The option strategist

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  • 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. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED AS IS. McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WAR- RANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MER- CHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be unin- terrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccu- racy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. 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
  • 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. , ,
  • 4. To my wife, Lynda
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  • 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.
  • 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
  • 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
  • 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
  • 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.
  • 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,