The option strategist

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<ul><li> 1. THE OPTIONS How to Invest and Trade Equity-Related Options MARC ALLAIRE EFFECTIVE STRATEGIES FROM BASIC TO ADVANCED OPTIONS ON ETFs AND INDEX FUNDS TECHNIQUES TO PROTECT YOUR INVESTMENTS STRATEGIST </li> <li> 2. Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be repro- duced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior writ- ten permission of the publisher. 0-07-142905-0 The material in this eBook also appears in the print version of this title: 0-07-140895-9. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occur- rence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. For more information, please contact George Hoare, Special Sales, at or (212) 904-4069. TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (McGraw-Hill) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engi- neer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sub- license the work or any part of it without McGraw-Hills prior consent. You may use the work for your own non- commercial and personal use; any other use of the work is strictly prohibited. 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McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possi- bility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. DOI: 10.1036/0071429050 </li> <li> 3. Want to learn more? We hope you enjoy this McGraw-Hill eBook! If you d like more information about this book, its author, or related books and websites, please click here. , , </li> <li> 4. To my wife, Lynda </li> <li> 5. This page intentionally left blank. </li> <li> 6. CONTENTS Introduction ix 1 Options 101: Basic Terms, Denitions, and Strategies 1 The Basics 1 Vocabulary and Denitions 4 Options Pricing: The Basics 10 The Four Basic Options Strategies 11 2 Basic Investment Strategies 29 Covered Writing 30 The Buy/Write 33 Rolling Strategies 39 v For more information about this title, click here. Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use. </li> <li> 7. Buying Protective Puts 43 Purchasing Call Options 45 Writing Equity Put Options 49 3 Basic Trading Strategies 55 Buying Calls 55 Buying Puts 68 4 Options 401: Option Pricing, Volatility, and a First Greek Letter 77 Option Pricing: Beyond the Basics 78 Volatility or Volatilities 89 The Greeks: Delta 94 The Risks of Early Assignment 100 5 Advanced Investment Strategies 103 Covered Straddles and Combinations 103 The Repair Strategy 111 Leveraging an Equity Position 118 More Later 125 6 Advanced Trading Strategies 127 Bull Call Spreads 127 Bear Put Spreads 135 Credit Spreads 137 Buying Volatility 141 vi Contents </li> <li> 8. Strangles 146 Buying Volatility: Call Back Spreads 148 Buying Volatility: Put Back Spreads 151 Selling Volatility: Straddles and Front Spreads 155 Synthetics 159 Buying Calls to Hedge a Short Stock 163 7 Options on Exchange-Traded Funds and on Indices 167 Options on Exchange-Traded Funds 167 Investment Strategies with Options on ETFs 168 Index Options: Special Features 171 Index Options: Investment Strategies 176 Index Options: Trading Strategies 183 8 Hedging Corporate Stock and Options 201 Equity Collars 202 The Two Half-Collars: Buying Puts, Writing Calls 207 Hedging Corporate Stock Options 212 9 Options 901: Advanced Theoretical Notions 217 Calculating Historical Volatility 218 Do the Markets Have the Monday Morning Blues? 220 Calculating Implied Volatility 222 The Markets Implied Volatility 223 The Greeks: Gamma 227 The Greeks: Theta 230 Contents vii </li> <li> 9. The Greeks: Vega 231 The Greeks: Rho 232 The Relationship Among the Greeks 233 Understanding the Black-Scholes Option Pricing Equation 234 A Note on Beta 236 Option Pricing and Interest Rates 236 Extra! Options Offered Below Intrinsic Value! 239 10 Tactical Considerations 241 Risk Management 241 Earning Your Stripes 245 Options in Tax-Deferred Plans 246 Options and Taxes 246 Finding Your Style 249 Index 251 viii Contents </li> <li> 10. INTRODUCTION T HE MAIN PURPOSE OF A BOOK TITLED The Options Strate- gist is self-explanatory: to present and explain different options strategies. Still, the contents and the structure of this book are based on a number of assumptions that we would like to set out. A major assumption is that people who use options fall into two broad categories: investors and traders. We made this distinction several years ago in a chapter titled Investing and Trading Strate- gies for the Individual Investor, which appears in Options: Essen- tial Concepts and Trading Strategies. In reality, most options users are neither pure investors nor pure traders. They invest part of their capital and trade with their mad money. This distinction led us to group the investment strategies in Chapters 2 and 5 and the trad- ing strategies in Chapters 3 and 6. Chapter 7, which deals with the special features of index options, presents both investing and trad- ing strategies. To understand any option strategy, some theoretical knowledge is necessary, but many options books present all of the theory before ix Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use. </li> <li> 11. explaining any strategies. By the time readers have plowed through the theory, their heads are spinning and they cant see the connec- tion between the theory and the strategies. We took a different tack. We believe that basic theory is necessary to understand basic options strategies, and more advanced theory is required for more advanced strategies. Thus, the basic theory pre- sented in Chapter 1 should help the reader understand the strate- gies presented in Chapters 2 and 3. The more advanced concepts in Chapter 4 lay the groundwork for the strategies in Chapters 5, 6, and 7. Chapter 8 looks at ways to hedge positions in corporate stock and options. Some of the strategies in that chapter could have been included with the other advanced strategies, so readers who dont hold any of their employers stock should resist the urge to skip Chapter 8. Chapter 9 goes back to theoretical notions, with more in- depth discussions of volatility, time decay, options valuation, and other concepts that were introduced in earlier chapters. Although this information is helpful, it is not critical in implementing trading or investing strategies; hence, there are no strategy chapters that fol- low Chapter 9. Finally, Chapter 10 discusses tactical considerations, since there is more to using options successfully than simply mas- tering all of the strategies. One goal we did not have was to maximize the number of strate- gies covered. Instead, we decided to concentrate on strategies the average investor can implement. In keeping with this restriction, we adhered to two principles: First, not all strategies are created equal and therefore do not get equal time. Compare the number of pages dedicated to the various aspects of buying calls to the number allo- cated to buttery spreads. We know from experience that just about everybody who trades options ends up buying calls sooner or later, but very few people ever initiate a buttery. Second, we found it necessary to present certain strategies just to caution our readers away from them. This may sound negative, but not losing money is just as important as establishing protable positions when invest- ing or trading with options or any nancial instrument. A participant in one of our seminars said he tried spreads and concluded that they dont work. After a little prodding, we found that if he had been aware of Regulation FD (full disclosure), a more accurate comment would have been, They didnt work the way I expected them to work, or They didnt work the way I expected x Introduction </li> <li> 12. them to work because I didnt know what to expect from these strategies. This traders knowledge of spreads was probably lim- ited to their risk and reward at just two points in timethe day the trade was initiated and at option expiration. An analysis of an option strategy is often limited to these two dates, but we have gone to great lengths to analyze how options positions can be expected to behave between the trade date and option expiration. Most read- ers will be surprised at how options can behave, especially in a com- plex position that involves more than one option. Certain advanced trading strategies are presented as equity strategies in Chapter 6, and others as index option strategies in Chapter 7. Readers should keep in mind that call back spreads, for example, can also be used with equity options, even though the only example in this book involves index options. A few housekeeping items regarding the examples in this book: We used both actual stocks and options prices and ctional ones in our illustrations. Readers nd it easier to relate to names they know, but to illustrate a point that requires a stock trading at exactly $50, we found it easier to refer to Nifty Fifty Inc. trading at the required level. As of this writing, options priced under $3 trade in ve-cent increments (i.e., $2.50, $2.55, $2.60) and options priced above $3 in ten-cent intervals (i.e., $3.40, $3.50, $3.60). In examples where we calculated theoretical prices to illustrate a point, we nar- rowed the pricing increments to a penny (i.e., $3.17 or $5.14), espe- cially where rounding these prices would have obscured the small changes we were trying to illustrate. In most instances where we calculated theoretical prices, we used the options pricing software available on-line on the website of the Chicago Board Options Exchange ( under the Trading Tools tab). Readers will nd this pricing tool to be adequate for most everyday situa- tions. (And in the spirit of Regulation FD, we note that we do act as an occasional consultant to the CBOE.) Most of our examples make no references to two real-life issues: trading fees and taxes. We are fully aware of the impact these can have, but illustrations such as you buy one call option on your favorite stock would not make any economic sense if transaction fees were included. The bad news is that trading options usually requires buying or selling more than one contract. The good news is that commissions at certain rms are signicantly lower than they were a decade or two ago, and that the breakpoint (the number of Introduction xi </li> <li> 13. contracts at which transaction costs become negligible) has moved signicantly lower. As an example, assume commissions of $25 per trade plus $2 per option, a rate that is neither the lowest available nor the highest. Buying one option at $2 (a value of $200) would generate trading fees of $27, or 13.5% of the options value. Increase the size of the trade to ve options and the commission rises to $35, which now represents 3.5% of the total option value. On 10 con- tracts, fees are $45, and only 2.3% of the options value. You get the picture. As far as taxes, we have made some brief comments in Chapter 10. The long and short of it is that options are securities, so traders and investors will end up with capital gains or losses if they use options. It would be futile to try to acknowledge everyone who has fur- thered our understanding of options during the past two decades. Nonetheless, we...</li></ul>