The Option Trader Handbook

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1 The Option Trader Handbook Strategies and Trade Adjustments GEORGE M. JABBOUR, PhD PHILIP H. BUDWICK, MsF John Wiley & Sons, Inc.

3 The Option Trader Handbook

4 Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers professional and personal knowledge and understanding. The Wiley Trading series features books by traders who have survived the market s ever changing temperament and have prospered some by reinventing systems, others by getting back to basics. Whether a novice trader, professional or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future. For a list of available titles, please visit our Web site at

5 The Option Trader Handbook Strategies and Trade Adjustments GEORGE M. JABBOUR, PhD PHILIP H. BUDWICK, MsF John Wiley & Sons, Inc.

6 Copyright 2004 by George Jabbour and Philip Budwick All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, , fax , or on the web at www. copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, , fax Limit of Liability/Disclaimer of Warranty: While the publisher and authors have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at , outside the United States at or fax Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at Library of Congress Cataloging-in-Publication Data: Jabbour, George (George Moussa) The option trader handbook : strategies and trade adjustments / George Jabbour, Philip Budwick. P. cm. ISBN (cloth : alk. paper) 1. Options (Finance) 2. Options (Finance) Prices. 3. Stock options. I. Budwick, Philip. II. Title. HG6024.A3 J '53 dc Printed in the United States of America

7 Contents Preface xi CHAPTER 1 Trade and Risk Management 1 Introduction 1 The Philosophy of Risk 2 Truth about Reward 5 Risk Management 7 Risk 7 Reward 10 Breakeven Points 11 Trade Management 12 Trading Theme 12 The Theme of Your Portfolio 15 Diversification and Flexibility 16 Trading as a Business 16 Start-Up Phase 17 Growth Phase 20 Mature Phase 20 Just Business, Nothing Personal 21 SCORE The Formula for Trading Success 22 Select the Investment 22 Choose the Best Strategy 24 Open the Trade with a Plan 24 Remember Your Plan and Stick to It 26 Exit Your Trade 27 CHAPTER 2 Tools of the Trader 29 Introduction 29 Option Value 30 v

8 vi CONTENTS Option Pricing 31 Stock Price 32 Strike Price 32 Time to Expiration 32 Volatility 32 Dividends 33 Interest Rates 33 Time Value Premium 33 Time Decay 33 Early Assignment 36 Implied Volatility 38 Synthetic Positions 41 Synthetic Stock 42 Synthetic Call 44 Synthetic Put 46 Basic Strategies 47 Long Call 47 Short Call 48 Long Put 48 Short Put 50 Basic Spreads and Combinations 50 Bull Call Spread 51 Bull Put Spread 51 Bear Put Spread 52 Bear Call Spread 53 Long Straddle 54 Long Strangle 54 Short Straddle 56 Short Strangle 57 Advanced Spreads 58 Call Ratio Spread 58 Put Ratio Spread 59 Call Ratio Backspread 60 Put Ratio Backspread 61 Long Butterflies 62 Short Butterflies 63 CHAPTER 3 Long Stock 65 Introduction 65 Protective Put 66 Stock Moves Higher 69 Stock Moves Lower 71

9 Contents vii Bear Put Spread 74 Rolling from a Protective Put into a Bear Put Spread 76 Rolling from a Bear Put Spread into a Protective Put 78 Call Replacement 80 Stock Moves Higher 81 Stock Moves Lower 82 Call Replacement versus Protective Put 83 Sell Covered Calls 83 Stock Moves Higher 85 Strike Selection 87 In the Money Calls 88 Time to Expiration 91 Scaling-Out Strategy 92 Collars 94 Opening Position Regular Collar 94 Stock Moves Higher Profit Collar 97 Ratio Write 100 Opening Position 101 Stock Moves Higher Regular Ratio Write 103 Stock Moves Higher Variable Strike Ratio Write 110 Stock Moves Lower Ratio Write/Variable Strike Ratio Write 114 Short Straddle/Short Strangle 117 Opening Position Short Straddle 117 Opening Position Short Strangle 121 Stock Moves Higher Short Straddle 123 Stock Moves Higher Short Strangle 129 Stock Moves Lower Short Straddle/Stock Repair 133 Stock Moves Lower Short Strangle 137 Call Ratio Spread 140 Opening Position 143 Stock Moves Higher 147 Stock Moves Lower Stock Repair Strategy 152 Call Calendar Spread 155 Opening Position 156 Stock Moves Higher 158 CHAPTER 4 Short Stock 163 Introduction 163 Protective Call Insurance 165 Opening Position Protective Call 165 Opening Position Protective Call Spread 170 Short Stock Protective Call Long Put 172

10 viii CONTENTS Stock Moves Lower Protective Call 174 Stock Moves Lower Protective Call Spread 177 Rolling between Protective Calls and Protective Call Spreads 181 Stock Moves Higher 183 Put Replacement 185 Stock Moves Lower 186 Stock Moves Higher 188 Put Replacement versus Protective Call 189 Covered Puts 190 Stock Moves Lower 191 Short Collars 196 Opening Position Regular Collar 197 Stock Moves Lower Profit Collar 199 Put Ratio Write 201 Opening Position 202 Stock Moves Lower Regular Ratio Write 205 Stock Moves Lower Variable Strike Ratio Write 210 Put Ratio Spread 212 Opening Position 212 Stock Moves Lower 215 Stock Moves Higher Short Repair Strategy 218 CHAPTER 5 Calls and Puts 221 Introduction 221 Long Call 222 Protective Put Stock Moves Higher 222 Protective Put Stock Moves Lower 224 Call Replacement 226 Rolling into a Bull Call Spread Stock Moves Higher 229 Rolling into a Bull Call Spread Stock Moves Lower/Call Repair Strategy 231 Rolling into a Bear Call Spread 232 Short Stock 235 Rolling into a Synthetic Straddle 236 Rolling into a Calendar Spread 237 Rolling into a Ratio Spread 240 Stock Moves Lower Call Repair Strategy 244 Short Call 248 Long Put 249 Protective Call 250 Put Replacement Therapy 253

11 Contents ix Rolling into a Bear Put Spread 255 Rolling into a Bull Put Spread 259 Long Stock/Synthetic Straddle 260 Put Calendar Spread 265 Put Ratio Spread 267 Short Put 273 CHAPTER 6 Spreads 277 Introduction 277 Bull Call Spreads/Bear Put Spreads 277 Protective Puts/Protective Calls 278 Convert to Ratio Spreads 283 Convert to Butterflies 297 Bear Call Spreads/Bull Put Spreads 300 Calendar Spreads 301 Call Calendar Spread 301 Put Calendar Spread 305 CHAPTER 7 Combinations 311 Introduction 311 Long Straddle 311 Straps/Strips 312 Modified Straps/Strips 315 Calendar Straddle 318 Rolling a Long Straddle into an Iron Butterfly 320 Diagonal Iron Butterfly 321 Partial Iron Butterfly 322 Long Call/Long Put Adjustments 323 Long Strangle 323 Diagonal Iron Butterfly 324 Calendar Strangle 325 Long Call/Long Put Adjustments 326 Short Straddle/Short Strangle 326 Short Straddle 327 Short Strangle 329 Index 331

13 Preface Option trading is both an art and a science. The science of option trading is very straightforward and mechanical and involves the specific steps in establishing a position, pricing, and understanding how movements in the underlying stock affect your trades. The art of trading, on the other hand, involves the use of your imagination and ingenuity. The market is your canvass and you coordinate different strategies and adjustments to create a unique painting, which is your portfolio. As mechanical as option trading seems, to be truly successful you will need to apply your own artistic style with respect to developing strategies and making trade adjustments. This book is about the art of making trade adjustments. Making an adjustment to a stock or option position is one of the most overlooked and underutilized skills in trading. Moreover, it is one area where your personal style and imagination are valued over any other quantitative trading skill. Options give you the flexibility to trade markets in any direction, or with no direction at all, and for as long or as short a time period as you want. Just as eight simple musical notes can be combined to make an infinite number of symphonies and songs, calls and puts also can be combined in a number of ways, using different expiration dates and strike prices, to create an almost infinite number of positions and follow-up adjustments. Using the right trade adjustment can hedge or even boost your profits, limit your losses, and create risk-free trades. Trade adjustments can also be used to repair losing positions. Whether you invest using only stocks, only options, or both, the information in this book is intended to give you the tools you need to improve your trading skills and performance. The material in this book presents the art of trade adjustments in a logical sequential order. First, we discuss the most important aspect of investing risk and trade management. Trade adjustments are tools used to implement trade and risk management. Therefore, you cannot understand how to use the tools if you are not aware of the theory behind them. That is why in the first chapter we present the guiding principles of risk and trade management and describe how to apply them to manage your xi

14 xii PREFACE portfolio. We discuss investment and portfolio themes and how to develop a professional approach to your trading. Finally, we detail our formula for trading success, known as SCORE, which not only teaches you how to incorporate our principles of risk and trade management into your daily trading, but also lays out a complete step-by-step trading and portfolio management system. After you have learned the theory, you need to know the right tools for effectively putting the theory into practice. Chapter 2 provides an overview of the tools you will need to control your risk, take advantage of the benefits of options, and make adjustments to your positions. This book is not meant for the pure beginner in options; we assume that the reader has a minimal understanding of how options work and a familiarity with the basic strategies. Nonetheless, we provide a quick overview of the most important characteristics of options and various strategies to remind the reader of the terms and strategies that are used throughout the book. The trade adjustments discussed range from basic to quite complex. Therefore, a general background in option strategies is required and presented in Chapter 2. We also discuss implied volatility and time decay, two often overlooked option characteristics, which, if used effectively, can reduce many common mistakes made by most traders. Once you have learned the theory and the tools to put that theory into practice, you are ready to learn the art of trade adjustments. The remaining chapters discuss how to adjust various trading positions to lock in a profit, hedge against a loss, or boost an overall profit. Each chapter covers a different type of underlying position and all the possible adjustments that can be made to that position, whether the underlying stock moves higher or lower, or even if it moves sideways. We start with long and short stock positions and the various adjustments you can make using options. We also deal with basic and advanced call and put positions and cover adjustments to more advanced strategies such as spreads and combinations. The strategies and adjustments in the book continually build on information presented in previous chapters. Therefore, you are encouraged to read the book straight through because the strategies and adjustments become more complex and follow a natural progression. However, most traders will probably use the text as a reference handbook and go directly to the chapter or strategy they are interested in reading about. In later chapters you may find references to earlier chapters or find short summaries of position analysis where the relevant background to a specific strategy was presented earlier in the handbook. We tried whenever possible to make it easy for the handbook users to read up on the specific strategy they are interested in and find all the information they need in one place. However, you will find that all

15 Preface xiii the strategies and adjustments complement each other and you will gain a better understanding of the art of trading by first reading the chapters in order. Thereafter, you can keep the handbook at your side and use it as a trading reference. Within each chapter, we use numerous examples to demonstrate the different trade adjustments using real stocks. The stocks used as examples are merely for illustrative purposes and in no way are to be construed as an investment opinion on whether to buy or sell such securities. Whenever we quote stock or option prices or specific strategy costs, we are estimating the premiums on the given options based on market prices at the time of writing for purposes of illustrating the given strategies and adjustments. The prices quoted for each option are the assumed prices you would hypothetically buy or sell those options for in each example and we ignore bid/ask spreads. When calculating the profit and loss for each strategy or adjustment as well as for the risk/reward profile charts contained in each chapter, we assume that the relevant options are at expiration and worth only their intrinsic value, if any. The positions can be terminated at any time prior to expiration either by closing the position or exercising the options. However, the only time we know the exact value of the option is on its expiration day, so we assume all positions are held to expiration. For simplicity, the profit calculations also exclude commissions, taxes, and other transaction costs as well as the effect of the time value of money. When discussing option pricing in Chapter 2, we present the Black Scholes option pricing model merely for purposes of explaining the different option pricing factors and how they affect the price of the option. Although the formula assumes that the options are European style, we apply the price sensitivity factors in the Black Scholes model to American-style equity options discussed in the handbook to simplify the explanation of how each pricing factor can affect the value of a call or a put. The number of possible trade adjustments to the positions we cover in the handbook is almost infinite and we could not possibly cover every single trading scenario or contingency. We try to present the best possible trade adjustments given the movement of the underlying stock and even present some adjustments that we do not recommend, for the sake of being as complete as possible. The number of possible adjustments that can be made is limited only by your imagination, so feel free to take what you read one step further whenever practical. Moreover, there are some strategies to which we did not cover trade adjustments. Because most complex option positions can be broken down into more familiar simple strategies already covered in this handbook, you can easily take the adjustments covered here and apply them

The Option Trader Handbook

The Option Trader Handbook Strategies and Trade Adjustments Second Edition GEORGE VI. JABBOIiR, PhD PHILIP H. BUDWICK, MsF WILEY John Wiley & Sons, Inc. Contents Preface to the First Edition Preface to