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June 28, 2012

Great Trader Part II

About two months ago, we talked about an options trader having a commitment to excellence. This time we’ll go over why an options trader needs a trading plan and how to go about writing one. This is the part nobody wants to do. Most options traders think that their trading plan is in their head and all I need is a proper options education. “I know what I need to do when I need to do it” most beginning and some veteran options traders will exclaim. If it was just that easy, everyone would be a great options trader. Unfortunately it’s not. That is specifically why you need a written options trading plan. Just because you know what to do doesn’t mean you will do it.

Before you even begin to write your options trading plan, you must take an inventory of yourself. What are your strengths and weaknesses? You must take the

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time to truly examine yourself and be honest about whom you are. Your options trading plan must match your personality.

The first thing you need to do to start your options trading plan is to write down your goals like we talked about last time. Once you do this, it brings everything into perspective. The same reason you need to write down your goals is the same reason you need to write down your options trading plan-so your thoughts are transformed from the subconscious to the conscious. It doesn’t matter if you write the plan on a nice piece of paper or a cocktail napkin. It just needs to be written down in your own words.

The next section of your options trading plan will be money management. This is one of the most crucial and often overlooked components of successful options trading. How much are you going to risk per trade? What are your weekly or monthly profit targets? What are the maximum

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losses you are comfortable with on a daily, weekly or monthly basis? All of these questions need to be answered right in this section.

Strategies will be the next component of your options trading plan. This will be the meat and potatoes of the plan so to speak. A thing to consider is to start with relatively a few simple strategies (long calls and puts) and master them before you write in more complex option strategies into your plan. You need to describe in as much detail as possible the strategy you intend to use. You will probably be making constant changes to this part until you get exactly what you want.

The last section will be the follow up and review. This is when an option trader needs to print out the charts and the option chains and review them. Did I follow my written options trading plan like I said I would? This needs to be done when the market is closed so all your attention can be on the review. You must keep a trading journal and must always acknowledge your winners and more importantly learn from your losing trades.

This is just a general outline of an options trading plan to get you started. We will go into more detail in each area in upcoming features.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 14, 2012

What Will You Settle For?

One infrequently discussed topic important to understand in becoming familiar with the mechanics of learning to trade options is that of the various settlement mechanisms. Most traders confine the universe of their option trading to two broad categories of underlyings. One group consists of individual equity issues and the similar group of exchange traded funds (ETF). The other group is composed of the various broad based index products. These two groups are not entirely mutually exclusive since a number of very similar products exist in both categories, for example the broad based SPX index and its corresponding ETF, the SPY.

The first category, the individual equities and ETFs, trade until the close of market on the third Friday of each month for the monthly series contracts. These contracts are of American type and as such can be exercised by the owner of the contracts for any reason whatsoever at any time until their expiration. If the contract is in-the-money at expiration by just one cent, clearing firms will also exercise these automatically for the owners unless specifically instructed not to do so. The settlement price against which these decisions are made is the price of the underlying at the final bell of the life of the option contract.

When this first group we are discussing settles, it is by the act of buying or selling shares of the underlying equity/ETF at the particular strike price. As such, the trader owning a long call will acquire a long position in the underlying and the owner of a put a short position. Conversely, the trader short these options will incur the offsetting action in his account. Obviously, existing additional positions in the equity/ETF itself may result in different final net positions.

The second category, the broad based index underlyings, are also termed “cash settled index options”. This category would include a number of indices, for example RUT and SPX. As the name implies, these series settle by movement of cash into and out of the trader’s account. The last day to trade these options is the Thursday before the third Friday; they settle at prices determined during that Friday morning.

One critically important nuance with which the trader needs to be intimately conversant is the unusual method of determining the settlement price of many of the underlyings; it is NOT the same as settlement described above. Settlement for this category of underlyings has the following two characteristics important

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for the trader to understand: 1.The settlement value is a calculated value published by the exchange and is determined from a calculation of the Friday opening prices of the various individual equities, and 2. This value has no obligate relationship to the Thursday closing value for the underlying.

Many option traders choose never to allow settlement for the options they hold, either long or short. For those who do allow positions to settle, careful evaluation of the potential impact on capital requirements of the account must be a routinely monitored to avoid unpleasant surprises.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 10, 2012

Back to Basics: Part II

Perhaps the most easily understood of the options price influences is the price of the underlying. All stock traders are conversant with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but suffice it to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.

The price influence, time, is easily understood; in part because it is the only one of the forces restricted to unidirectional movement. The core reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.

The third price influence is perhaps the most important. It is without question the most neglected and overlooked component: implied volatility. Implied volatility taken together with time defines the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to price of the underlying and represents the aggregate trader’s view of

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the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can wax and wane as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).

New traders beginning to become familiar with the world of options trading should direct their attention to understanding the impact of each of these options pricing influences. The options markets are ruthlessly unforgiving to those who choose to ignore the impact of the valuation metrics that underpin daily life in their world.

Edited by John Kmiecik

Senior Options Instructor

Market Taker Mentoring