Ideally the stock will remain between the lower and higher strikes, with the maximum profit occuring if the options expire when the stock is priced at the central strike price.

Buy lower strike put + Sell middle strike put, Sell middle strike call + Buy higher strike call = Long Iron Butterfly

Maximum Risk: [Difference in adjacent strikes - net credit]

Maximum Reward: [Net credit received]

Breakeven Down: [Middle strike - net credit]

Breakeven Up: [Middle strike + net credit]

With Long Iron Butterflies, your outlook is direction neutral. You expect little movement in the stock price. It’s safest to trade this strategy on a short-term basis, preferably with one month or less to expiration.

Advantages

1. Profit from a rangebound stock for no cost and low downside risk.

2. Capped and low risk compared with potential reward.

3. Comparatively high profit potential if the stock remains rangebound.

Disadvantages

1. The higher profit potential comes with a narrower range between the wing strikes.

2. The higher profit potential only comes nearer expiration.

3. Bid/Ask Spread can adversely affect the quality of the trade.

Example

ABCD is trading at $25.00 on April 12, 2004. Buy the May 2004 $20 strike put for $0.30. Sell the May 2004 $25 strike put for $1.50. Sell the May 2004 $25 strike call for $2.00. Buy the May 2004 $30 strike call for $0.50.

Net Credit: Premiums sold – premiums bought
2.70
Maximum Risk: Difference in adjacent strikes – net credit
5.00 – 2.70 = 2.30
Maximum Reward: Net credit
2.70
Breakeven Down: Middle strike – net credit
25.00 – 2.70 = 22.30
Breakeven Up: Middle strike + net credit
25.00 + 2.70 = 27.70
Max RO: 117.39% if the stock is at the middle strike at expiration

The concept is that in owning the stock, you then sell an Out of the Money (stock< call strike price) call option on a monthly basis as a means of collecting rent ( a a dividend) while you own the stock. If the stock rises above the call strike, you’ll be exercised, and the stock will be sold and you make a profit anyway. If the stock remains static, then you’re better off becaouse you collected the call premium. If the stock falls, you have the cushion of the call premium you collected.

Buy stock + Sell OTM call = Covered Call

Maximum risk [Stock price paid-call premium]

Maximum Reward [Call strike-stock price paid]+ call premium

Breakeven [Stock price paid-call premium]

With a Covered Call, your outlook is neutral to bullish. You expect a steady rise. To buy ( or own) a stock for the medium or long term with the aim of capturing monthly income by selling calls every months. This is like collecting rent for holding the stock and will have the effect of lower your cost basis of holding the stock.

The advantages of Covered Call are:

-Generate monthly income;

-lower risk than simply owning the stock;

- Can profit from rangeboundstocks.

The disadvantages are:

- Capped upside if the stock rises;

-Upcapped downside if the stock falls, cushioned only by the callpremium received.

1. Pricing forecasting

price forecasting indicates which way a market is expected to trend. It is the crucial first step in the trading decision. The forecasting process determines whether the trader is bullish or bearish. It provides the answer to the basic question of whether to enter the market from the long or short side, If the price forecast is wrong, nothing else that follows will work.

2. Trading tactics, or timing

Trading tactics, or timing, determines specific entry and exit points. It’s quite possible to be correct on the direction of the market, but still lose money on a trade if the timing is off. Timing is almost entirely technical in nature. Therefore, even if the trader is fundamentally oriented, technical tools must be employed at this point to determine specific entry and exit points.

3. Money management

Money management covers the allocation of funds. It includes such areas as portfolio makeup, diversification, how much money to invest or risk in any one market, the use of stops, reward-to-risk ratios, what to do after periods of success or adversity, and whether to trade conservatively or aggressively.

The simeplest way to summarize the three different elements is that price forecasting tells the trader what to do, timing helps decide when to do it, and money management determines how much to commit to the trade.

The lower strike put that you buy is further OTM (stock price > put strike price) than the higher strike put that you sell. Therefore, you receive a net credit because you buy a cheaper option than the one you sell. If the stock rises, both puts will expire worthless, and you simply retain the net credit. If the stock falls, then you breakeven is the highere strike less the net credit you receive. Provided the stock remains above the level, then you’ll make a profit. Otherwise, you could make a loss.

Buy lower strike put + sell OTM put = Bull put spread

Maximum Risk: [Difference in strikes - net credit]
Maximum Reward: [Net credit received]
Breakeven: [Higher strike - net credit]

With bull puts, your outlook is bullish or neutral to bullish. It’s safest to trade this strategy on a short-term basis, preferably with one month or less ot expiration.

Advantages

1.Short-term income strategy not necessarily requiring any movement of the stock.

2. Capped downside protection compared to a Naked Put.

Disadvantages

1. Maximum loss is typically greater than the maximum gain, despite the capped downside.

2. High yielding trades tend to mean less protective cushion and are therefore riskier.

3. Capped upside if the stock rises.

Example

ABCD is trading at $27.00 on May 12, 2004. Buy the June 2004 $20 strike put for $0.50. Sell the June 2004 $25 strike put for$1.00.

Net Credit: Premium sold – premium bought
1.00 – 0.50 = 0.50
Maximum Risk: Difference in strikes – net credit
(25-20) – 0.50 = 4.50
Maximum risk is greater than your net credit
Maximum Reward: Net credit
0.50
Breakeven: Higher strike – net credit
25.00 – 0.50 = 24.50
Max ROI: 11.11%
Cushion: $2.50 or 9.26% from breakeven

Profits and losses on options trading are treated as capital gains and losses. Therefore, options profits and losses are subject to all the regular rules that pertain to all capital gains and losses. In general, long-term capital gains qualify for favorable tax treatment.Capital losses offset capital gains and thereby reduce taxable income. However, capital losses are deductible only up to the amount of capital gains plus $3,000. Any excess capital loss cannot be decucted, but must be carried forward to offset capital gains in subsequent years.

The tax treatment differs for buyers and sellers of options and the tax treatment becomes very complicated for combinations of options. Here, we consider the four simplest stock option positions: long a call, short a call, long a put, or short a put.

Long a Call

If a call is exercised, the price of the option, the exercise price, and the brokeage commissions associated with purchasing and exercising the option are treated as the cost of the stock for tax purposes. If the option is sold before expiration, the capital gain or loss is the sale price of the option minus the purchase price of the option minus any brokerage fees incurred.

Short a Call

When a trader sells a call, the premium that is received is not treated as immediate income. If the call expires without being exercised, the gain on the transaction equals the price of the option less any brokerage fees, and this gain is always treated as a short-term gain. If the trader offsets the position before expiration, the capital gain or loss equals the sale price minus the purchase price minus any commissions, and this gain or loss is considered a short term gain or loss. If the call is exercised against the trader, the strike pirce plus the premium received minus any commissions becomes the sale price of the stock for determining the capital gain or loss.The gain or loss will be short-term or long-term depending on how the stock that is delivered was acquired.

Long a Put

If a put is purchased and sold before expiration, the gain or loss equals the sale price minus the purchase price minus any brokerage commissions, and the gain or loss will be short-term or long-term depending on how long the put was held. If the put expires worthless, the loss equals the purchase price plus the brokerage commissions, and the loss can be either short-term or long-term. If the trader exercises the put, the cost of the put plus commission reduces the amount realized upon the sale of the stock delivered to satisfy the exercise. The resulting gain or loss can be either short-term or long-term depending on how long the delivered stock was held.

Short a Put

The premium received for selling a put is not classified as income until the obligation from the sale of the put is completed. if the trader offsets the short put before expiration, the capital gain or loss equals the sale price minus the purchase price minus the brokerage commissions, and the resulting gain or loss is always a short term gain or loss. If the put expires worthless, the capital gain equals the sale price less the brokerage commissios, and the capital gains is a short-term gain. If the put is exercises against the trader, the basis of the stock acquired in the exercise equals the strike price plus the commission minus the premium received when the put was sold. The holding period for determining a capital gain or loss begins for the stock on the day following the exercise.

The symmetrical triangle

The symmetrical triangle shows two converging trendlines, the upper line descending and the lower line ascending. The vertical line at the left, measuring the height of the pattern, is called the base. The point of intersection at the right, where the two lines meet, is called the apex. The symmetrical triangle represents a pause in the existing trend after which the original trend is resumed. 

Example of a bullish symmetrical triangle. Notice the converging trendlines. A close outside either trendline complete the pattern. The vertical line at the left is the base. The point at the right where the two lines meet is the apex.

There is a time limit for the resolution of the pattern, and that is at the apex. As a general rule, prices should break out in the direction of the prior trend somewhere between two-thirds to three-quarters of the horizontal width of the triangle.That is, the distance from the vertical base on the left of the pattern to the apex at the far right.

Volume should diminish at the price swings narrow within the triangle. But the volume should pick up noticeably at the penetration of the trendline that completes the pattern. The return move should be on light volume with heavier activity again as the trend resumes. Volume is more important on the upside than on the downside. An increase in volume is essential to the resumption of an uptrend. Even though trading activity diminishes during formation of the pattern, a close inspection of the volume usually gives a clue as to whether the heavier volume is occuring during the upmoves or downmoves. In an uptrend, for example, there should be a slight tendency for volume to be heavier during the bounces and lighter on the price dips.

The ascending triangle

The ascending triangle has a rising lower line with a flat or horizontal upper line. This pattern indicates that buyers are more aggressive than sellers.It is considered a bullish pattern and is usually resolved with a breakout to the upside. The bullish breakout is signaled by a decisive closing above the flat upper trendline. As in the case of all valid upside breakouts, volume should see a noticeable increase on the breakout. A return move back to the flat upper line is not unusual and should take place on light volume. 

An ascending triangle. The pattern is completed on a decisive close above the upper line. This breakout should see a sharp increase in volume. That upper resistance line should act as support on subsequent dips after the breakout. The minimum price objective is obtained by measuring the height of the triangle (AB) and projecting that distance upward from the breakout point at C.

The descending triangle

The descending triangle, is just a mirror image of the ascending, has the upper line declining with a flat or horizontal bottom line. It is generally considered a bearish pattern. This pattern indicates that sellers are more aggressive than buyers, and is usually resolved on the downside. The downside signal is registered by a decisive close under the lower trendline, usually on increased volume. a return move sometimes occurs which should encounter resistance at the lower trendline.

A descending triangle. The bearish pattern is completed with a decisive close under the lower flat line. The measuring technique is the height of triangle (AB) projected down from the breakout point at C.

The left and right shoulders (A and E) are at about the same height. The head (C) is higher than either shoulder. Notice the lighter volume on each peak. The pattern is completed on a close under the neckline (line 2), which can be drawn under the lost two reaction lows (point B nad D). The minimum objective is the vertical distance from the head to the neckline projected downward from the breaking of the neckline. A return move will oftern occur back to the neckline, which should not recross the neckline once it has been broken.

In generally, the basic ingredients for a head and shoulders top are as follows:

1. A Prior uptrend.

2. A left shoulder on heavier volume (point A) followed by a corrective dip to point B.

3. A rally into new highs but on ligher volume (point C).

4. A decline that moves below the prvious peak (at A) and approaches the previous reaction low (point D).

5. A third rally (point E) on noticeably light volume that fails to reach the top of the head (at point C).

6. A close below the neckline.

7. A return move back to the neckline (point G) followed by new lows.

The pattern, however, is not complete until the neckline is decisively broken on a closing basis. Until that downside violation takes place, there is always the posibility that the pattern is not really a head and shoulders top and that the uptrend may resume at some point.

The accompnaying volume pattern plays an important role in the development of the head and shoulders top. As a general rule, the head should take place in lighter volume than the left shoulder and volume on the third peakshould be noticeably lighter than on the previous two peaks. Volume should then expand on the breaking of the neckline, decline during the return move, and then expand again once the return move is over.

The method of arriving at a price objective is based on the height of the pattern. Take the vertical distance from the head (point C) to the neckline. Then priject that distance from the point where the neckline is broken. For example, the top of the head is at 100 and the neckline is at 80. The vertical distance would be the difference, which is 20. If the neckline is at 82 when broken, a downward objective would be projected to the 62 level. It is important to remember that the objective arrived at is only a minimum target.

Types of traders

There are three different kinds of taders on the floor of the exchange: Market makers, floor brokers, and order book officials.

The market maker.

A trader who trades for his own account is a market maker.The typical market maker owns or leases a seat on the options exchange and trades for his or her own account to make a profit. Typically, a market maker will concentrate on the options of just a few stocks. Market makers follow different trading stratigies and switch freely from one strategy to another. Some market makers are scalpers who follow the psychology of the trading crowd and tries to anticipate the direction of the market in the next few minutes. Generally, the scalper holds a position for just a few minutes, trying to make a profit on moment ot moment fluctuations in the option’s price. By contrast, a position tader buys or sells options and holds a position for a longer period. This commitment typically rests on views about the underlying worth of the stock or movements in the economy.

The Floor Broker.

A trader who executes orders for another is a floor broker. Many options traders are located away from the trading floor. When an off-the -floor trader enters an order to buy or to sell an option, the floor broker has the job of executing the order. Floor brokers typically represent broerage firms. They work for a salary or receive commissions, and their job is to obtain the best price on an order while executing it rapidly.

The order book official.

The order book official is an employee of the exchange who makes certain kinds of option trades and keeps the book of orders awaiting execution at specified prices. The order book official is an employee of the exchange who can also trade. However, the official cannot trade for his or her own account. Instead, he or she primarily helps to faciliate the flow of orders. In essence, the order book official performs many of the functions of a speciallist on a stock exchange.

Exchange officials.

Exchange officials comprise the third group of floor participants. Besides the order book offical and assistants are exchange employees, there are other exchange employees on the floor, such as price reporting officials and surveillance officials. After every trade, price reporting officials enter the order into the exchange’s price reporting system. Then traders and other interested parties around the world will know the price and quantity of a particular option that just traded. The exchange also has personnel on the floor to monitor floor activity. The exchange has the responsibility of providing an honest marketplace, so it strives to maintain an orderly market and to ensure that brokers and market makers follow exchange rules.

Types of orders

Every options trade falls into one of four categories. It can be an order to (1) open a position with a purcahse; (2) open a position with a sale; (3) close a position with a purchase; or (4) close a position with a sale.

As in the stock market, there are numerous types of orders in the options market. The simplest order is a market order. A marekt order instructs the floor borker to transact at whatever price is currently available in the marketplace. The alternative to a market order is a limit order. In a limit order, the trader instructs the broker to fill the order only if certain conditions are net.

Order routing and execution

Suppose a professor decides that today is the day to buy an option on XYZ. He calls his local broker and places a market order to buy a call. The broker takes the order and makes sure he has recorded the order correctly. The broker then transmits the order to the brokerage firm’s representatives at the exchange. usually this is done over a computerized system operated by the brokerage firm.

The brokerage firm’s clerical staff on the floor of the exchange receives the order and gives it to a runner. The runner quickly moves to the trading area and finds the firm’s floor broker who deals in XYZ options. The floor borker executes the order by trading with another floor broker, a market maker, or an order book official. Then the floor broker recordes the price obtained and information about the opposite trader. The runner takes this information from the floor broker back to the clerical staff on the exchange floor. The brokerage firm clerks confirm the order to the broker, who tells the professor the result of the transaction. Normally, the entire process takes about two minutes and the professor can reasonably expect th receive confirmation of his order in the same phone call used to place the order.

What is resistance? Resistance represents a price level or area over the market where selling pressure overcomes buying pressure and a prce advance is turned back. Usually a resistance level is identifed by a previous peak.

In an uptrend, the resistance levels represent pauses in that uptrend and are usually exceeded at some point. In a downtrend, support levels are not sufficient to stop the decline permamently, but are able to check it at least temporarily.

The amount of trading in a given support or resistance area can be determined in three ways: the amount of time spent there, volume, and how recently the trading took place.

The longer the period of time that prices trade in a support or resistance area, the more significant that area becomes. For example, if prices trade sideways for three weeks in a congetion area befor moving higher, that support area would be more important than if only three days of tading has occurred.

Volume is another way to measure the significance of support and resistance. If a support level is formed on heavy volume, this would mark that support level as more important than if very little trading had taken place.

A third way to determine the significance of a support or resistance area is how recently the trading took place. The more recent the activity, the more potent it becomes.

How to draw trendline

An up trendline is a straight line drawn upward to the right along successive reaction lows. A tentative trendline is first drawn under two successively higher lows, but needs a third test to confirm the validity of the trendline. A down trendline is drawn downward to the right along successive rally peaks. Similarly, the tentative down trendline needs two points to be drawn and a third test to confirm its validity.

The correct drawing of a trendline should include the entire day’s trading range. The technique of including the day’s price range take into account all of the activity ans is the more common usage.

How to determine the significane of a trendline?

The answer to the question is twofold–the longer a trendline has been intact and the number of times it has been tested.

What constitutes a valid breaking of a trendline?

Most technicians employ a variety of time and price filters in an sttempt to isolate valid trendline penetrations and eliminate bad signals.

One example of a price filter is the 3% penetration criteria. This price filter is used mainly for the breaking of longer term trendlines, but requires that the trendline be broken, on a closing basis, by at least 3%.

An alternative to a price filter is a time filter. A common time filter is the two day rule.To have a valid breaking of a trendline, prices must close beyond the trendline for two successive days.

Measuring implications of trendlines

Trendlines can be used to help determine price objectives. Stated briefly, once a trendline is broken, prices will usually move a distance beyond the trendline equal to the vertical distance that prices achieved on the other side of the line, prior to the trend reversal. In other words, if in the prior uptrend, prices moved $50 above the up trendline, then prices would be expected to drop that same $50 below the trendline after it’s broken.

The relative steepness of the trendline

In general, most important up trendlines tend to approximate an average slope of 45 degrees. The 45 degree line reflects a situation where prices are advancing or declining at such a rate that price and time are in perfect balance. If a trendline is too steep, it usually indicates that prices are advancing too rapidly and that the current steep ascent will not be sustained. If a trendline is too flat, it may indicate that the uptrnd is too weak and not to be trusted.