Table Of Content

NUIF NEW YORK INSTITUTE OF FINANCE NEW YORK • TORONTO • SYDNEY • TOKYO • SINGAPORE NEW YORK INSTITUTE OF FINANCE NYIF and New York Institute of Finance ar; trademarks of Executive Tax Reports, Inc., used under license by Penguin Putnam Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. -From a Declaratlon of Principles jointly adapted by a Committee of the American Bar Association and a Committee of Publishers and Associations. Copyright © 2002 by Penguin Putnam Inc, Prentice Hall® is a registered trademark of Pearson Education, Inc. All rights reserved. No part of this book may be reproduced in any form or by any means, without per mission in writing from the publisher. Library of Congress Cataloging-in-Publication Data McMillan, L. G. (Lawrence G.) Options as a strategic investment/ Lawrence G. McMillan. - 4th ed. p.cm. Includes index. ISBN 0-7352-0197-8 (cloth) 1. Options (Finance) I. Title. HG6042.M35 2001 332.63'228-dc21 00-053319 Associate Publisher: Ellen Schneid Coleman Production Editor: Mariann Hutlak Interior Design/Formatting: Inkwell Publishing Services Printed in the United States of America 10 9 8 7 6 5 4 3 ISBN 0-7352-0197-8 Most NYIF and New York Institute of Finance books are available at special quantity discounts for bulk purchases for sales promotions, premiums, fund-raising, or educational use. Special books, or book excerpts, can also be created to fit specific needs. For details, write: Special Markets, Penguin Putnam Inc., 375 Hudson Street, New York, New York 10014. Contents Preface .......................................................... xv Part I BASIC PROPERTIES OF STOCK OPTIONS Chapter 1 Definitions ................................................. 3 Elementary Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Factors Influencing the Price of an Option .... ........................... 9 Exercise and Assignment: The Mechanics ............................... 15 The Option Markets ................................................ 22 Option Symbology ................................................. 23 Details of Option Trading ........................................... 27 Order Entry ...................................................... 32 Profits and Profit Graphs ........................................... 34 Part II CALL OPTION STRATEGIES Chapter2 Covered Call Writing ........................................ 39 The Importance of Covered Call Writing ............................... 39 Covered Writing Philosophy ......................................... 42 The Total Return Concept of Covered Writing ........................... 45 Computing Return-on Investment ..................................... 47 iii iv Contents Execution of the Covered Write Order ................................. 56 Selecting a Covered Writing Position ................................... 58 Writing against Stock Already Owned. ................................. 62 Diversifying Return and Protection in a Covered Write .................... 66 Follow-Up Action ........ .......................................... 70 Special Writing Situations ........................................... 87 Covered Call Writing Summary ...................................... 93 Chapter3 Call Buying ................................................ 95 Why Buy? ....................................................... 95 Risk and Reward for the Call Buyer ................................... 97 Which Option to Buy? .............. ............................... 101 Advanced Selection Criteria ........................................ 103 Follow-Up Action ............... .................................. 107 A Further Comment on Spreads ..................................... 117 Chapter4 Other Call Buying Strategies ................................ 118 The Protected Short Sale (or Synthetic Put) ............................ 118 Follow-Up Action ................................................. 122 The Reverse Hedge (Simulated Straddle) ...... ......................... 123 Follow-Up Action ...... ........................................... 126 Altering the Ratio of Long Calls to Short Stock .......................... 128 Summary ....................................................... 131 Chapter 5 Naked Call Writing ........................................ 132 The Uncovered (Naked) Call Option .... .............................. 133 Investment Required ............ .................................. 135 The Philosophy of Selling Naked Options .............................. 137 Risk and Reward ................................................. 138 Summary ....................................................... 144 Chapter 6 Ratio Call Writing ......................................... 146 The Ratio Write .................................................. 146 Investment Required .... ....................._ . .................... 150 Contents V Selection Criteria ................................................. 151 The Variable Ratio Write ........................................... 155 Follow-Up Action ................................................. 158 An Introduction to Call Spread Strategies .. ............................ 168 Chapter7 Bull Spreads .............................................. 172 Degrees of Aggressiveness .......................................... 175 Ranking Bull Spreads ............................................. 176 Follow-Up Action ................................................. 179 Other Uses of Bull Spreads ......................................... 180 Summary .... ................................................... 185 Chapter 8 Bear Spreads Using Call Options ............................ 186 The Bear Spread ................................................. 186 Selecting a Bear Spread ... ......................................... 189 Follow-Up Action ................................................. 190 Summary ......... .............................................. 190 Chapter9 Calendar Spreads .......................................... 191 The Neutral Calendar Spread ..... .................................. 192 Follow-Up Action ................................................. 194 The Bullish Calendar Spread ... ..................................... 196 Follow-Up Action ........ ......................................... 197 Using All Three Expiration Series .................................... 198 Summary ....................................................... 199 Chapter 10 The Butterfly Spread ....................................... 200 Selecting the Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 Follow-Up Action ... .............................................. 206 Summary ....................................................... 209 Chapter 11 Ratio Call Spreads ......................................... 210 Differing Philosophies ............................................. 213 vi Contents Follow-Up Action ..... ............................................ 217 Sumniary ....................................................... 221 Chapter 12 Combining Calendar and Ratio Spreads ...................... 222 Ratio Calendar Spread ............................................ 222 Choosing the Spread .............................................. 225 Follow-Up Action ... .............................................. 226 Delta-Neutral Calendar Spreads ....... .............................. 227 Follow-Up Action ... .............................................. 229 Chapter 13 Reverse Spreads ........................................... 230 Reverse Calendar Spread ........................................... 230 Reverse Ratio Spread (Backspread) ................................... 232 Chapter 14 Diagonalizing a Spread ..................................... 236 The Diagonal Bull Spread .......................................... 236 Owning a Call for "Free" ............ ............................... 239 Diagonal Backspreads ............................................. 240 Call Option Sumniary ............................................. 241 Part III PUT OPTION STRATEGIES Chapter 15 Put Option Basics . ....................................... ~ " 245 Put Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 Pricing Put Options ............................................... 247 The Effect of Dividends on Put Option Premiums ........................ 248 Exercise and Assignment ........................................... 250 Conversion ...................................................... 253 Chapter 16 Put Option Buying . ........................................ 256 Put Buying versus Short Sale .. ...................................... 256 Selecting Which Put to Buy ......................................... 258 Contents vii Ranking Prospective Put Purchases ................................... 261 Follow-Up Action ................................................. 262 Loss-Limiting Actions ............................................. 267 Equivalent Positions .. ............................................. 270 Chapter 17 Put Buying in Conjunction with Common Stock Ownership ..... 271 Which Put to Buy ................................................ 273 Tax Considerations ............................................... 275 Put Buying As Protection for _the Covered Call Writer .................... 275 No-Cost Collars .................................................. 278 Chapter18 Buying Puts in Conjunction with Call Purchases ............... 281 Straddle Buying .................................................. 282 Selecting a Straddle Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285 Follow-Up Action ................................................. 285 Buying a Strangle ................................................ 288 Chapter 19 The Sale of a Put ..................................... : .... 292 The Uncovered Put Sale ............................................ 292 Follow-Up Action .......... ....................................... 295 Evaluating a Naked Put Write ....................................... 296 Buying Stock below Its Market Price .................................. 299 The Covered Put Sale ............................................. 300 Ratio Put Writing ................................................. 300 Chapter 20 The Sale of a Straddle ...................................... 302 The Covered Straddle Write ........................................ 302 The Uncovered Straddle Write ...................................... 305 Selecting a Straddle Write .......................................... 307 Follow-Up Action ....... .......................................... 308 Equivalent Stock Position Follow-Up .................................. 312 Starting Out with the Protection in Place .............................. 313 Strangle (Combination) Writing ..................................... 315 Further Comments on Uncovered Straddle and Strangle Writing ............ 318 viii Contents Chapter21 Synthetic Stock Positions Created by Puts and Calls ............ 321 Synthetic Long Stock .............................................. 321 Synthetic Short Sale ............................................... 323 Splitting the Strikes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325 Summary ....................................................... 328 Chapter22 Basic Put Spreads .......................................... 329 Bear Spread ..................................................... 329 Bull Spread ..................................................... 332 Calendar Spread ................................................. 333 Chapter 23 Spreads Combining Calls and Puts ........................... 336 The Butterfly Spread .............................................. 336 Combining an Option Purchase and a Spread ........................... 339 A Simple Follow-Up Action for Bull or Bear Spreads ..................... 342 Three Useful but Complex Strategies .................................. 345 Selecting the Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 Summary ........................................................ 356 Chapter 24 Ratio Spreads Using Puts ................................... 358 The Ratio Put Spread .............................................. 358 Using Deltas ..................................................... 361 The Ratio Put Calendar Spread ...................................... 361 A Logical Extension (The Ratio Calendar Combination) .... ............... 364 Put Option Summary .............................................. 366 Chapter 25 LEAPS ................................................... 367 The Basics ...................................................... 368 Pricing LEAPS ................................................... 369 Comparing LEAPS and Short-Term Options ............................ 374 LEAPS Strategies ................................................. 375 Speculative Option Buying with LEAPS ............................... 382 Selling LEAPS ................................................... 390 Contents ix Spreads Using LEAPS ............................................. 403 Sum111ary ....................................................... 409 PartIV ADDITIONAL CONSIDERATIONS Chapter 26 Buying Options and Treasury Bills ........................... 413 How the Treasury Bill/Option Strategy Operates ......................... 413 Sum111ary ....................................................... 421 Chapter 27 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422 Basic Put and Call Arbitrage ("Discounting") ........................... 423 Dividend Arbitrage ............................................... 425 Conversions and Reversals .......................................... 428 More on Carrying Costs ............................................ 430 Back to Conversions and Reversals ................................... 431 Risks in Conversions and Reversals ................................... 433 Sum111ary of Conversion Arbitrage ................................... 437 The "Interest Play". ... ............................................ 438 The Box Spread .................................................. 439 Variations on Equivalence Arbitrage .................................. 443 The Effects of Arbitrage ............................................ 444 Risk Arbitrage Using Options ....................................... 445 Pairs Trading .................................................... 454 Facilitation (Block Positioning) ...................................... 455 Chapter 28 Mathematical Applications . ................................. 456 The Black-Scholes Model ........................................... 456 Expected Return ................................................. 466 Applying the Calculations to Strategy Decisions ......................... 472 Facilitation or Institutional Block Positioning ........................... 482 Aiding in Follow-Up Action ......................................... 485 Implementation .................................................. 488 Sum111ary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 X Contents PartV INDEX OPTIONS AND FUTURES Chapter 29 Introduction to Index Option Products and Futures ............. 493 Indices ............................................ : ............ 493 Cash-Based Options .............................................. 500 Futures ........................................................ 506 Options on Index Futures .......................................... 512 Standard Options Strategies Using Index Options ........... ............. 516 Put-Call Ratio ................................................... 520 Summary ....................................................... 523 Chapter30 Stock Index Hedging Strategies . ............................. 531 Market Baskets .................................................. 531 Program Trading ................................................. 537 Index Arbitrage .................................................. 547 Follow-Up Strategies .............................................. 557 Market Basket Risk ............................................... 560 Impact on the Stock Market ......................................... 561 Simulating an Index ............................................... 566 Trading the Tracking Error .... ..................................... 574 Summary ....................................................... 577 Chapter31 Index Spreading ........................................... 579 Inter-Index Spreading .. ........................................... 579 Summary ....................................................... 588 Chapter32 Structured Products ........................................ 589 Part I: "Riskless" Ownership of a Stock or Index ........................ 590 The "Structure" of a Structured Product ............................... 590 Cash Value ...................................................... 593 The Cost of the Imbedded Call Option ................................ 594 Price Behavior Prior to Maturity ..................................... 595 SIS ............................................................ 596