncated risk. You can never lose more than your original investment, but your potential profits are theoretically unlimited.

Now you'll find that successful options traders almost always have more losing trades than profitable trades, but they still achieve substantial bottom-line gains. This is because their winners yield far more dollars per trade than are lost in their losing trades. It takes only one five thousand dollar profit in four separate one thousand dollar investments to achieve a minimum 50% bottom-line gain, even if all three remaining positions are total losses.

Never look for perfection in your options trades. A reasonable batting average will still yield large profits. A four hundred hitter in options trading is very rare



indeed, just as it is in baseball.

Number eight: don't trade without a profit plan and a projected closeout date. This is extremely important. The options market is very fast moving. On a particularly wild trading day, it's been possible to quadruple your money on stock index calls in a matter of hours, before the market reverses direction and you're sitting in a losing position. Always select a target profit at the time you establish your option position, and stick to it. I suggest a target profit of at least 100% for each trade. A full-service broker can monitor your positions for you and sell when you achieve your targets, or you can enter your sell orders at your targets in advance. This is the route I would recommend.

Many greedy options traders have seen their profits evaporate, and often turn to losses after they refuse to take a healthy profit in their attempt to strike it rich from just one trade. Never attempt to strike it rich from just one trade. You should also select a date on which you will close out your position if your target is not achieved. This also is extremely important. The average option trader concentrating on 3-6 month options should typically have a close-out date no later than one month prior to option expiration.

Number nine: avoid perennial takeover candidates. The call open interest on these issues tends to be very large, which is negative, as I've previously discussed. And option premiums tend to be sky-high, so if you keep buying calls to replace those that have expired worthless in hopes that the takeover will ultimately take place, your total expenditure could eat up most or all of your potential profits even if you're right. Conversely, such issues offer excellent opportunities for the covered call writer. Sell calls that are one or two strikes out-of-the-money, and keep rolling them out every month. But you must be psychologically prepared to lose your stock at a cheap price should a takeover actually occur!

Finally: don't place orders at the opening or closing bells. Never place an order to buy or sell an option at the market at the opening. Even the more actively traded options are not very liquid in early trading and late in the session. It is difficult for the options floor to hedge their positions with stock. So market orders are often executed at unfavorable prices at the beginning of trading and at very late in the options trading session.

Since we have some extra time, I'll throw in a few "bonus rules":



Number one: determine the strike price that you'd like to buy and then move one strike "closer to the money". Why? Because most options traders incorporate their most optimistic expectations for the underlying stock into their strike price decision. They fail to take into account such things as unfavorable market movements and small rather than big movement in the stock. So, if XYZ Corporation is at 100 and you're looking at the 110 call, but the 105 strike instead. And if you feel you can't afford the higher-price 105 call, then you probably shouldn't be playing the riskier 110 call either. The only exception to this rule would be in a situation where the 110 strike is significantly undervalued compared to the 105, a situation that occurs rarely and is usually quickly pounced on by professionals.

Number two: by the same reasoning, go to the next expiration month beyond that which you were looking to buy. Most option players don't give themselves enough time until expiration for their scenario to work out, and many novices get caught up in the extremely difficult game of buying options with just a few weeks or even days until expiration. And while we normally don't recommend going more than one strike out-of-the-money, if you must buy a far out-of-the-money option, make sure you have 4, 5, or even 6 months until expiration.

Number three: shop around for attractive "deep discount" commissions. If you use a discounter, remember that the option rates for the "Big 3" of Schwab, Quick & Reilly and Fidelity can be far higher than those for the deep discounters. And if you trade actively with a "full-service" broker, negotiate a discount off the firm's published rate schedule. It's done all the time. And remember, full-service should mean keeping track of your orders, confirming executions and providing you with advice when you want or need it.

In closing, I'd like to remind you that these trading principles plus much more are covered in my new book "The Option Advisor: Wealthbuilding Strategies for Equity and Index Options."

Thank you for spending this time with me.


Top Gun Trading Techniques - Brokerage Firms




Section 1:


Section 2:


Section 3:


Section 4:


Section 5:


Section 6: Brokerage Firms that Go the Extra Mile for Option Investors


To help you search for a broker that best meets your needs, SchaeffersResearch.com provides a short list of brokers firms to compare and investigate. The brokerage firms listed at the links below have supplied information at SchaeffersResearch.com's request. Inclusion on this list does not represent a recommendation or preference for any or all of these firms over any other firm.

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Top Gun Trading Techniques - Brokerage Firms

Please realize this does not represent a commission schedule. Commissions vary depending on account activity and account size.

Auto-TradeYou may notice that certain firms offer automatic trading for SchaeffersResearch.com customers. Customers may automate trading by authorizing the use of limited discretion for order execution. Upon the receipt of a recommendation, the broker implements a trade in either dollar amount or quantity according to your prior allocation instructions. Please call each firm for the specific details of their auto trading process.

NOTE: The information obtained for this listing is believed to be from reliable sources, but cannot be guaranteed. In addition, SchaeffersResearch.com has no affiliation with any brokerage firm, and cannot accept any responsibility for an individual's experience with any brokerage firm. The responsibility lies solely with the customer in determining whether or not auto trading suits his or her individual investment situation.

Click here to view broker list in PDF format

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Bernie Schaeffer - Option Advisor - Top Gun Trading Techniques