The options strategist : how to invest and trade equity-related options : effective strategies from basic to advanced options on ETFs and index funds, techniques to protect your investments

264 Pages·2003·0.902 MB·English

by  Marc Allaire

THE
OPTIONS
STRATEGIST
How to Invest and Trade Equity-Related Options
EFFECTIVE STRATEGIES FROM BASIC TO ADVANCED
OPTIONS ON ETFs AND INDEX FUNDS
TECHNIQUES TO PROTECT YOUR INVESTMENTS
MARC ALLAIRE
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DOI: 10.1036/0071429050
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CONTENTS
Introduction ix
1 Options 101: Basic Terms, Definitions, and Strategies 1
The Basics 1
Vocabulary and Definitions 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
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vi Contents
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
Contents vii
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 Market’s Implied Volatility 223
The Greeks: Gamma 227
The Greeks: Theta 230
viii Contents
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
INTRODUCTION
THE 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
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x Introduction
explaining any strategies. By the time readers have plowed through
the theory, their heads are spinning and they can’t 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 don’t
hold any of their employer’s 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 nothave 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 butterfly 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 butterfly. 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 profitable positions when invest-
ing or trading with options or any financial instrument.
A participant in one of our seminars said he tried spreads and
concluded that they don’t 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 didn’t work the way I
expected them to work,” or “They didn’t work the way I expected
Introduction xi
them to work because I didn’t know what to expect from these
strategies.” This trader’s knowledge of spreads was probably lim-
ited to their risk and reward at just two points in time—the 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 fictional ones in
our illustrations. Readers find 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
five-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 (www.cboe.com under the Trading Tools tab). Readers
will find 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 firms are significantly lower than they
were a decade or two ago, and that the breakpoint (the number of
xii Introduction
contracts at which transaction costs become negligible) has moved
significantly 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 option’s value. Increase
the size of the trade to five 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 would like to specifically thank Bernard and Denis,
who took a chance on a rookie with very little option know-how;
Guy and Robin, who helped us develop our presentation skills; Bill
and Larry, who gave us free rein and let us develop as an option
strategist; and Curtis, who created a position for us when we
decided that after so many years in the educational field, it was time
to get our hands dirty again.
We also want to thank the staff of The Options Institute at the Chi-
cago Board Options Exchange who compiled all the data required
for our historical analyses.
Two people reviewed the first draft of this manuscript. Marty
Kearney, with whom we collaborated on our Understanding LEAPS
book, provided comments that helped us clarify some of the more
technical points, and detected inaccuracies. Lynda Walker, who
made time in her very busy schedule, tried to curb our run-on sen-
tences and made numerous suggestions to clarify the presentation
of the strategies.
Finally, Stephen Isaacs, our editor, and Craig Bolt, our project edi-
tor, answered our numerous questions, kept us on schedule, and
guided us through the process of producing a book.
To these and all those who contributed to this book, many thanks.
For any remaining errors, of omission or commission, we take full
responsibility.