Essential Option Strategies. J. J. Kinahan
appreciate it. Thanks to the Marketing Team for all the help getting started and the constant guidance along the way. CAPAE Team, you are always a pleasure to work with, and Legal Team, thank you for your trusted counsel.
Fred Ruffy, it was great working with you. Thank you for the insight and suggestions. Thanks to the folks at Wiley. You are wonderful partners who made the process easy.
Thanks to both Zack Fishman and Paul Picchietti for taking a chance on me straight out of college and beginning to teach me the world of options. And also, thanks to Tom Sosnoff, from whom I have learned so much.
Most importantly, I want to thank my family – my late parents who did an amazing job of showing me the meaning of work ethic and sacrifice; my brothers and sisters for helping their youngest sibling every step of the way; and, of course, my wife, Karen, and our children, Kaitlin, Kevin, and Kelly.
About the Author
An options industry veteran, JJ Kinahan started his trading career in 1985 at the Chicago Board Options Exchange (CBOE). As a market maker, he traded primarily on the floor in the S&P 100 (OEX) and S&P 500 (SPX) pits. Later, he worked for ING Bank and Blue Capital. He then became managing director of options trading for Van der Moolen, USA.
In 2006 JJ joined the Chicago-based options trading brokerage firm thinkorswim where he served many roles, including developing educational content and helping build the tools that are integrated into the thinkorswim® platform today. JJ is now chief market strategist for TD Ameritrade, which acquired thinkorswim in 2009.
JJ is a frequent CNBC guest, a Forbes contributor, and often quoted in The Wall Street Journal, Financial Times, Reuters, and many other respected media outlets. He is on the Advisory Board at the CBOE. When not busy working or trading, he is an avid Chicago sports fan who enjoys reading, fishing, and spending time with his wife and three children.
Part I
Getting Started in Investing
Chapter 1
The Opening Bell
At 9:30 a.m. (EST) on every business day, a bell at the New York Stock Exchange sounds, and trading on the exchange floor begins. Investors buy and sell stocks like jockeys scrambling for positions at the Kentucky Derby. News flow drives the buying and selling decisions from one day to the next.
When the day's news doesn't deviate too much from expectations, the result is typically orderly and normal market action. However, when unexpected events result in dramatic changes in the expectations, large price moves and fast trading ensue. In other words, the day's news events can result in changes in investor sentiment and result in higher or lower levels of market volatility.
It can seem overwhelming. I remember when I left the trading floors after twenty-one years at the Chicago Board Options Exchange (CBOE). My focus shifted from a small number of instruments to a huge universe of different opportunities. I started trading in markets that were unknown to me. The results were horrible. Over time, I realized that it was better to keep a laserlike focus on markets that I understood and believed in. It is simply impossible to track the moves of every different market, much less trade them all effectively.
Moreover, the importance of news events will also vary from one investor to the next. A large pension fund taking positions in a widely held stock like Apple (AAPL) or General Electric (GE) for a longer-term portfolio isn't likely to react to a news report the same way as a stock trader buying and selling stocks for short-term profits. A retiree has a different set of goals than a recent college graduate. An options market maker on the CBOE is using equity options differently than a financial adviser selling options in an attempt to generate income for a customer's portfolio.
Although we all have different goals and objectives, the millions of participants in the financial markets digest the day's news, and the results move asset prices as the information becomes available. This is not only true of U.S. markets, but of financial instruments around the globe.
My focus in this book is primarily on U.S. Exchange listed equities, options, and equity futures markets that are open during the regular hours of 9:30 a.m. to 4:00 p.m., Monday through Friday, but there are many investments that trade beyond that. In 1985, regular trading hours were expanded beyond these hours. Premarket trading now begins at 4:00 a.m., and the after-hours session runs from 4:00 to 8:00 p.m.
Options, meanwhile, trade on thirteen different exchanges from 9:30 a.m. to 4:00 p.m. currently, and those hours may soon be expanded. Trading hours for futures and futures options vary by product, but more popular instruments like S&P 500 futures now trade nearly around the clock beginning Sunday at 6:00 p.m. and continuing through Friday evening. So when you come home at 2:00 a.m. after a few drinks at a neighborhood party, you can trade S&P 500 futures from your online brokerage account. However, that is not really recommended!
The expansion of trading hours and growth in financial markets is being driven by the exchanges to satisfy investor demand for new investment products and opportunities. At the same time, technology has created better efficiency and linked global markets. News flow travels fast and often results in sudden market moves that ripple from one economy to the next.
Yet, while today's faster and more complex market sometimes seems daunting to investors, the principles of investing have not changed. With a bit of time and effort, the fundamentals are easy to understand. So let's begin.
Probabilities
“How do I get started?”
I hear that question a lot. Many people understand the importance of investing and building wealth but don't know where to turn. Interest rates have been historically low for quite some time, and traditional banking instruments like money markets and savings accounts are not offering much in the way of yields. So what choices exist when seeking returns on one's hard-earned money?
Before I dive into specific instruments, let me introduce the probability concept. There are a myriad of different opportunities available to investors today, and all of them have varying probabilities of success. We can never predict the future with certainty, and so investments decisions are based on expectations about probable outcomes. We might say, based on our expectations, that an outcome is likely, is probable, or has a good chance.
Just like risk and reward, probability and strategy selection are two sides of the same coin. You have no doubt heard the expression, “high risk, high reward.” It refers to the fact that investments that offer the highest rewards typically have the greatest risk. Playing the lottery is an example of an extreme high-risk, high-reward endeavor. There is a very high rate of failure, but a winning ticket would mean a big payoff. On the other hand, burying your life's savings in the backyard is probably a low-risk, low-reward scenario (although risks increase if you bury everything near the family dog's bone stash).
In trading options, and remember, options are simply pricing probabilities, a strategy that has a very high probability of success and a low probability of loss is likely to have smaller potential for profit. On the other hand, a strategy with a small probability of profit should generate a larger potential profit when successful.
In later chapters, we will explore simple probability concepts and ways to compute probabilities for various options strategies. The important point to take home for now is that various investments or strategies are more than just good or bad ideas. Each strategy has a quantifiable probability of success.
Getting Started
What investments have the greatest probability of helping you attain your goals? There's no one single right answer, because every individual and institution is different. It's like asking, what's the best car to buy? It really depends on what you're using it for.
The first step to finding appropriate investments is to outline longer-term goals and objectives. Obviously, we all want to build more wealth, but unless we outline a concise plan, we are unlikely to set money aside each month or invest on a regular basis to achieve our objectives. The best investment choices often depend on a person's age, ambitions, and investment time horizon. For instance, as you will see in later chapters, some options contracts exist for a mere week, while others have lives that span many years.